HISTORY OF ECONOMIC

THOUGHT

Only Study Guide for ECS3705

Compiler: Piet-Hein van Eeghen

Department of Economics
University of South Africa
Pretoria
© 2012 University of South Africa

All rights reserved

Printed and published by the

University of South Africa
Muckleneuk, Pretoria

ECS3705/1/2013-2015
 iii ECS3705/1/2013-2015

CONTENTS
Page

INTRODUCTION ............................................................................................................................ 1

STUDY UNIT 1 ............................................................................................................................. 11

Mercantilists, physiocrats and classical forerunners

STUDY UNIT 2 ............................................................................................................................. 27

Adam Smith

STUDY UNIT 3 ............................................................................................................................. 40

Malthus, Ricardo and Mill

STUDY UNIT 4 ............................................................................................................................. 64

Socialism and Marx

STUDY UNIT 5 ............................................................................................................................. 81

The marginalist/neoclassical school, Marshall and Walras

STUDY UNIT 6 ............................................................................................................................. 96

The historical and institutionalist schools, Veblen and Galbraith

STUDY UNIT 7 ........................................................................................................................... 109

The Keynesian and Chicago schools and some concluding thoughts
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INTRODUCTION

MODULE OUTCOMES

Through a study of this module, you can look forward to acquire:

1 a better understanding of the present economic situation by way of a better understanding

of past economic situations.

2 a greater appreciation for the fact that many popular ideas which seem novel and
contemporary are, in fact, reformulations of old ideas.

3 a deeper insight into the thought world of famous economists of the past, like Adam Smith,
Karl Marx and John Maynard Keynes.

4 a better grasp of how economic thinking has developed over the centuries

5 an improved ability to evaluate old ideas and their relevance for the present

6 a better idea of the pros and cons of the various ideological systems as related to
economics

STUDY MATERIAL

The study material for this course consists of

• a prescribed book,
• a study guide (which you are presently holding in your hand) and
• a number of tutorial letters.

The prescribed book is:

Grant, Randy R, and Stanley L Brue, 2007. The history/evolution of economic thought. 7th
edition. Mason: Thomson South-Western.

We shall most commonly refer to the prescribed book as “the textbook” or as “Grant and Brue”.
If, for example, we wish to direct you to something on page 53 of Grant and Brue, we will write:
“textbook (2007: 53)”, “Grant and Brue (2007:53)”, or “(2007:53)” or simply “(p 53)”.

Because of the limited time available during a semester, we are unfortunately not in a position to
prescribe the whole book. Table 1 below gives an overview of the prescribed sections of the
textbook, which is not to say that the other sections are unimportant or uninteresting. You can
still read and study them with much benefit. Know, however, that they are not prescribed for the
examination. Again, only the prescribed sections given in table 1 need to be studied for the
examination.
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PRESCRIBED SECTIONS OF THE TEXTBOOK:

INTRODUCTION

• all of chapter 1

STUDY UNIT 1:
MERCANTILISTS, PHYSIOCRATS AND CLASSICAL FORERUNNERS

• chapter 2: only the sections “Overview of mercantilism” (pp. 13-20, excluding “2-1
Past as prologue” on p 17) and “2-2 Past as prologue: Lingering mercantilism” (pp. 21-
22)

• all of chapter 3, excluding “3- Past as prologue” (p. 41)

• chapter 4: only the sections “Overview of classical school” (pp 45-49) and “David
Hume” (pp. 54-57)

STUDY UNIT 2:
ADAM SMITH

• all of chapter 5, excluding “5-1 Past as prologue” (pp. 75-76)

STUDY UNIT 3:
MALTHUS, RICARDO AND MILL

• all of chapter 6

• chapter 8: only the section “Say's law of markets” (pp. 128-131)

• all of chapter 7, excluding “The currency question” (pp. 101—102), “Rent at the
intensive margin of cultivation” (pp. 104-105) and “7-1 Past as prologue” (pp. 109-110)

• chapter 8: only the section “John Stuart Mill” (pp. 135-146, excluding “The law of
international value” on pp. 142-143)

STUDY UNIT 4:
SOCIALISM AND MARX

• chapter 9: only the section “Overview of socialism” (pp. 149-155)

• all of chapter 10

STUDY UNIT 5:
THE MARGINALIST/NEOCLASSICAL SCHOOL, MARSHALL AND WALRAS

• chapter 12: only the section “Overview of marginalist school” (pp. 211-215)

• all of chapter 15, excluding “15-1 Past as prologue” (pp. 280-281), “15-2 Past as
prologue” (pp. 293-294), “Elasticity of demand” (pp. 283-284) and “Welfare effects of
taxes and subsidies” (pp. 315-317)

• chapter 18: only the section “Leon Walras” (pp. 347-351)

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STUDY UNIT 6:
THE HISTORICAL AND INSTITUTIONALIST SCHOOLS, VEBLEN AND GALBRAITH

• chapter 11: only the section “Overview of the German historical school” (pp. 193-197)

• all of chapter 19, excluding “19-1 Past as prologue” (pp. 376-377), “Wesley Clair
Mitchell” (pp. 384-388) and “19-2 Past as prologue” (pp. 393-394)

STUDY UNIT 7:
THE KEYNESIAN AND CHICAGO SCHOOLS AND SOME CONCLUDING THOUGHTS

• all of chapter 21, excluding “21-1 Past as prologue” (pp. 442-443)

• chapter 22: only the sections “The Phillips curve” (pp. 460-461), “The post-
Keynesians” (pp. 464-466) and “The new Keynesians” (pp. 466-469)

• all of chapter 24, excluding “24-1 Past as prologue” (pp. 505-506), “Consumption
Function (pp. 497-498) and “Gary S. Becker” (pp. 508-516)

• all of chapter 25

In addition to the prescribed book, this study guide is also part of the study material. To state
the obvious, a study guide is intended to function as a guide. At a residential university you
would have a lecturer to guide you through the course. At a distance learning institution like
Unisa that function is largely taken over by the study guide, which is not to say that your
lecturers will not try to do their utmost to give you additional assistance. Therefore, always feel
free to contact us by phone, post, or preferably email, with any query or question. Relevant
addresses and telephone numbers are provided in Tutorial letter 101.

The guide seeks to help you in the following ways:

• It divides the prescribed material in the textbook up into seven “bite-sized” chunks, called
study units, to which you were already introduced through table 1.

• It indicates a number of study outcomes for each study unit, which identify what you need
to know and understand to master that particular study unit. You can then direct your
studies towards obtaining that knowledge and understanding.

• It introduces each important historical person or school of thought with a section called
“Economics in Action”. These sections are intended to arouse your interest in these
historical persons or schools of thought by way of a fictional or real story or a
contemporary perspective on them. Under the rubric of “Economics in Action”, you are
also encouraged to answer certain questions, as a way of practically applying your
knowledge.

• Following the “Economics in Action” section, there is a section called “Content”, which
seeks to give you practical help in going through the relevant study material in the
textbook. Because the textbook is generally quite lucid, there will often be no need to
repeat what is already clearly set out there. Hence the “Content” section will, as a rule,
confine itself to some additional explanation and background information where deemed
necessary and appropriate. In the process, your lecturer will not shy away from giving his
own, at times controversial, opinion on theoretical as well as socio-economic issues under
 4

discussion, which will hopefully further liven up your studies. You should, of course, feel
no obligation whatsoever to agree with your lecturer.

• Under the heading of “Relevance for Today” we will occasionally interrupt our discussions
by expanding on a certain theme indicated in the study material, where that theme has
relevance for modern-day South Africa. “Relevance for Today” sections are typically
contained in a box. Once again, your lecturer will not shy away from given his own,
sometimes seriously controversial opinion in these sections, with which you should again
feel no obligation to agree. The “Relevance for Today” sections will occasionally also
contain questions intended to stimulate your thoughts.

• Each study unit ends with a section called “Economics in Action: Looking Back” which will
do exactly as the label suggests.

In addition to the prescribed book and the study guide, tutorial letters are also part of the study
material. Tutorial Letter 101 contains important information about the scheme of work,
resources and assignments for this module. Tutorial letters 201 and 202 will provide answers to,
and explanations of, the various hand-in assignments. A further Tutorial letter 301 contains
among other things information about the discussion classes (time, date, venue) and the format
and date of the exam.

There is plenty of opportunity to test and evaluate your progress when studying for this course:

• the questions at the end of each chapter in the textbook;

• two assignments which you can hand in and for which Tutorial letters 201 and 202 will
give you answers and explanations;

• the self-assessment assignment questions (mostly the textbook’s end-of-chapter

questions) contained in Tutorial letter 101, for which that same tutorial letter will give you
rough model answers as well;

• some old exam papers which will give you an idea of the type of questions asked;

• the discussion classes (see Tutorial letter 301 for particulars of date, time and venue),
during which you can ask questions and check how well you understand the work;

• a series of informal lectures given at Unisa offices by your lecturer, and their notes as
posted on MyUnisa. Note, however, that these informal lectures are voluntary for both you
and your lecturer. Hence there is no guarantee that they will be given at any given
semester. At the start of each semester you will be informed about whether the lectures
will take place. The lecture notes will typically be posted on MyUnisa after each lecture.

Make an effort to use all these opportunities to familiarise yourself with the prescribed work!

The examination questions will be based on the work identified in the above three study
materials: prescribed textbook, study guide and tutorial letters. Of course we encourage
you to read more widely and the textbook provides good suggestions for further reading after
each chapter, as well as in the appendix to chapter 1 (2007:9-12). The Unisa library, which truly
is world class and has just about everything (and if it does not have some book or article, it will
get it for you), is at your disposal. The service is free, included in your fees. Why not make use
of all that we’re offering you! Those of you who have access to the Internet will be interested in
following up some of the websites which the textbook suggests in the appendix to chapter 1
(2007:9-12).
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OVERVIEW OF THE COURSE

Because chapter 1 of the textbook provides a useful overview of the course, there is no need to
attempt our own here.

Pay particular attention to the “A Time Scale of Economic Ideas” (2007:2-3) appearing on the
inside of the front cover. Make sure you understand the logic of the graph with its various kinds
of arrows.

Take note of the “Five major questions” that the textbook (2007:3-6) plans to use in its
interrogation of the various schools of thought:

(1) What was the historical background?

(2) What were the major tenets?

(3) Whom did it benefit or seek to benefit?

(4) How was it valid, useful, or correct in its time?

(5) Which tenets became lasting contributions?

These are good questions, which facilitate penetrating discussion, as you are soon to find out.
Make sure you understand what the questions are about. In the context of question 1, pay
particular attention to the disagreement between those who argue that economic ideas are
primarily formed in reaction to the problems of the day and those who, by contrast, argue that
economic ideas are primarily formed in reaction to the logical inconsistencies and paradoxes
found in previous theories. In the context of question 4, the textbook points towards two
opposing dangers in the study of the history of ideas: either the danger of viewing “the latest as
the best” with the implicit suggestion that past writers were somewhat naive or ignorant, or the
danger of giving up all critical examination of past theory in the belief that what was written then
was fine for the time. The study of the history of ideas will have to steer something of a middle
course in this regard.

The above “five major questions” are used to examine the following schools of thought:
mercantilism in chapter 2 (2007:13), the physiocrats in chapter 3 (2007:33), the classical school
in chapter 4 (2007:45), socialism in chapter 9 (2007:149), the German historical school in
chapter 11 (2007:193), the marginalist school in chapter 12 (2007:211), the institutionalist
school in chapter 19 (2007:369), the Keynesian school in chapter 21 (2007:427) and the
Chicago school in chapter 24 (2007:493). As you can check in table 1, all this material is
prescribed for the examination.

Take careful note of the textbook’s discussion of “The value of studying economics and its
history” (2007:6-7). This discussion should motivate you in your studies, especially the remark:
“Hopefully, as our economic understanding grows and our mastery over social problems
increases, as our material well-being rises, as our appreciation of the cultural, aesthetic, and
intellectual facets of life enlarges, we will become more civilized, more humane, and more
considerate of each other” (2007:7-8). As far as your lecturer is concerned, this is indeed what
the study of the history of economic thought is all about.

Finally, do not ignore the appendix to chapter 1 (2007:9-12), as it really does provide useful
information for further study. If you have access to the internet, do try to have a look at some of
the relevant websites, which are interesting too.
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SOME EXTRA HISTORICAL BACKGROUND

In order to be able to understand the various schools of economic thought, a rudimentary

knowledge of European history of the time period between 1500 to the present is indispensable.
We will attempt to provide you with a very brief overview of that period in the hope that you will
find it interesting.

But before we come to that, some of you may wonder why the history of economic thought is so
overwhelmingly Eurocentric, dealing mainly with European economic thought against the
backdrop of European history. This Eurocentrism can be explained by the fact that crucial
economic phenomena such as a high degree of labour specialisation, intensive trade and the
resultant development of markets, the use of bank money and the industrial mode of production
manifested themselves earlier and more conspicuously in Europe than elsewhere. It is precisely
these phenomena which stimulated economic thought. Economic science developed because
people wanted to know why these phenomena occurred, what role they played in wealth
creation, what negative side-effects were associated with them, which sections of society they
benefited most, which government policies could be used to accelerate or slow down their
development or counteract their negative side-effects, and so on. Nonetheless, you will also
notice that many of the economic problems with which Europe grappled between 1500 and say
1900 are still very relevant for Africa today: wide differences between rich and poor; the
concentration of land ownership in the hands of a few; greedy capitalists; intrusive, corrupt and
wasteful governments, and suchlike. So the relevance of these phenomena and the issues that
arise from them is, by no means, confined to Europe. Whether we like it or not, we are all part of
a world with a high degree of labour specialisation, intensive trade, the use of bank money and
the industrial mode of production.

The period of the Middle Ages is generally considered to have come to an end around the year
1500. In the light of what we said in the previous paragraph, you will understand why the
textbook takes this year as its starting point. Medieval economic life, especially before 1200,
was fairly uncomplicated, centred on more or less self-sufficient agricultural communities.
Because labour specialisation had not progressed very far, there was relatively little trade (also
because transport was costly and unsafe) and markets were small. In short, medieval economic
processes were just not interesting enough to stimulate systematic analysis, except for the
consideration of ethical questions such as the determination of a just price or the admissibility of
charging interest. Only once labour specialisation and trade had gained some momentum,
which happened between 1200 and 1400 with the development of the late-medieval trade fairs,
did economic thinking start to develop. Cities existed in medieval times as well, but from around
1200 onwards they gradually became so rich and powerful that their prosperous merchants and
artisans were overtaking the medieval landed aristocracy in economic importance, although
traditional land-owning aristocracy still dominated the political arena. Mercantilism (derived from
the Latin for “merchant”) comprises a body of ideas and policies prevalent during this new
period of merchant capitalism.

The heyday of merchant capitalism and the dominance of mercantilist ideas runs from roughly
1500 until around the late 1700s and early 1800s, when the Industrial Revolution and the
publication of Adam Smith’s An inquiry into the nature and causes of the wealth of nations
(commonly abbreviated to The wealth of nations) inaugurated a new period of liberal-industrial
capitalism. Briefly and crudely stated, mercantilism was about the use of state power and state
intervention to enhance the competitive position of a country’s merchants vis-à-vis the
merchants of other countries. The aim was to stimulate such a country’s exports so that more
money-wealth (“treasure”) would flow into it, which the monarch could then tax to finance the
expansion of empire – particularly through a strong army and navy. To paint a fuller picture of
the mercantilist era, it may be interesting to note some of its most significant events and
developments, such as the discovery of America by Columbus in 1492 and the subsequent
rapid expansion of the Spanish and Portuguese colonial empires in Middle and South America,
the rise of Protestantism around 1500 and the ensuing religious wars all over Europe which
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lasted until around 1700, the reign of Elizabeth I (the most important Protestant monarch of her
time) in England from 1558 to 1603, the defeat of the Spanish Armada by English and to a
lesser degree Dutch ships in 1588, the birth of Shakespeare and Galileo in 1564, the birth of
Rembrandt in 1606 (who painted The Nightwatch in 1642), the height of Dutch commercial
power centred on Amsterdam between 1600 and 1700, the arrival of Jan van Riebeeck at the
Cape in 1652, the British overtaking of the Dutch in commercial importance around 1700 (British
economic supremacy lasting until roughly 1890, when first the United States and then Germany
overtook Britain in industrial output - but we are running ahead of our story), the birth of Adam
Smith in 1723, the death of Newton in 1727 and the birth of Mozart in 1756 who composed his
famous piano concertos between 1782 and 1786. As already indicated, the ending of the
mercantilist period was in no small measure due to the monumental influence of Adam Smith’s
The wealth of nations published in 1776, which incidentally was the same year that 12 British
colonies situated on the East coast of the North American continent gained independence from
Britain (after a fairly bloody war of independence), to form the United States of America.

Prior to the publication of The wealth of nations, there had already been an anti-mercantilist
movement in France called “the physiocracy”, which had, in fact, been an important inspiration
to Smith. The heyday of physiocratic thought ran from about 1760 to 1780, as you can read off
the textbook’s introductory “Time Scale” that we mentioned above. Because the physiocracy
was predominantly a French phenomenon, our description of its historical background can
confine itself to France. The economic resilience of France was finally broken after decades of
excessively high and unjust taxation, crippling mercantilist regulation, a corrupt state officialdom
and a wasteful government burdened by the court extravagance and warring of its Bourbon
kings - starting with the “Sun King” Louis XIV, and lasting until Louis XVI and his wife Marie
Antoinette who were beheaded during the French Revolution in 1793. In fact, the seeds of the
French Revolution, which broke out in 1789, were already clearly evident during the mercantilist
period, given the desperate situation of the French workers and peasants and the radicalism of
its intellectuals. This is speculation, but had some of the proposals of the physiocrats and Adam
Smith been implemented earlier, the destruction and bloodshed of the French Revolution and its
Napoleonic aftermath may, perhaps, have been avoided. Napoleon, incidentally, started his
public career as an officer in the revolutionary army of France. In the power vacuum which
ensued after the revolution had degenerated into chaos and the indiscriminate killing of even the
original revolutionary leaders themselves (“the revolution devours its own children”), Napoleon
seized control of France, made himself Emperor and started a campaign to conquer all of
Europe, which was again enormously wasteful both in human life and economic resources,
even if it gave France back some lost dignity. Napoleon was finally defeated in 1813 at the
battle of Waterloo by the combined forces of England, Holland and Germany, and was exiled to
the island of St Helena, where he died in 1823. There is a South African connection to this story:
when in exile on St Helena, Napoleon is reputed to have developed a taste for South African
wines, which were especially shipped out to him from the Cape.

The subsequent liberal-industrial period in Europe roughly covered the 19th century (the 1800s).
It was the period in which Adam Smith’s ideas about free trade and minimal government were
largely implemented, especially in Britain. These measures were indeed amazingly successful
in raising the average standard of living, not least of all because they coincided with what is
known as the Industrial Revolution. Industrialisation means that production processes are
increasingly performed by machines rather than by the strength and dexterity of the human
hand (sometimes aided by animals). Mechanisation obviously implied a great increase in
productivity and a reduction in prices. Britain was the first country to industrialise, as illustrated
by the fact that the steam engine (the first real machine) was patented there by James Watt in
1769. After the defeat of Napoleon, industrialisation spread rapidly all over Europe and
everywhere industrial manufacturing plants powered by steam engines sprang up. The 19th
century was indeed a period of tremendous scientific progress and cultural optimism.
Europeans were confident that, through the agencies of science and reason, society could
gradually evolve towards a state of happiness and fulfilment for all. The savagery and
 8

destruction of World War I (1914-1918) and the Russian Revolution of 1918 cruelly destroyed
that illusion.

Moreover, industrialisation proved to be a mixed blessing. On the one hand, it created scope for
large increases in productivity and made it possible for a broader section of society to live
comfortable middle-class lives. On the other hand, industrialisation, because it goes hand-in-
hand with increased capital intensity and a greater average size of firms, also created a greater
concentration of economic power and wealth in the hands of the people now owning the much
reduced number of firms. This trend towards concentration of economic power became even
more pronounced after the limited-liability corporation had become the dominant form of
industrial organisation around 1900. Previously only firms involved in international trade,
infrastructure and banking tended to be incorporated (or “chartered” as the term then was) while
the majority of manufacturing firms were still organised around families as proprietorships or
partnerships. In addition, the wages and working conditions of labourers were initially very poor,
giving rise to the socialist movement, the most important representative of which was, of course,
Marx. Marx was born in 1818 and (together with Engels) wrote the Communist manifesto in
1848.

The 19th century also inherited from its medieval past an extremely uneven distribution of land
ownership, whereby relatively few aristocratic landlords owned most of the agricultural land
which they rented out to tenant farmers for cultivation. This circumstance played an important
role in the economics of Ricardo, who published his Principles of political economy and taxation
in 1817. However, as industrialisation progressed and the relative contribution of agriculture
towards the national product fell, the concentration of ownership in agricultural land became a
less important contributory factor to inequality of income. Even so, in some cases
industrialisation meant enormous windfall gains for those aristocratic landlords whose ancestral
lands happened to lie around the new expanding centres of industrialisation and urbanisation,
which they could thus sell at massively increased prices. Some of the richest aristocratic
families in Europe amassed their fortune in precisely that way.

The liberal values of the 19th century had not only economic consequences. It soon became
evident that the greater rights and freedoms which governments granted to their citizens could
no longer be confined to the economic sphere; people wanted political freedoms and rights as
well. So the days of absolute monarchy (i.e. the system according to which sovereignty rests
with hereditary kings and queens) were numbered and most European countries indeed
became full-blown parliamentary democracies around the 1850s, although the vote was still far
from universal, women for example being excluded; universal suffrage had to wait another 60
years, to around 1910. Most monarchies transformed themselves into so-called “constitutional
monarchies”, whereby monarchs became little more than ceremonial figureheads. The United
States of America had, of course, preceded Europe in this trend towards democratisation by
already becoming a democracy at independence in 1776. The US is, in fact, the world’s oldest,
still existing democracy. Interestingly enough, precisely those European monarchies which did
not democratise during the 19th century, namely Imperial Germany, Austria and Russia, were
lost during the conflicts of the early 20th century (in particular World War I and the Russian
Revolution); there is no longer a German, Austrian or Russian monarchy, although the
respective royal families (Hohenzollern, Habsburg and Romanov) still exist. The main point to
be noted is that democracy too can be regarded as a manifestation of 19th century liberalism.
Capitalism (in the sense of free enterprise) and democracy (in the sense of representative
government, an elected parliament and freedom of expression through a free press) are closely
linked, both philosophically and historically.

The marginalist/neoclassical school of thought, which sprang up around the second half of the
19th century, remained classical, in that it broadly favoured the liberal values of free trade and
minimal government inherited from Smith, Ricardo and Mill. Its differences from the classical
school were more theoretical than ideological. Neoclassical theory rejected the typically
classical labour theory of value according to which value and price are determined solely from
 9 ECS3705/1

the supply side by labour cost (which Smith, Ricardo and Marx had in common). Instead, the
neoclassical school offered a theory of value according to which price is determined by the
interaction between supply and demand. The marginalist/neoclassical school was, of course,
also different from classical theory because it made more extensive use of the marginal
principle, meaning that it theorised in terms of profit or utility maximisation, which is reached
when cost equals revenue at the margin.

The negative side-effects of industrialisation, such as a relatively marked inequality of income

and concentration of economic power in the hands of a few, carried over into the 20th century.
There are, however, a few respects in which 20th century capitalism is different from its 19th
century predecessor. First, in the 20th century inequalities have to a greater degree been
counteracted by government measures to limit the power of firm owners and give extra power to
workers, particularly by stimulating the formation of trade unions. Second, 20th century
capitalism afforded a greater role for government to provide social security as well as various
social services like health care and education on an equal basis to all its citizens. Particularly
the provision of good-quality education for all meant that the opportunities for economic
advancement were open to a larger section of society than had ever been the case before. In
the light of this, it is a tragedy that South African state education for the previously
disadvantaged (especially at the primary and secondary level) is generally still of such a poor
quality.

All in all, some of the rougher edges of early capitalism were thus removed in the 20th century.
The irony is, however, that the cultural optimism of the 19th century had given way in the 20th
century to a greater cultural pessimism and sense of unease about the sustainability and moral
defensibility of the Western industrialised lifestyle. Although the average standard of living in the
most advanced capitalist nations is very high indeed, problems remain. There is an ever-
widening gap between rich and poor, within nations as well as between nations; there is an
ever-increasing concentration of economic power in the hands of relatively few big corporations;
there is an ever-greater instability and volatility of world financial markets; there is an ever-more
worrying state of the natural environment; and there is an ever growing sense of social
fragmentation and alienation among the increasingly urbanised masses of society in the wake
of the weakening of traditional social structures like the family and the local community (the
village or the tribe). At the same time, any radical communist alternative, at least in its
collectivist form where most production factors are kept in the hands of an authoritarian absolute
state, appears not only to lead to even greater poverty, inequality and environmental
degradation, but to the loss of personal freedom and political rights as well. These are some of
the dilemmas with which our current, 21st century generation will need to grapple, just as any
generation has had to grapple with the problems of its time. When studying the history of
economic thought one becomes aware that many of the current debates are not new; a study of
the history of economic thought will hopefully help us to avoid some of the old mistakes as well
as to pick up and develop some of the old good ideas.

The institutionalist school of thought, which rose up in the early 1900s with economists such as
Veblen, already displayed some of this 20th century cultural pessimism of which we spoke in
the previous paragraph. Although institutionalists were, and are, not necessarily pro-communist
or socialist, they do have grave doubts about the justice and sustainability of capitalism in its
current form. Analytically, the institutionalists reacted against the increasing mathematisation of
neoclassical/marginalist theory in particular, believing that mathematical economic theory does
not do justice to the human element in economic behaviour and to the way in which institutions
shape and condition that behaviour. Humans are not machines and their behaviour cannot,
therefore, be described mathematically. On the other hand, institutionalists have not yet offered
a credible theoretical alternative to neoclassical, mathematically inclined theory.

A further difference between the 19th and the 20th century lies on the monetary front. Most
countries in the 19th century were on the Gold Standard. Roughly, according to this monetary
 10

system, legal tender consisted of bank money (deposits, notes and token coins) issued by a
central bank and denominated in abstract money units, which was convertible into gold. The
central bank guaranteed such convertibility at a fixed gold price and kept large amounts of gold
reserves for that purpose. At the same time, a considerable proportion of the total money stock
consisted, not of the legal tender (notes and deposits) issued by the central bank, but of
deposits issued by commercial banks in the course of granting credit to, and buying real or
financial assets from, the non-bank public. In the 20th century two things changed. First, from
around the 1930s onwards, central banks suspended convertibility of notes and token coins into
gold; only the American Federal Reserve Bank maintained the convertibility of the dollar into
gold, while the dollar became the unofficial reserve currency for non-American central banks.
Second, the proportion of the total money stock consisting of deposits issued by commercial
banks in the course of granting loans and buying real or financial assets increased even further
to around 90% or more. These differences in the monetary system gave rise to different
opinions about the role of money in the economy, as well as about the inherent stability of the
total demand for goods in a capitalist system. The controversy between Keynesians and
monetarists (the Chicago school) can be understood along those lines. John Maynard Keynes
was born in 1883, the same year that Karl Marx died.

We can conclude with a few interesting dates relating to South Africa. Right up to the end of the
19th century (the late 1800s), European involvement and settlement in Africa had been largely
confined to coastal areas. In this respect, South Africa was the exception, where the Boers had
already moved inland during the 1830s to escape from British rule in the Cape. This movement,
together with the settlement of British farmers in the Eastern Cape around the 1820s and later in
KwaZulu-Natal, gave rise to a great number of clashes with indigenous black people. Shaka
ruled his Zulu empire during the period between around 1810 and 1828, and the battle of
Isandlwana when Zulu impis routed a British regiment took place in 1879. The discovery of gold
around Johannesburg in the 1880s not only led to the Boer Wars but also shaped the South
African economic landscape as no other event did. Roughly at the same time that British
farmers settled in the Eastern Cape, the famous classical economist Ricardo died in Britain in
1823 from an ear infection at the age of 51; you see, penicillin was only discovered by a
Scotsman named Alexander Fleming in the 1930s.
 11 ECS3705/1

STUY UNIT 1
Mercantilists, physiocrats and classical forerunners

Study the following prescribed material in the textbook:

• chapter 2: only the sections “Overview of mercantilism” (pp. 13-20, excluding “2-1
Past as prologue”, p. 17) and “2-2 Past as prologue: Lingering mercantilism” (pp. 21-
22)

• all of chapter 3, excluding “3-1 Past as prologue” (p. 41)

• chapter 4: only the sections “Overview of classical school” (pp. 45-49) and “David
Hume” (pp. 54-57)

STUDY UNIT OUTCOMES

When studying this unit, you should aim at gaining knowledge and understanding of the
following:

For mercantilism:

• The historical background to mercantilism, with particular reference to the growth in

commerce, the development of cities as centres of economic power and wealth, and
the rise of the nation-state with its greater centralisation of political power in the hands
of the monarch.
• The meaning of bullionism, and the advantage of wealth-as-money (as opposed to
wealth-as-useful-goods) for the monarch.
• The meaning of the “fear of goods”.
• The view of international trade as a zero-sum game and how it encourages conflict
between nations.
• The various ways in which state power was used for mercantilist ends.
• How mercantilist policies favoured the interest of the king, the merchants and the state
officials at the expense of the common populace.
• Mercantilism as “rent-seeking behaviour”.
• The role of “derived demand” in mercantilist thought.
• The ways in which bullionism did make some economic sense at the time.
• The merits of mercantilism in enhancing our understanding of (a) the economic
contribution of commerce and trade, international trade in particular, (b) the concept of
the balance of payments, (c) the benefit of state regulation in certain areas, and (d) the
role and nature of the chartered trading company as the forerunner to the modern
limited-liability corporation.

For the physiocrats:

• The particular nature of French mercantilism at the time (from 1759 until the outbreak
of the French Revolution in 1789), against which the physiocrats reacted.
• The role of “the natural order” and “the rule of nature” in physiocratic ideas.
• Physiocratic views on the role of government as following from their ideas about
natural order.
 12

• Physiocratic views on the contribution of agriculture and the other economic sectors
(manufacturing, finance and trade) to wealth creation.
• How taxation was organised under French mercantilism.
• Physiocratic tax reform proposals with their emphasis on the taxation of land rents
received by landowners.
• The physiocratic preference for large-scale over small-scale farming.
• Henry George’s views on land rents as “unearned income” and their taxation.
• The role of “tax shifting” in physiocratic thought.
• How the policies of the physiocrats unintentionally favoured industrial economic
development
• Quesnay’s representation of the “circulation of wealth and goods” analogous the
circulation of blood in living organisms.

For the classical forerunners (Hume):

• Hume’s price specie-flow mechanism and why it undermines the practicality of

mercantilist policy.
• Hume’s reasoning as to why international trade may not be a zero-sum game.
• Hume’s reasoning as to why international trade will tend to melt away the differences
between rich and poor nations.

MERCANTILISM

• chapter 2: only the sections “Overview of mercantilism” (pp. 13-20, excluding “2-1 Past as
prologue”, p. 17) and “2-2 Past as prologue: Lingering mercantilism” (pp. 21-22)

ECONOMICS IN ACTION

Consider the following fictitious musings of Elisabeth I, Queen of England between 1558 and
1603.

“My name is Elisabeth. I am Queen of England in the line of the Tudors. I love my country and
my people. God Himself has entrusted me with the sacred duty of protecting England against
the mighty King of Spain who has since long been plotting England’s downfall and the
destruction of her ancient freedoms, in particular the freedom to practice the new religion which
has spread to our island from Germany where Herr Luther started a revolt against the Roman
church. But God has also given me the authority to rule. I am Queen by Divine Right and my
subjects, therefore, owe me allegiance. Without their loyalty and devotion, I cannot execute my
God-given task of protecting England, preserve her freedom, promote her power, wealth and
fame and so further the splendour of my own dynasty too. Not only do I need the loyalty and
devotion of my subjects, I also need money. It is money which enables me to afford the lifestyle
which befits the dignity of England’s Queen. And it is money which allows me to pay the soldiers
and build the warships necessary to defend the independence of my beloved realm. I will save
money where I can on my court expenses, but if I am to resist the King of Spain I need more
money, lots more money. Who has the money around here? There are the aristocratic
landlords; they are good as military strategists, army officers, political advisors and
ambassadors, but not particularly adapt at the commercial arts. Due to their extravagant lifestyle
they are also likely to be as cash-strapped as I am. And their income, typically derived from land
rents, does not add to the total amount of money circulating in England. I will impoverish
England if I tax more of their money. Only the international merchants of places like London or
Bristol bring money into the country so that I hurt England less if I tax them. There must be ways
of enabling these merchants to bring even more money into England and then to tax part of that
money for my sake and the sake of England. I will speak to my Lord Chancellor about this.”
 13 ECS3705/1

Question: You are the Lord Chancellor (call him an economic advisor) to Elisabeth. She is your
Queen and you are her loyal and devoted servant. After having studied this section on
mercantilism, seek an audience with your Queen and give her some useful advice in the
mercantilist tradition. But do be careful to point out to her that your advice may have some
negative side-effects too and that you are not always sure about the efficacy of some of your
suggestions. Your Queen will expect nothing less than total honesty from you. Now do your duty
to Queen and country, and diligently study the ideas of the mercantilists!

CONTENT

As already mentioned in the introduction, the period of the Middle Ages is considered to have
ended roughly around 1500. By that time, the unique military function of the feudal lord (that of
soldier on horseback) as well as his economic power base (as big landowner) had lost a great
deal of their functionality and significance. Economic life had become less and less organised
around largely self-sufficient, agricultural communities headed by the landlord and more and
more around cities dominated by craftsmen and merchants. These cities eventually became so
prosperous and powerful that they undermined medieval power relations. Moreover, concurrent
with the rise of merchant capitalism around the cities, there was a trend towards the increased
centralisation of political power in the hands of the monarch at the expense of regionally based
noble lords, which signified an increased importance of the nation-state. Hence the rise of
nationalism, especially in France, England and Spain.

Mercantilism can roughly be characterised as an exercise in nation building by way of an

alliance between the city merchant and the monarch, both of whom had gained in power and
prestige as a result of the trends mentioned above. The monarch (king or queen) gave the
merchant the protection and privileges of monopoly that he needed for his business endeavours
and, conversely, the merchant provided the monarch with the tax income in the form of precious
metals (gold and silver) to finance his or her wars. Bear in mind that armies in those days
consisted almost exclusively of paid mercenaries, who obviously had to be compensated in
cash (gold and silver); conscription, which already existed in Roman times, was only re-
introduced into the modern era by Napoleon in the late 1700s. It was thus in the interest of the
king to gear policies towards the accumulation of precious metals within the borders of his
realm.

Bullion is another word for plain bars of (unminted or uncoined) precious metal. Accordingly, the
idea that wealth is equal to precious metal money (gold and silver or “treasure”) and that a
nation’s wealth, therefore, consists of the total amount of gold and silver within its borders is
called “bullionism”. The modern contrary view is that the wealth of a nation consists of the
quantity and quality of useful goods (food, housing, clothing, education, law and order,
entertainment, etcetera), which its citizens can enjoy. Hence, a “wealthy” nation is a nation in
which people can enjoy an abundance of such goods. Mercantilists view wealth as money
rather than as useful goods, because wealth in the form of money is malleable. It can be taxed
and redirected in accordance with the particular preferences and ambitions of the king, which is
mostly to finance his court and his military ventures. Wealth as useful goods already has a
purpose, namely to meet the needs which these goods are designed to meet. Thus
mercantilism boils down to a programme of enriching the king (and the merchant) at the
expense of the general population.

Because the textbook’s (2007:13-26) “Overview of mercantilism” is pretty self-explanatory,

some clarification of concepts will suffice.

The textbook (2007:14) speaks about “derived demand”. This term is often used in the context
of the labour market, meaning that the demand for labour is derived from the demand for goods,
either generally for all goods or particularly for a certain good requiring a particular labour skill.
In this context, the demand for fishermen is derived from an enforced demand for fish (by
 14

enacting a law coercing people to eat fish on Friday - still a common practice in many European
countries), which in turn guaranteed a supply of experienced sailors for a country's navy.

The textbook (2007:14) notes how merchant capitalism “wanted to keep the colonies eternally
dependent upon and subservient to the mother country”, which is probably primarily written with
the United States in mind (remember, Grant and Brue are American). In mercantilist times, the
United States was still a colony of Britain with colonists indeed being discriminated against by
the mother country through a host of restrictions and punitive taxations. It was this type of
discrimination which motivated the American colonies to fight for independence from Britain.
The battle cry “no taxation without representation”, which was sometimes used during the days
of struggle in this country as well, actually originated with the Americans during their war of
independence.

The textbook also mentions (2007:15) the opposition of mercantilists to “internal tolls, taxes and
other restrictions on the movements of goods”, because these were measures that hampered
intranational (as opposed to international) trade. Note that these measures were an inheritance
from the Middle Ages, as the beneficiaries of such tolls and restrictions were often the landlords.
Due to its greater feudal flavour, French mercantilism still maintained such measures.

The strong mercantilist emphasis on state regulation may sound strange on modern ears; after
all, modern merchants and capitalists advocate laissez-faire and economic freedom rather than
government regulation. Government regulation can, however, also be used to favour
commercial interests, namely when aimed at preserving monopoly rights and keeping out any
emerging competitors. Such was indeed part of the nature of mercantilist state regulation. Even
today’s businesses often lobby government for certain types of regulation and protection,
thereby not quite sticking to the liberal philosophy which is the foundation of their basic rights
and freedoms. Indeed such lobbying for government favours can be regarded as “rent seeking”,
on which the textbook (2007:16-18) elaborates.

The textbook (2007: 19) mentions as one of the lasting contributions of mercantilism an
increased appreciation for the economic contribution of trade (“the merchant”) – international
trade in particular. But what actually is the productive contribution of middlemen between the
producers and ultimate users of a good? Given that traders do not alter any of the physical
qualities of a good, this contribution does not seem not obvious. In essence, traders are what
we nowadays call “market specialists”. A market specialist is a person which specialises in
obtaining market information in a particular market, meaning that he or she has invested time
and money in finding out who wants to supply or demand what, where, when, in what quantity,
and at what price in that market. Because market specialists specialise in obtaining market
information in that particular market, they can obtain and distribute that information at a much
lower cost than the average occasional buyer and seller in that market can. Rather than trying to
obtain market information themselves, it may then be worthwhile for occasional market
participants to seek the services of a market specialist. That is why we often make use of an
estate agent when we buy or sell a house. Market specialists come in two basic forms: brokers
and dealers. Brokers will attempt to bring prospective buyers and sellers together without buying
or selling the goods themselves, like estate agents. Accordingly they do not keep an inventory
of the relevant goods. Brokers make their money by charging a fee for services rendered.
Contrary to brokers, dealers do keep an inventory of the relevant goods. They buy the goods
from producers in order to sell them on to users. The fact that dealers keep an inventory means
that they can serve their buyers by making the good immediately available at a convenient
location – which is essentially what a shopkeeper does. For that purpose, dealers often incur
the cost of warehousing and transporting goods. Without dealers, buyers have to look for
producers themselves, order the good at these producers, wait for the good to be finished, and
arrange for its transport to their preferred location, which can be highly inconvenient and costly.
It may also be worthwhile for producers to work through dealers because dealers can often
guarantee them a more steady stream of larger orders. Dealers obviously make their money out
of the difference between the price at which they buy from producers and sell to consumers.
 15 ECS3705/1

As a further lasting contribution of mercantilism, the textbook mentions that it indirectly

encouraged the gradual introduction of the corporate form of enterprise into capitalism. We tend
to think of the limited-liability corporation as an integral part of private enterprise. But it has not
always been like that. During mercantilist times the colonial trading companies, like the British
and Dutch East India Companies, were really the only incorporated business firms, or
“chartered companies” as the term then was. All other business ventures were still
unincorporated proprietorships or partnerships with full liability for their owners. At the time,
private citizens did not have the right to freely incorporate their businesses as they presently
have. Instead, the incorporation of one’s business was a privilege which the state granted on
the basis of the business serving some area of public interest. Colonial trading was considered
one of these public interests. Moreover, the state sanctioned corporate status for a limited
period only, after which it was up for review by parliament. In addition to colonial trading,
governments came to bestow corporate status on other types of activity too, like infrastructural
development (road, railway or canal building), central banking, commercial banking, and
insurance. During the 1700s and 1800s, the typical manufacturing company was still organised
as an unincorporated proprietorship or partnership. The right of business people freely to
incorporate their firms dates from the late 1800s. Corporate business started to dominate
manufacturing from only the early 1900s onwards.

A brief explanation of the general idea of incorporation may be in place. The essence of an
incorporated business firm is that its assets are owned by the firm as a legal entity in its own
right, separate from its shareholder-owners and managers. The company becomes a legal
person, meaning that the law regards it as a person able to sue and be sued, even if it is not a
natural person. If, for argument sake, you own half of all the shares of Shell Incorporated, you
do not own half its oil refineries, petrol stations and whatever else Shell may own. You own
none of Shell’s assets; corporate shareholders do not own any corporate assets. Ownership in
half the shares in Shell Incorporated merely entitles you to half the dividends as and when
declared, and half the voting rights in shareholder meetings to elect management. The assets of
Shell are owned by Shell as a legal person separate from shareholders and management.
Because shareholders have no ownership rights over the assets of the corporation, they also
are not responsible for its debts. Shell as a legal entity in its own right has that responsibility.
Therefore, if Shell were to be incapable of meeting its debts and go bankrupt, its creditors
cannot lay claim to the assets of Shell’s shareholders to recover the unpaid debts. As a result,
shareholders in Shell Incorporated can at the most lose their initial investment. It is in that sense
that shareholders in incorporated businesses enjoy “limited liability”. By contrast, the partners in
unincorporated partnerships or the proprietor in an unincorporated sole proprietorship are also
the owners of their firm’s assets. Hence they are also fully liable for its debts.

Being a legal entity in its own right (separate from office bearers) was originally a characteristic
attribute of the state. It prevented the state’s office bearers (ultimately the king) from claiming
personal ownership of the state and so denied them the right to rule it at their own discretion.
The French king, Louis XIV, was famous for claiming “l’état, c’est moi”, meaning “I am the
state”, by which he asserted his absolute right to rule as he pleased. Denying kings ownership
of the state and granting the state corporate status meant that it could be run in accordance with
law rather than the king’s whim. The king could now be placed under the law, and his powers
circumscribed by law. Giving the state a legal entity separate from office bearers was thus an
essential element in the rule of law, which made it possible to curb state absolutism and allowed
citizens of Western nations a freedom which was generally not enjoyed elsewhere. From the
1600s onwards, however, governments increasingly granted private firms corporate status if
they felt that these firms served some area of public interest and were, in that sense, regarded
as arms of the state. There was an evident advantage to having corporate status: the limited
liability which shareholders enjoyed allowed corporate firms to bring together the capital
contributions of a much larger number of shareholders than unincorporated partnerships ever
could. The corporate form of business thus stimulated capital intensity and made it possible to
realise much larger economies of scale. For that reason, governments have from the 1860s
 16

onwards generally granted their citizens the freedom to incorporate their firms at their own
discretion, without needing prior approval by the state. Whereas previously corporate status was
granted by the state as a privilege on the basis of serving the public interest, it now became the
right of every private citizen to incorporate his business, irrespective of whether it served the
public interest. Since that time corporate business has started to dominate Western capitalism.
But it all started with the colonial trading companies of the mercantilist era, such as the English
and Dutch East India Companies – the latter well-known to South Africans1.

RELEVANCE FOR TODAY

Mercantilism prevailed during a time of absolute monarchy. Absolute monarchs were prone to
equate the interest of their realm with their own personal interest. This is not to deny that these
interests were often closely connected and that many monarchs did often self-sacrificially offer
their lives on the battlefield in an effort to protect their subjects against the rape and pillage of
advancing barbarian hordes. But driven by personal ambition and pride, monarchs could also
involve their country in meaningless wars which wasted the lives and property of countless of
their subjects. Because of their inclination to equate their own interest with that of their country,
monarchs found it easy to sacrifice the life and property of their subjects for the sake of their
own glory and fame. You can take some of the mercantilist policies as a case in point. The
ostensible intent of mercantilist ideas is not primarily to further the prosperity of the broad mass
of people themselves, but rather to raise tax income for the king – tax income which was
sometimes used to serve a genuine public interest but often also to satisfy the personal
ambitions of the king.

The issue has relevance for modern times: there is an abiding temptation for anyone in power to
imagine that one is serving the interest of the people when, in reality, one is merely protecting
one’s own interest. With an appeal to the interest of the people, a great many injustices have
been perpetrated against the people by the supposed representatives of the people.

ECONOMICS IN ACTION: LOOKING BACK

Have you already prepared your advice to the Queen? Make haste, the King of Spain is building
an Armada and your Queen is in distress!

PHYSIOCRACY

• All of chapter 3, excluding “3-1 Past as prologue”

ECONOMICS IN ACTION

As an introduction to physiocratic thought, consider the following fictitious conversation between

a contemporary white South African farmer and a contemporary black South African land
reformer. We call the white farmer Tom and the black land reformer Sipho, who, while in
opposite political camps, have been old friends from school. They meet again at some school
reunion. We catch them in the middle of an increasingly heated debate.

Sipho: The government’s land reform policy of “willing buyer, willing seller” is just not working. It

1
For more on the corporation, see PH van Eeghen (1997). The capitalist case against the corporation.
Review of Political Economy 55: 85-113; and PH van Eeghen (2005). The corporation at issue; part I and
part II. Journal of Liberatarian Studies 19 (no 3 and 4): 49-70 and 37-57.
 17 ECS3705/1

takes too long and costs too much. The wrongs of the past are not being put right quickly
enough; at this pace, we will have to wait till judgment day for justice to be done. We will need
to resort to expropriation of white-owned land. I am afraid, my mate, your land may just be a
candidate.

Tom: Wow wow, my family has owned and farmed my land for five generations. We built it up
from nothing. We carried off the boulders, built the fences, provided the irrigation system, built
the barns .. and now you want to take all that away from us without proper compensation and
give it to someone with no experience in commercial farming …

Sipho: I am not so sure your people did all that carrying off of boulders and building of fences on
their own. You probably used black workers to do that for you, and you probably paid them
preciously little in return. And the fact that your family has been owning and farming this land for
five generations … well, the more reason to right the wrongs of the past all the more speedily
and return the land to its rightful owners as soon as possible. Your great-great grandfather stole
the land from us.

Tom: Granted, my forebears did take the land from you guys. But regard it simply as military
conquest. You blacks also fought wars among each other and the victorious party also took the
land (and women) of the defeated party. Shaka defeated other tribes and took their land. When
black people take land from each other through military conquest, you don’t moan. But when
whites take land from blacks through the same process, it suddenly becomes a crime! Is that
not a double standard? Moreover, by farming the land productively, I feel we have in the mean
time earned the right to own it. You and your family want to eat “pap en vleis” and buy it at a
reasonable price, don’t you? That requires efficient, commercial farming. That is what we do,
and we are doing it well. It is true that my forebears may have used a great deal of black labour
and it is true that they may have underpaid them. But my forebears were quite poor for the first
couple of generations too and could barely survive themselves .. thanks, in part, to some of you
guys who kept on stealing our cattle. And, in any case, I now pay my workers a reasonable
salary (especially considering all the additional benefits), although I admit that many farmers
don’t …

Sipho: Not so fast, my broer. I don’t care about the wars Shaka fought all these years ago, and
they may well have been wrong. If you want to use warfare as a justification for your stealing of
our land…, well then we just stole your cattle as a way of warfare too. “All is fair in love and
war”, or is it? The point is that we are now one country and that a white minority now owns by
far the greatest proportion of good agricultural land in this country. Surely that can’t be right.
Surely my people ought to get a fair share in the land of their forefathers. Why should the
natural resources of a country by controlled by a small minority? The warmth of the sun and the
air that we breathe are not monopolised by a minority, so why should the land be? Our people
need food and they need to get it at a reasonable price, I agree. But I am not so sure that white
farmers always farm so very productively and I am frankly offended by your suggestion that the
average black farmer would not be able to be as productive as the average white farmer is –
given sufficient support and skills transfer.

Tom: I am sorry if I offended you. I did not want to say that black farmers would not be able to
farm as efficiently as white farmers do. I was merely trying to make the point that current land
owners have earned the right to their land by farming it efficiently. You say that your people
have a right to a fair share in the land. That may be so. But with the right to own land comes the
responsibility to farm it productively. The nation needs to be fed. Because I am farming my land
productively, I feel that I am contributing towards feeding the nation. As a result, I feel I have
earned the right to keep my land, which you, therefore, have no right to take from me. And let us
do some straight talking here. Black farmers may certainly farm my land as productively as I do,
but it does not seem a priority in your land reform policies that my land is indeed given to
serious black farmers. For all I can see, you have destined my land to be given to people,
 18

however legitimate their historical claims, who have no serious intention to farm it commercially.
And worse still, it may well be given to someone with connections high up.

Sipho: Stop, stop!! If you want to talk straight, let me do some straight talking myself. Don’t
speak to me as we are in Zimbabwe. This is South Africa. I am no fan of Uncle Bob. His is not
proper land reform but a land grab to the benefit of his cronies. I have already told you that the
productivity of farming ought to be a consideration in land reform policies, but it cannot be the
only consideration. There are issues of justice and equity too. Land ownership cannot be
monopolised by a minority, as if the majority does not exist. Land is important to us black
people; it is part of our identity; each black person desires deep in his heart to own his bit of
Africa.

Tom: And why do I not qualify? Is five generations not enough to make me an African? I don’t
want to leave. I may not be black but I feel an African too; this is where my heart lies. And your
land reform will, in any case, not be able to give land to each and every black person. Your
vision of giving each African his bit of Africa is just not on the cards - at least not when it comes
to agricultural land. If agricultural land is commercially farmed on a fairly large scale, it is
inevitable that a minority owns most of that land. Given that in modern societies agriculture
makes only a relatively small contribution towards total production and employment, this
inequality contributes relatively little to overall inequality anyway. It is only a minority of white
people that now owns most of the agricultural land, and the likely outcome of your land reform is
that it will be a minority of black people who then own most of the land. In other words,
agricultural land ownership will remain a minority affair, whether it is black or white. The only
interest which the vast majority of black and white people have in agriculture is that sufficient
food gets produced at a reasonable price. And when it comes to poverty, land redistribution will
barely make any difference. The handful of new black farmers will hardly make a dent into the
poverty problem in this country. And what makes you think that these black farmers will, on
average, treat their workers so much better than we do? Plus, although successful land
redistribution will hardly contribute much to alleviate the plight of the poor, unsuccessful land
redistribution will seriously harm the plight of the poor. Land reform is, therefore, risky business
for our country. If land redistribution were to damage employment and productivity in agriculture,
the poor will be hit the hardest. A disproportionate number of the poor find employment in
commercial agriculture. And the poor are disproportionately dependent on affordable basic
foodstuffs produced by commercial agriculture. Should we not be more concerned about
poverty than some abstract idea of justice which, in any case, will benefit only a handful of new
black land owners ..?

Sipho: Go away Tom. Since when are you so desperately concerned about the plight of the
poor? Why should land redistribution be unsuccessful? If properly managed, food production
should not suffer. And while it may be true that land reform will not turn the broad mass of black
people into land owners, it will at least make the race composition of land ownership more
representative of the total population. And that is important too! It seems to me that you cannot
get away from this racist idea that black people cannot farm as productively as white people
can. What makes you think that white people invariably make such wonderful farmers? What
makes you think that we wish to expropriate all white-owned land? You keep on thinking in
Zimbabwe-inspired stereotypes and caricatures.

Tom: You may be right. I may think in stereotypes and caricatures. But I have another concern
which does make me worry we are on the Zimbabwe road: if the government is so keen on
increasing black land ownership, why doesn’t it start with land which is already owned by the
state and which could straightaway be handed over to black farmers. Why does it start with land
that is white-owned, as if it is more important to reduce white land ownership than it is to
increase black land ownership? Such an attitude smacks of racism to me, in that disadvantaging
the whites is implicitly regarded as more important than advantaging the blacks. It is such
racism which makes me worry we are on the Zimbabwe road.
 19 ECS3705/1

Sipho: I think you are grossly overreacting now, and don’t you talk to me about racism!! Even
so, I admit that much more state-owned land could already have been handed over to blacks.
Remember that I am not the government. I do not wish to defend everything they do. Also bear
in mind that far from all currently white-owned land is optimally used. Much of it is badly farmed
or not farmed at al! Such land could easily be redistributed to blacks without any risk to
agricultural productivity.

Tom: Okay, okay – granted. But then start expropriate that type of underutilised land first, and
leave my farm alone! I do farm my land fairly productively – although one always feels one can
do better. Incidentally, if you still wish to expropriate my land and give it to somebody who is not
serious about commercial farming, I would even be prepared to lease it back from him so long
as the rent is reasonable and I get some sort of security of tenure – otherwise there is no
incentive for me to keep on investing in the land. In that way he will get a steady stream of cash
income from the land, and I can keep my farm. Is that a proposition?

Sipho: Yes, but that depends on ..

Tom: Okay, but why not ..

Sipho: Perhaps there is merit, but ..

Tom: So why don’t you and I work together on this and ..

Question: After having studied this section on the physiocrats and our comments below, see
how the insights you have gained can inspire you to write a continuation of the debate between
Tom and Sipho, and bring it to some sort of mutually acceptable resolution?

CONTENT

French mercantilism differed from its English counterpart in two main ways. First, it had a
stronger feudal flavour, meaning that its policies and regulations were also aimed at protecting
the interests of the landed nobility in addition to the interests of the merchants. That is why tolls
and other restrictions on intranational trade were part of mercantilist state regulation in France
too. Second, French mercantilism was probably stricter, more elaborate, more intrusive and
more crippling than anywhere else in Europe. Add to that the exceptional corruptness of French
state officialdom as well as the court extravagance and wasteful warring of its Bourbon kings,
and one can understand why France had become desperately poor at the time (second half of
the 1700s, 2007:33-34).

The physiocracy was the first anti-mercantilist movement in Europe, which sought to rebuild
France, primarily by liberating its agriculture from mercantilist restrictions and tax burdens, but
also by making government less corrupt and wasteful. Physiocracy means “rule of nature”, as its
advocates believed in the existence of natural laws which, when given the chance, would
spontaneously steer the economy towards harmony and prosperity – a philosophical idea which
also underlied Smith’s economics as we will see shortly. The detailed direction of economic life
by a coercive government was therefore considered unnecessary as well as harmful, which one
can understand given the particularly stifling nature of French mercantilism. And remember that
government intervention was, at the time, used primarily to favour the interests of the rich and
powerful rather than the poor, which is indeed not uncommon even in modern times!

For a more detailed examination of the policies and ideas of the Physiocrats, the textbook’s
“Overview of the physiocrats” (2007:33-37) is once again comprehensive as well as fairly easy
 20

to follow. Only Quesnay’s tableau economique (economic table) may be a bit more challenging,
for which we will, therefore, provide some additional explanation. Otherwise, just a few remarks
as “asides” will suffice.

The physiocrats overcame mercantilist bullionism by acknowledging that wealth consists of

useful goods rather than precious metals. But they added to this sound idea the odd idea that
only those goods produced in the primary sector (mainly agriculture, but also mining and
fisheries) contributed to the national product. Manufacturing, trade, finance and the professions
were considered sterile, meaning that the value of their output was merely equal to the cost of
production, no extra value being added. The potentially tremendous contribution to national
wealth of manufacturing, especially when industrialised, was thus insufficiently appreciated by
the physiocrats, although their emphasis on laissez-faire and their proposed freedom of taxation
for all non-landowners unwittingly gave scope for industrialisation. Nonetheless, when an
economy lies in complete ruins, it is not a bad idea to start rebuilding it by focusing on its
agriculture - then, at least, people have food to eat and a surplus is created to feed people
involved in non-agricultural pursuits, like manufacturing and trade. The mistaken idea that only
production in the primary sector adds value seems to be based on the erroneous view that only
tangible, material goods are useful and that intangible, immaterial goods (services), therefore,
have no value. After all, the secondary sector (manufacturing) merely reshapes the tangible raw
material obtained from the primary sector and, as such, adds no matter and thus seemingly no
value to its end products, while the tertiary sector (trade and services) produces intangible,
immaterial goods.

The textbook (2007:35) argues that the physiocratic preference for taxing the rent received by
landlords is based on the mistaken notion that “only agriculture ... produced a surplus”. But this
seems just a part of the story. While the physiocrats did not question the right of landlords to
receive rent as a reward for the capital expended to originally acquire the land (see 2007:40-
42), they also regarded rent as partially unearned income, which is part of the reason why they
wanted to tax it as well. And the physiocrats would be correct to a degree. Landlords did run a
risk on the capital invested when originally obtaining the land: the risk that land values drop (if
land is held speculatively) and the risk that land is farmed irresponsibly by tenants, leading to
soil erosion or other forms of permanent land degradation. Landlords obviously also ran a risk
on the capital invested in land improvements such as fencing, irrigation, fertilisation and the
built-up structures like farmhouses and barns. Rent rightly compensated landlords for these
kinds of risk. But rent clearly compensates for more than only these risks. It is also a reward for
contributing the original productive powers of the soil, which, in so far as the land is farmed
responsibly, are everlasting and therefore not subject to depreciation. When there is no
depreciation, nothing is given up to merit a reward. The portion of rent which is a reward for
contributing these original productive powers of the soil (and the sun), therefore, does seem to
constitute unearned income, as also indicated by the simple fact that human beings do not
cause the plants to grow or the animals to increase. It is this unearned portion of the rent that
the physiocrats wanted to tax away. Adam Smith, who had been influenced by the physiocrats,
significantly remarked in this regard that “landlords, like all other men, loved to reap where they
did not sow and demand a rent even for [land’s] ... natural produce”. One should, of course, be
cautious about saying the same of modern farmers, like farmers in South Africa, who cultivate
their own land - by contrast, the landlords of physiocratic times were not cultivators of their land.
They merely owned and rented it out to tenants who did the real farming. Even so modern
farmers’ incomes do also contain, according to the physiocratic logic, a portion of unearned
income, although it may be argued that farmers anyhow lose that unearned income in the form
of taxes paid on earned income.
 21 ECS3705/1

RELEVANCE FOR TODAY

The 19th century American economist Henry George (mentioned and criticised by the textbook,
2007: 36, 270) proposed to tax away the value of unimproved land (the pure site value of land
expressed as an annual rent) for redistribution and social spending, while scrapping all other
forms of taxation. Apart from whether George’s proposal is practicable, which is open to debate,
he does tackle an issue of potentially great relevance to our region. Henry George’s classic
work is entitled Progress and Poverty, and is still worth a read for those who are interested
(although some of the analysis is flawed). Very briefly, George advocated that land be privately
owned but that private land owners compensate all other citizens for the right to exclude them
from their parcel of land by paying an annual rent representing the naked site-value of land (the
value of land net of man-made improvements). The pool of funds thus collected could then be
used for social spending or evenly distributed over all citizens as some kind of a basic income
grant. Land does seem unique in that, unlike any other good, it is not man-made (it is a gift of
nature), is fixed in supply and its site-value is, in part, socially determined by the spill-over
effects from how others use the surrounding land parcels and from the public infrastructure
available on surrounding land parcels. Your lecturer is not yet fully convinced that George’s
ideas are practicable, but it does seem worthy of closer investigation, especially since land
ownership is such a hot and divisive issue in South Africa with the potential of creating major
and very damaging social strife. It is interesting that a free-market advocate like Friedrich Hayek
is surprisingly complementary about Henry George’s ideas: “[George’s proposals] seems to me
to the present day the most defensible of all socialist proposals and impractical only because of
the de facto impossibility of distinguishing between the original and permanent power of the soil
and the different kinds of improvements.”2

The textbook (2007:36,270) criticises George’s policy proposal on the grounds that it reduces
the market price of the site value of land to virtually zero which would cause major losses to
people who had just bought land for large sums of money. The criticism could, however, be
overcome by giving people tax credits up to the value of the price they originally paid for the
land as an interim measure.

The textbook (2007:35) mentions how the physiocrats sought to replace the complex indirect tax
system of the mercantilists with a simpler system of direct taxation on rent. We take it you
understand the difference between direct and indirect taxation. Direct tax is tax on income (in
the form of profit, rent, wage or interest), while indirect tax is a tax on goods, like our modern
VAT, import duties or excise tax on alcohol and tobacco.

We provide some additional explanation of Quesnay’s tableau economique (see 2007:37-40),

not only because Figure 3-1 may be somewhat confusing but also because the figure nicely
sums up some of the main ideas of the physiocrats. For that purpose, we introduce three
income-spending statements, for tenant farmers (productive class), landlords (proprietor class)
and manufacturers/traders (sterile class) respectively. The numbers used in these statements
correspond with those used in Figure 3-1.

2
Hayek, F.A. (1994). Hayek on Hayek; An Autobiographical Dialogue, edited by S. Kresge and L. Wenar.
Chicago: University of Chicago Press, p.63.
 22

Tenant Farmers (productive class)

Income: Spending:
Sales of agricultural goods 1 billion livre Purchases of manufactured 1 billion livre
to landlords goods from manufacturers/
traders
Sales of agricultural goods 2 billion livre Surplus (=rent) paid to 2 billion livre
to manufacturers/traders landlords in this period
Total 3 billion livre Total 3 billion livre

This period’s total agricultural production is 5 billion livre (the livre was the pre-Revolution
French money unit), of which 2 billion is cost of production in the form of seeds and food needed
by the tenant farmers themselves. So tenant farmers sell only 3 billion worth of agricultural
produce, as can be seen from the total on the left-hand side of the statement. Of that 3 billion,
they sell 1 billion to landlords and 2 billion to manufacturers and traders, as can also be seen
from the left-hand side of the statement. Tenant farmers used their 3 billion income to buy 1
billion worth of manufactured goods from manufacturers/traders, while the remaining 2 billion is
rent, which they pay to the landlords. See right-hand side of the statement.

The next income-spending statement is that of the landlords (proprietary class).

Landlords (proprietary class)

Income: Spending:
Previous period’s rent 2 billion livre Purchases of manufactured 1 billion livre
from tenant farmers goods from manufacturers/
traders
Purchases of agricultural 1 billion livre
goods from tenant farmers
Total 2 billion livre Total 2 billion livre

Their rent income (see right-hand side of the statement) of 2 billion corresponds with the 2
billion rent which tenant farmers pay to landlords, except that this 2 billion is rent paid during the
previous period, while the 2 billion rent paid by tenant farmers during this period is only income
for landlords during the next period. Note that periods repeat themselves in a uniform manner.
Landlords spend their 2 billion rent income on 1 billion worth of manufactured goods from
manufacturers/traders, and 1 billion worth of agricultural goods from tenant farmers, which is
also recorded on the income side of the tenant farmers. As you can see from this income-
spending statements, landlords do not generate a surplus. In accordance with physiocratic
ideas, only tenant farmers do.

Lastly, the income-spending statement of manufacturers/traders (the sterile class):

Manufacturers/traders (sterile class)

Income: Spending:
Sales of manufactured 1 billion livre Purchases of agricultural 2 billion livre
goods to landlords goods (including raw
material) from tenant farmers
Sales of manufactured 1 billion livre
goods to tenant farmers
Total 2 billion livre Total 2 billion livre

Their income from selling manufactured goods to landlords and tenant farmers also appears as
spending categories in their income-spending statements. Manufacturers’ spending on
agricultural goods, which comprises food for the manufacturer and raw material for his
production, are also recorded as income for tenant farmers above. You notice that the cost and
the sales value of their production are equal (2 billion livre), which illustrates how the
 23 ECS3705/1

manufacturing sector is supposed to be “sterile” in the sense of not producing a surplus. Again,
only the tenant farmers produce a surplus in physiocratic thought.

Of course, it is easy to shoot holes in the Tableau. For instance, how would any manufacturer
be able to accumulate capital to finance implements and tools, if he or she cannot make a
genuine profit. Why would one want to expend the extraordinary effort of running a business if
there is hardly any profit incentive? Even so, Quesnay’s Tableau is important in that it was the
first attempt to highlight the interconnection between economic sectors. As such it is a
rudimentary form of national-income accounting and input-output analysis. The Tableau also
expressed physiocratic concerns about the non-interruption of the circular flow of the net
product, which they believed was achieved when the investments made by tenant-cultivators
got back to them so that the same amount of investment could be repeated and agricultural
production could expand to the benefit of society at large. These are foreshadowings of modern
Keynesian concerns about leakages from the circular flow of money, which could lead to a
contraction of aggregate investment or aggregate demand in general. We pay more detailed
attention to the income-spending circulatory stream at the macro level in our discussion of Say’s
Law and of Keynes below.

The physiocrats were also modern, in that they already recognised the phenomenon of tax
shifting (see 2007:37, 42-43). Tax shifting occurs, for example, when a manager of a big
corporation makes his salary demands in after-tax terms, which means that the income tax is
effectively borne by the firm rather than the manager on whom it is levied. The physiocrats
argued that all taxes were eventually borne by the landowners because of tax shifting, so that
one might as well tax their income directly. Their reasoning was based on the idea that
everybody apart from landowners more or less operated on a subsistence income and so
already paid the maximum they could afford - any income losses would mean starvation. Price
increases due to taxation would, therefore, eventually reduce rent paid by the tenant-cultivators
to their landowners. In general, the degree of tax shifting, as with the passing on of any cost
increase, depends on the relative market power of those on whom it is levied. For example,
when management skills are scarce, managers may have the market power to shift their tax
payments onto firms and negotiate their salary in after-tax terms. Similarly, continually living on
a minimum salary awkwardly gives one bargaining power to shift one’s increased taxes forward,
assuming that others, eventually landlords, do not wish you to starve. Take note of Hume’s
disagreement with this argument (see 2007:57). Instead, Hume believed that wages are
determined by demand and supply and that competitive relations in the labour market are not
always such that workers live on the bread line or have no bargaining power whatsoever other
than the threat of starvation.

The fact that the physiocrats wished to tax only landlords but not craftsmen or merchants should
obviously not be taken to mean that they were somehow pro-craftsman and pro-merchant and
anti-landlord, although some landlords of the time would undoubtedly have accused them of
exactly that. If anything, the physiocrats looked rather askance at merchants in particular,
questioning whether trade adds any value to goods. The physiocrats argued that, because of
tax shifting, all the tax would anyhow be carried by the landlord, and that using the landlord’s
rent income as the tax base would simply be a more convenient way of collecting tax plus a way
of keeping the price of agricultural products low, which was in the interest of all classes of
society (see 2007: 42-43).

The section on Turgot (2007:40-43) makes interesting reading, even if it does not have a great
deal of extra information about physiocratic ideas. The textbook (2007:37) speaks of the
“dauphin of France”; the “dauphin” is another name which the French used for their crown
prince, the heir to the French throne.
 24

RELEVANCE FOR TODAY:

It is interesting to note that the main leaders of the physiocratic movement, Quesnay and
Turgot, came from the class of aristocratic landowners themselves. Apparently they were able
to overlook the narrow interests of the class into which they were born for the sake of justice
and the broader interest of France as a whole, which is to be admired indeed. South Africa
could do with a few more politicians and business leaders like that.

ECONOMICS IN ACTION: LOOKING BACK

Have Tom and Sipho stopped arguing already?

THE CLASSICAL SCHOOL AND CLASSICAL FORERUNNERS

• Chapter 4: Only the sections "Overview of classical school" (pp 45-49) and "David Hume"
(pp .54-57).

ECONOMICS IN ACTION

Classical liberalism is now regarded as a conservative ideology. But at its inception it was seen
as very progressive and even subversive to the status quo as dominated by mercantilist ideas.
As an introduction to the classical school, consider the following imaginary reflections of a
typical mercantilist government official who notices, with alarm, the increasing popularity of
classical liberal ideas.

“These liberals, these rascals! They think they do our Kingdom a favour by removing all proper
government controls on entry into the crafts, do away with all controls on the price and quality of
the goods produced and cancel all controls on trade between nations. Every Tom, Dick and
Harry can now become a candlestick maker and sell his candlesticks at any price he wants.
How will the public know that the candlesticks are of the required quality? And how will existing
candlestick makers be able to make a living if anybody with half an idea of how to make a
proper candle can sell his rubbish at any price to the unsuspecting public? And how can it serve
the interest of our country if foreigners are allowed freely to sell their products in our country and
so take the jobs and incomes away from our own people? It is ridiculous! This newfangled idea
of giving the uneducated masses the freedom to do what they want is a recipe for disaster. How
can there be order in the chaos of freedom? We, of the old school, brought peace and order to
this country. We made sure that things were done properly, with a proper price for a properly
produced good. Liberty is fine as far as it goes, but surely you can’t give unrestricted liberty to
the uncivilised masses, the majority of which do not know what to do with it anyway. It will be
chaos, I am telling you! The vices of greed and licentiousness will go rampant! And now the
liberals want to grant people the liberty to practice their own self-invented religion too. What is
next? There should be one religion, the True Religion, and the King should make sure that
everybody practices it in the proper way. Imagine all the nonsense that people will start to
believe in if you allow them to believe what they want? Chaos, I’m telling you! Just now they
want to follow that mischievous new country, the United States of America, and give the rabble
the right to elect the government of their choice! Sedition, that is what it is! What will happen to
our beloved King?! What has become of the world? Where will I find another job at my age ...?”

Question: After having studied the “Overview of the classical school”, how would you evaluate
the ideas of this conservative mercantilist? To what extent should the government curtail
freedoms in an effort to protect its citizens against their own ignorance or folly, and to what
extent should the government allow people to make their own decisions with the implication that
they may need to suffer the negative consequences of these decisions? What alternative, non-
 25 ECS3705/1

governmental controls on economic life are possible?

CONTENT

As mentioned in the introduction, the classical school began with the publication of Adam
Smith’s The wealth of nations, which was published in 1776 and dealt a death blow to
mercantilism. Nonetheless, as is often the case with scientific breakthroughs, many of the
central ideas were already formulated by others in partial or rudimentary forms.

Once more, Grant and Brue’s (2007:45-49) “Overview of the classical school” is clear enough
so we do not need to add much by way of additional explanation; also, much of its content is
repeated and elaborated on when the textbook discusses the classical economists themselves,
like Smith, Ricardo and Mill. This is not to say these sections are less worthy of careful study.
Grant and Brue’s (2007: 45-47) discussion of the two “revolutions” that contributed to classical
liberal thought – the scientific revolution and the industrial revolution – is particularly interesting
and revealing. A careful reading of these sections will give you an appreciation for the fact that
both were real revolutions: they dramatically changed the way people thought (scientific
revolution) and lived (industrial revolution) at the time. The industrial revolution, among other
things, caused the demise of traditional handicraft production in favour of factory production,
which has a major impact on social life; it further shifted economic power and wealth away from
agriculture towards industry and trade; and it dramatically increased urbanisation and stimulated
large-scale agriculture.

We will just clarify a few terms here.

Just as the concept of monopoly refers to a market form where there is only one supplier, so the
concept of monopsony (2007:49) refers to a market in which there is only one demander. Both
monopolists and monopsonists would have almost total power to set the price in their markets.

The textbook (2007:49) refers to public goods being “indivisible”, which is an unusual way of
describing them. Public goods are more commonly described as non-excludable and non-rival.
Non-excludability means that non-payers cannot be excluded from the benefits of these goods
when they are provided, like the benefit of defence against foreign aggression by an army. Non-
excludability thus implies the problem free-riding. Goods are non-rival when their increased
consumption by some does not diminish their availability to others. The general idea is that
unless public goods are provided by the state, they tend not to be provided at all. Hence there is
an argument that such goods should be provided by the state and financed out of taxation. The
services of military defence and lighthouses are often used examples.

Of the classical forerunners, you only need to study Hume (2007:54-57). Pay particular attention
to Hume’s price specie-flow mechanism, with which you should already be familiar if you have
taken a course in international trade. The price specie-flow mechanism suggests how surpluses
and deficits on the balance of payments trigger forces which will cause the balance of payment
to spontaneously revert back to equilibrium. The basic presupposition of this mechanism is that
the exchange rate between local and foreign currencies remains more or less unchanged, which
is to be expected if local and foreign money units (say, the pound, euro, or dollar) reflect given
amounts of precious metal, as they did at the time. If we then assume, for example, a surplus on
the balance of payments, the resultant increase in the local money stock will cause local prices
to rise, which will make exports less and imports more competitive, which, in turn, will eventually
cause the surplus to dwindle and equilibrium on the balance of payments to be restored again.
When exchange rates are flexible (as they are in modern times), an important part of the
necessary adjustment in import and export prices is brought about by changes in the exchange
rate, which may cause the balance of payment to revert back to equilibrium quicker and with
less impact on the local money supply, and hence on local prices. Hume, of course, used the
 26

specie-flow mechanism to show how surpluses on the balances of payments cannot be

maintained indefinitely, so that mercantilist policies to stimulate the inflow of bullion (monetary
gold and silver) by way of the stimulation of exports and the discouragement of imports are
unsustainable and self-defeating.

Hume’s controversial assertion that the difference between rich and poor nations would
eventually even out is interesting. As Grant and Brue (2007: 56) correctly emphasise, there is a
kind of self-reinforcing tendency according to which rich nations get richer and poor nations
poorer. Because rich nations accumulate more capital, they can grow faster. This growth, in
turn, expands the size of their market, which creates scope for further investment, innovation
and growth. Moreover, rich nations are able to lure away the best talent from other, poorer
nations, which adds impetus to their wealth-creating ability. But, as Hume already noted, there
are also contrary forces. For one, prices and labour cost tend to be higher in richer nations,
which creates an opportunity for poorer nations to supply technologically unsophisticated,
labour-intensively produced goods at a price which is competitive and attractive in the richer
nations’ markets. The profits generated in this way can then be used to accumulate capital,
which enables poor nations steadily to move into more capital-intensive, more technologically
sophisticated production. Taiwan, South Korea and China have successfully applied this very
strategy over the last couple of decades – a strategy which was already identified by Hume.
However, it presupposes a deliberate low-wage policy (at least at the initial stages), which may
not be feasible in South Africa where the difference between rich and poor is already so stark.
Ironically, China could enforce a low-wage policy, because its government was, and still is,
communist and in that sense completely authoritarian.

ECONOMICS IN ACTION: LOOKING BACK

Classical liberalism, with its emphasis on individual freedom, private property and minimal
government, is alive and well today. Yet it is also under stress. Societies are struggling to strike
a balance between individual rights and individual responsibilities, between “society owes me”
and “I owe society”, between allowing people make their own decisions and not allowing them to
hurt the common good, and between the wealth of the few and the poverty of the many.
Somehow it seems increasingly difficult to strike such a balance, mainly because the
irresponsibility of some (say, a few Wall Street bankers) tend to have increasingly large negative
spillovers for many.
 27 ECS3705/1

STUDY UNIT 2
Adam Smith

Study the following prescribed material in the textbook:

Chapter 4: only the “Overview of classical school” (pp. 45-49), again

All of chapter 5, excluding “5-1 Past as prologue” (pp. 75-76)

STUDY OUTCOMES

When studying this unit, you should aim at gaining knowledge and understanding of the
following:

• The main tenets of the Enlightenment worldview.

• How both the Theory of Moral Sentiments and the Wealth of Nations suggest different
ways of reconciling individual freedom with the achievement of the common good.
• How the division of labour enhances productivity and ultimately leads to mechanisation
and industrialisation.
• How the size of the market limits the division of labour.
• The meaning of Smith’s concept of self-interest and how that concept may be
differentiated from pure selfishness or greed.
• Why in modern capitalism competition is less likely to guide private interests towards
the common good than in Smith’s time.
• The two main reasons why, according to Smith, state interference is likely to be
ineffective in furthering the common good.
• The forms of state interference which Smith, nonetheless, advocates.
• Smith’s argument in favour of free international trade.
• Smith’s distinction between value in use and value in exchange.
• The meaning of the water-diamond paradox, why it caused Smith to focus on value in
exchange and ignore value in use (utility).
• The distinction between relative price and absolute nominal price, and the role it plays
in Smith’s labour theory of exchange value.
• The distinction between short-term market price and long-term natural price, and the
role it plays in Smith’s labour theory of exchange value.
• The sense in which Smith’s labour theory of exchange value is applicable to an “early
and rude state of society”.
• How, according to Smith (and Hume), the general price level is determined by the
quantity of money in circulation.
• The wages-fund theory, and why it is more applicable to an agricultural society than to
a modern industrial society.
• On what grounds Smith disagreed with the low wage doctrine of the mercantilists, and
the “iron law of wages” of later classical authors.
• Smith’s determinants of the wage structure in a free society.
• Smith’s view of profit as the reward for risk-taking.
• How the classical authors in general insufficiently distinguished between profit and
interest.
• Why profit rates, according to Smith, tend to be lower in rapidly advancing nations than
in poor stagnating nations, which can be more than offset by the lower wages paid in
poor nations.
 28

• After having studied Ricardo: how Smith’s theory of rent is similar to Ricardo’s.
• How Smith’s anti-bullionist stance caused him to underestimate the contribution of
money to wealth creation.
• The grounds on which Smith opposed the rising national debt of his day.
• The virtuous circle implicit in Smith’s ideas, according to which increased productivity
and wealth creation leads to even greater increases in productivity and wealth
creation.
• Smith’s distinction between productive and unproductive labour.

ECONOMICS IN ACTION

Consider the following fictitious deliberations of the very Adam Smith himself, which illustrate
the Enlightenment worldview.

Only about 100 years ago, people thought that the workings of nature, the movement of material
objects like the stars, were an impenetrable mystery. Since Mr Newton’s discoveries, we now
realise that nature is actually ordered; it can be rationally understood. This is utterly amazing!
There is a beautiful harmony in the behaviour of things, which can elegantly be described with
the aid of mathematics. Nature is not random; it obeys certain laws. And it is the duty of science
to discover these laws to the benefit of mankind. It seems that the Almighty has given man a
brain capable of comprehending the world round about him. The implications are stupendous!
Away with all woolly speculation and superstition! We no longer need to take seriously the
babblings of self-styled prophets, mystics and other such crackpots who get pleasure out of
frightening people. Our rational faculty is the yardstick of all truth. Only that which is rationally
understandable and conforms to the laws of nature qualifies as valid knowledge. All the rest is
humbug. Moreover, if each human being is endowed with this rational faculty, then governments
no longer need to prescribe to people what is good for them and what is right for them to
believe. People can discover that for themselves. People can be free! If there are natural laws
which govern the behaviour of physical objects, surely there must be natural laws which govern
the behaviour of people too. If we can discover such laws and give them free rein, there can be
spontaneous harmony in human affairs. Society can be spontaneously ordered, without having
to impose that order from above by an oppressive and coercive government. This vision is truly
inspiring. It defines my life’s work!

Question: Smith’s vision of reality can be regarded as the essence of the Enlightenment, which
dominated the intellectual climate in Europe from the early 1700s onwards. Although the
Enlightenment worldview was an important cultural advance, it is not beyond reproach. After
having studied Adam Smith’s ideas can you possibly identify some weaknesses in the
Enlightenment worldview (nowadays more popularly labelled “modernism”)? Can nature be
completely demystified by human intelligence? Can all aspects of life be rationally understood in
the way of physical science or mathematics? Can human behaviour be adequately described by
way of laws analogous to the laws of physics?

CONTENT

Although the textbook’s discussion of Smith is again lucid, needing little further clarification, we
will make quite a few additional comments, which we hope you will find useful and interesting.
Many of these comments will apply not only to Smith, but to all classical authors (in particular
Ricardo and Mill). In the next study unit (study unit 3), you will therefore find reason regularly to
refer back to this study unit.
 29 ECS3705/1

The textbook pays significant attention to Smith’s Theory of moral sentiments, which makes for
interesting reading. The essence of the section on Smith’s Moral sentiments is aptly summed up
by the textbook (2007:65) as follows:

Both Moral Sentiments and Wealth of Nations reconcile the individual with social interest
through the principle of the invisible hand, or natural harmony, and the principle of natural
liberty of the individual, or the right to justice. In Moral Sentiments, sympathy and
benevolence restrain selfishness; in Wealth of Nations, competition channels economic
self-interest toward the social good.

RELEVANCE FOR TODAY:

Some of Smith’s remarks in Moral Sentiments can be surprisingly modern and relevant as well
as full of practical wisdom. Take the following observation: “Society may subsist, thought not in
the most comfortable state, without beneficence; but the prevalence of injustice must utterly
destroy it.” In other words, a society without beneficence (that is, human solidarity or people
caring for each other) will not be a very nice place, but it will survive. However, a society without
law and order where another man’s life and property are easily taken, will utterly destroy itself.
Those responsible for law and order in South Africa take note!

In the Wealth of nations, Smith portrays self-interest as the driving force behind free-enterprise
capitalism, as illustrated by the famous quote: “It is not from the benevolence of the butcher, the
brewer, or the baker, that we expect our dinner, but from their regard to their own interest”
(textbook, p. 67). This self-interest is supposed to be kept in check by competition, understood
as the existence of a large number of suppliers or demanders in a market. If, for example, your
butcher charges unreasonably high prices for his meat, competition gives you the opportunity to
go to another butcher. Butchers are thus forced, by the threat of losing customers to competing
butchers, to be reasonable in the pricing of their meat. That is how their self-interest is kept in
check by competition and how the “invisible hand” of competition, analogous to Newton’s law of
gravity in a system of natural harmony, automatically guides self-interest towards the common
good.

Competition (understood as the availability of alternative suppliers or demanders) as a

protection against social victimisation is a particular incidence of a more general principle. That
general principle can formally be stated as follows: disassociation provides the best protection
against possible harm resulting from association. For example, if I join an association like a
trade union, a business agreement, a business partnership, a church or a sports club, but my
associates turn out to be unpleasant, unreliable or even positively harmful and dangerous, I
protect myself from any further harm by simply disassociating myself from them: leave that trade
unions, business agreement, business partnership, church or sports club and join another. It is
for that reason that both the freedom of association (the freedom to cooperate with others for
mutual benefit) and the freedom of disassociation (the freedom to terminate that cooperation
with others when it is perceived to be no longer beneficial) are necessary to balance the
potential benefit and the potential harm of human cooperation. When the freedom to
disassociate from others is absent, I get locked into association with them (no exit). People gain
power over me, which creates scope for abuse. Such is also the power of monopoly, that is, the
lack of competition (no exit).

While Smith’s argument thus presented contains important truths, it is open to a number of
misunderstandings. We will spend some time expelling some of these misunderstandings,
which are still widespread in our day.

Many people mistakenly regard Smith’s idea of self-interest as equivalent to selfishness, in the
morally objectionable sense of being only and exclusively concerned with one’s own interests at
 30

the expense, if necessary, of the interest of others. There is, however, a subtle but important
difference between Smith’s self-interest and plain selfishness. Smith’s self-interest refers to the
desire to meet one’s own needs – earn one’s own income and pay for one’s own food, clothes
and housing. Clearly, that kind of self-interest is entirely moral, even if only minimally so. While
morality challenges people to go a step further and also be concerned about the needs of
others, people must at least look after themselves. Otherwise, that step further would not even
be possible; only people who have already looked after their own needs can afford to be
concerned about the needs of others. Self-interest as the desire to meet one’s own needs is
thus not inherently immoral, selfish or greedy. It becomes immoral, selfish and greedy only
when done at the exclusion of a concern for the interests of others, that is, when it is pushed so
far that it squeezes out any generosity or any desire to see others get a fair deal too, which is
not at all what Smith had in mind. Smith did not exclude the possibility that his “butcher, brewer
or baker”, even while being self-interested, are also keen to give their clients a fair deal or to
spend part of their fairly earned income on contributing towards the needs of others. While
generosity and fair play are not inherent in Smith’s concept of self-interest, they are not
excluded by it.

Therefore, Smith’s idea that self-interested people can serve the common good should not be
interpreted as a justification for selfishness: “why should I worry about being selfish if my
selfishness serves the common good?” Although this interpretation was not intended by Smith,
he is partly to blame for it. The problem lies in Smith’s proposition that the invisible hand of
competition operates like an impersonal natural law and that the mechanism is, therefore,
automatic and inevitable. But contrary to harmony in the material world of physics, harmony in
the world of human affairs is never automatic or inevitable, for which there are a number of
reasons. First, markets are far from always sufficiently competitive to constrain rampant self-
interest and guide it towards honesty and decency in business dealings. Second, even if
markets were highly competitive, people are still in need of some degree of moral restraint and
benevolence if their behaviour is to be in the interest of all, as Smith himself argued in his
Theory of Moral Sentiments. In essence: competition cannot completely replace the role of
moral self-restraint.

Similarly, by emphasising self-interest as the driving force behind liberal capitalism, Smith does
not wish to suggest that liberal capitalism is based on selfishness or even on greed. While
liberal capitalism gives people considerable freedom to pursue their own interests according to
their own values, it would be a caricature to suggest that its core value is that of the “law of the
jungle” where “might is right” and selfishness is given free rein. It would be more correct to
argue that a liberal, free-enterprise system is based on the idea that the responsibility to provide
for one’s own needs lies, first and foremost, with private individuals themselves. Instead of
looking to the state or their fellowmen for their means of existence, private individuals have to
accept responsibility for their own needs, even if it may still be the duty of a liberal state to
create an environment which makes it reasonably possible for people to look after themselves.
In addition liberals would also wish the state to provide some minimum safety net for those who
fail to make an adequate living for themselves – as Smith himself advocated. And if people are
to carry the responsibility to provide for their own needs, they must also be given the freedom to
do so, which requires that the means of production be privately owned and that exchange be
largely voluntary. Because freedom can be abused (freedoms can always be abused; this is
their drawback but not always a good enough reason to abolish them), selfishness, greed and
social injury can play a role too – see again Smith’s Moral sentiments. But, says Adam Smith,
the scope for such abuse of freedom can be brought back to acceptable proportions when there
is sufficient competition (Wealth of Nations) and when there is a sufficiently strong sense of
voluntary self-restraint based on moral conviction (Theory of Moral Sentiments).

This brings us to the Wealth of nations itself. As the textbook points out, economics as a
separate field of inquiry was really established by this book; previously economics had been
treated more as a branch of applied moral philosophy. Apart from being a towering
achievement, Wealth of nations is also still a surprisingly readable and accessible book. Do
 31 ECS3705/1

yourself a favour and take the book out from the library or access it on the internet. We would
not expect you to read it from cover to cover (there being 900 pages to it!), but you will be
surprised what a good and stimulating read it still is, on just about all it covers.

Note how Smith explains the “wealth of nations” primarily in terms of the division of labour, a
greater division of labour (labour specialisation) creating scope for greater productivity (2007:66-
67). Labour specialisation in general occurs in two forms. The first is specialisation in producing
a particular product. For example, some people specialise in baking bread, others in brewing
beer and still further people in producing pins; call this “product specialisation”. The second form
is the specialisation in certain parts of the production process necessary to produce a given
product; call this “operation specialisation”. For example, staying with Smith’s pin example,
some people specialise in cutting wire, others in straightening wire, still others in sharpening the
end of a wire, etc. When Smith refers to labour specialisation, he more particularly means what
we call operation specialisation, although it is clear that product specialisation will most often
imply a degree of operation specialisation as well.

Smith mentions various reasons why a greater division of labour (more labour specialisation)
increases productivity: more scope for developing better skills, less time lost in changing over
from the one task to the next, etc. But by far the most important reason which is perhaps not
sufficiently emphasised is that labour specialisation creates possibilities for mechanisation and,
as such, paves the way for industrialisation. Labour (operation) specialisation facilitates
mechanisation, because it divides up the production process into a large number of repetitive,
standardised productive handlings, which makes it possible for machines to take over these
repetitive handlings. The enormous productivity gains from industrialisation and mechanisation,
which Smith only partly anticipated, can thus indirectly be attributed to Smithian labour
specialisation too.

Always be aware of the fact that the scope for labour specialisation, and thus for
industrialisation too, is limited by the size of the market.

Incidentally, when we speak of a market, we obviously do not mean a physical market place
where people come together to trade their goods. In the modern world, people can trade with
each other without physically meeting. A market should, therefore, more generally be
understood as a collection of demanders and suppliers who, given their preferences and
abilities, are potentially interested in trading with each other, because they are able to
communicate market information with each other (types of good on offer, prices, qualities,
delivery times etc) and can reliably transport the relevant goods to each other at an non-
prohibitive price. Hence the size of the market, for a supplier, is determined by the number of
potential demanders as well as the average purchasing power of each potential demander.

Back to our point as to why the size of the market limits the scope for labour specialisation. The
textbook emphasises this important point only later in the chapter, when it discusses Smith's
views on economic development (2007:79-81), although it does not provide a clear explanation
for it. The size of the market limits the scope for labour specialisation, because increased
specialisation, whether in product or in productive operation, always involves dividing up the
market into smaller sub-markets – one for each specialised product or productive operation. In
short: the division of labour implies a division of the market too. As a result, only when the
market is initially large enough can its division into these sub-markets keep these sub-markets
large enough for a specialist to make a living. That is why the growth of a market, say of the
population of a town, leads to the establishment of more specialised shops in that town. When a
town is really small, only a single general store can make a living there. As the town grows,
however, a specialised bakery, butchery and clothing shop may be able to establish
themselves, offering better quality, a wider selection and better prices than the general store
previously could. That general store, therefore, goes out of business unless it specialises itself.
As the town grows even further, there may even be space for a watch-maker, a tobacco shop
 32

and a dentist. And so the process goes on. Note that there is a way in which labour
specialisation in itself already increases the size of the market: by being more productive and
lowering the cost of production and thus the price of goods, more people can afford these
goods, which in itself enlarges the market for these goods. This effect is, however, never quite
so strong that the size of the market never limits the possibilities for labour specialisation.

Given that the size of the market limits labour specialisation and industrialisation, any measure
which increases the size of the market aids the scope for labour specialisation and thus for
greater prosperity in general. Three ways in which markets can expand spring to mind.

First, given that the ability of potential demanders and suppliers to communicate with each other
and transport goods (and money) to each other defines a market – as stated above –, it is clear
that improvements in transport and communication technology increase the size of markets. As
transport and communication keep on getting faster and cheaper, the market which any given
producer with access to that technology can reach keeps on growing too, to the point where the
whole world has now just about become one huge market for everyone. On the downside, if
transport and communication were somehow to deteriorate through increased cost, slowness,
unsafety or other forms of unreliability, the effects on the achievable degree of productivity
through reduced specialisation and industrialisation will be equally significant. In some ways,
modern industrialised economies have thus become more vulnerable. If the road, railway, air
traffic and communication infrastructure were somehow to deteriorate, farmers could no longer
reliably and cheaply get their crops to their market, information about available qualities and
prices could no longer be spread among potential market participants quickly and cheaply,
producers could no longer reach their market except for those who live in close proximity to their
factory, and so on. When markets shrink in this way, possibilities for labour specialisation
decrease and productivity falls. There is a lesson for South Africa in this: it is imperative that we
take good care of our transport and communications infrastructure.

Second, markets can grow by removing restrictions on international trade. Smith’s advocacy of
free international trade (2007:69-70) is based on precisely this point. Smith thereby takes it for
granted that countries always have some area in which to develop a competitive advantage vis-
à-vis other countries. If this is not the case, a country will not necessarily benefit by free trade
(but see Ricardo's theory of international trade in the next study unit). The free trade argument
then points out that a country, when exposed to the winds of competition, will eventually develop
competitive strength in some area, just as talented soccer players tend to improve their game
when playing consistently against stronger opponents. The current trade policy of the South
African government is roughly based on this very idea: the economy is gradually exposed to
international competition by reducing its legacy of import protection and export subsidisation
(partly because international trade agreements force the government to do so), in the hope that
the South African economy will react to this greater competition by eventually developing its
own strengths. There are signs that this is indeed happening, although some sectors, like the
textile industry, have been seriously hurt by foreign competition, especially from China.

Third, the market for an individual firm can also expand by reducing the number of competing
firms. Such a reduction is often a more or less spontaneous by-product of the process of
advancing mechanisation: the firms which are quickest to apply the latest, most efficient
machinery are typically also the ones which can produce at the lowest cost. By thus being able
to offer the goods at a lower price, they obtain a larger share of the market often at the expense
of a multitude of smaller, less progressive operators, who are then forced out of business. That
is partly why oligopoly rather than perfect competition is the typical market form in the modern
industrialised world, in spite of the fact that markets have kept on growing due to the falling cost
and increasing efficiency of transport and communication. You should bear in mind that highly
mechanised firms can only exist by virtue of large scale production, which means that, for a
given size of the total market, there may only be space for a handful of firms – if we wish firms
to produce at the lowest possible price. It seems that the loss of competition in markets is, to
some extent, the inevitable downside of the economies of scale and the higher standard of living
 33 ECS3705/1

made possible by mechanisation and mass production.

As noted before, Smith assigns an important role to competition as the invisible hand which
spontaneously guides individual interests towards the common good. In Smith’s day, however,
industrialisation had not progressed very far in Britain. There were hardly any big factories. Most
production was still handicraft production performed by artisans in small family enterprises
organised as unincorporated proprietorships or partnerships. Under these circumstances, there
was indeed a good chance that competition was vigorous in most markets. Modern capitalism
with its far advanced industrialisation dominated by corporate firms may have had huge
advantages in terms of raised productivity, but it has not been conducive to competitive
markets. Most markets in modern capitalism are oligopolistic rather than perfectly competitive.
Hence Smith’s invisible hand has a much reduced chance of success in modern capitalism than
in Smith’s own day.

According to Smith, government intervention through coercive laws does not further the
common good for two main reasons. First, people know their own interest better than
government officials do: “[E]very individual , it is evident, can, in his local situation judge [his
own economic interest] much better than any statesman or lawgiver can do for him .. It is the
highest impertinence and presumption .. in kings and ministers to pretend to watch over the
economy of private people” (textbook, p. 68). Second, government officials tend to waste public
resources: “They are themselves always, and without any exception, the greatest spendthrifts in
the society. Let them look after their own expense and they may safely trust private people with
theirs.” (textbook, ibid). Take note, however, that Smith is not entirely against government
involvement and interference. Government still plays an important role in Smithian liberal
capitalism and he still assigns some essential functions to it (2007:70-71). Make sure you know
what these functions are.

Smith was the first to think more systematically about what determines the value of a good. As
an introduction to his theory of value (2007:71-73), we will briefly discuss the basic principles of
value determination.

Smith already distinguished between two value concepts: value in use and value in exchange.
Value in use, or utility, is about how much pleasure or convenience someone gets out of owning
and using a good, which is, of course, subjective and difficult to measure objectively. By
contrast, value in exchange, or market price, is about the price which a good would fetch when
selling it in the market, which is obviously objective and easy to measure in quantities of money
(10 rand or 6 dollar).

A market price (value in exchange) is basically an agreement between a demander and a

supplier about the price which is mutually acceptable to both. A mutually acceptable market
price must lie somewhere in between the demander’s and the supplier’s valuation of the good. If
the price rises above the demander’s valuation, he would no longer benefit from the deal, as he
would have to pay more money for the good than what it is worth to him. The demander’s
valuation is, therefore, a maximum cut-off price for him, determined by value in use (utility): how
much pleasure he expects to get out of consuming the good. Similarly, if the market price falls
below the supplier’s valuation, she would lose from the deal as she would obtain less money for
the good than what it is worth to her. The supplier’s valuation is thus a minimum cut-off price for
her, which is determined by the cost incurred in producing the good as well as by a minimum
acceptable reward which she wants in compensation for the entrepreneurial effort spent in
making the good available. While cost of production can more or less objectively be determined
as the amount of money spent in making the good available (money cost), the reward which she
wants in compensation for the entrepreneurship in making the good available would be more
subjective. Hence the supplier’s valuation is also partly subjective.

The market price can obviously be influenced by both the demander’s and the supplier’s
 34

valuation of the good, depending on the valuation of all the other demanders and suppliers in
the market and on the degree of competition in that market. That is why we study demand and
supply curves (which are essentially collections of demander and supplier valuations) and
market forms, like perfect competition, monopoly and oligopoly. Broadly speaking, the degree to
which the market price is determined by the demander’s or the supplier’s valuation depends on
where the bargaining power advantage lies. If suppliers have a bargaining advantage over
demanders, the market price will be pushed up towards the maximum price acceptable for
demanders. And if the bargaining advantage lies on the side of demanders, the price would be
pushed down towards the minimum price acceptable for suppliers. That is where the relevance
of market forms comes in: monopoly, perfect competition, oligopoly, etcetera.

Now, Adam Smith saw an irreconcilable conflict between value in use (subjective utility) and
value in exchange (objective market price), as exemplified by the water-diamond paradox
(2007: 71): how was it possible that water has a very high value in use but a very low value in
exchange, while diamonds have a very low value in use but a very high value in exchange?
Unable to resolve this conflict, Smith rejected the relevance of value in use (utility) as a
determinant of exchange price and looked only at cost of production. As such, Smith ignored the
demander’s valuation (maximum cut-off price) and considered only the supplier’s valuation
(minimum cut-off price) and made the latter the sole determinant of a good’s market price.

But if it is realised that market price can be influenced by both the demander’s valuation (utility)
and the supplier’s valuation (cost of production plus reward for entrepreneurial effort) of the
goods, the water-diamond paradox allows for a simple resolution. Water has a very low market
price in spite of its high utility because its cost of production is very low. And since it is in
abundant supply (permanent excess supply), the bargaining advantage lies on the side of
demanders who will then have the power to push the market price down towards this very low
minimum price which is the supplier’s valuation. By contrast, diamonds have a high market price
in spite of their low utility because their cost of production is high. And since diamonds are
relatively scarce, the bargaining advantage lies on the side of suppliers who will then have the
power to push the market price up towards the maximum as determined by the demanders’
valuation of diamonds (their utility or value in use).

What saved Smith’s cost-of-production theory of value from being unrealistic is that he did not
wish to use his theory to explain the short-term, day-to-day level of prices, in which demand
factors (and thus utility) will play a more important role. Rather, Smith used his theory to explain
long-term price levels, that is, those levels towards which short-term prices are supposed to
gravitate towards or fluctuate around. Now, if we may assume that there is enough competition
in a market (which Smith takes for granted) and that production technology remains stable
(unchanged long-term average cost or “constant cost per unit of output” as the textbook calls it),
it is not unrealistic to claim that market price will fluctuate around some stable level
predominantly determined by cost of production, given that cost of production will include some
level of normal profit too. So, by explaining long-term rather than actual short-term prices, the
defect of Smith's theory - its neglect of utility (demand factors) - could be compensated for.

Note furthermore that Smith wished to explain, not the absolute money price of a good but its
relative price, which is the price of one good (say, shoes) relative to another (say, trousers). So
Smith did not intend his theory to explain why shoes cost R300 or trousers R200, but why the
price of shoes relative to trousers is 3:2. This distinction between the absolute money price and
the relative price of a good can, however, also be misleading, because of the sense in which an
absolute money price is a relative price too. After all, the absolute money price of R300 for a
pair of trousers expresses the value of the trousers relative to the value of money. When I say
that a pair of trousers is worth at least R300 to me, what I am actually saying is that it is worth at
least 300 times the value of R1 to me. Value is in essence a subjective concept (my estimation
of the degree to which some good is expected to meet some need in me). Therefore, to make it
objectively quantifiable, we have to express it as a ratio of two subjective values: either the
value of one good relative to the value of money (absolute money price) or the value of one
 35 ECS3705/1

good relative to the value of another good (relative price). We will come back to this issue in
study unit 5.

Of course, Smith’s theory of value is not merely a cost-of-production theory of value, but more
specifically a labour-cost-of-production theory of value. Particularly, relative amounts of labour
cost are supposed to determine relative price. As the textbook (2007:72-73) points out, this may
be a reasonable proposition if labour cost can be regarded as the only cost of production, which
would demand “an early and rude state of society which precedes both the accumulation of
stock [of capital] and the appropriation of land”, that is, people make no use of capital and land
can be used for free. Otherwise, the use of capital and land will also create cost, and relative
price can no longer be determined by relative amounts of labour cost only.

Moreover, Smith measures labour cost as labour time. The reason that the price of shoes
relative to trousers is 3:2 is that it takes, for example, 3 hours to produce shoes but only 2 hours
to produce a pair of trousers. For this to be a valid proposition, Smith must additionally assume
that a labour hour in both the shoes and the trousers sectors is equally productive, stands for
the same amount of effort and skill, and is equally priced, which furthermore presupposes that
capital-labour ratios are roughly the same in both sectors.

All these restrictive assumptions make his theory, of course, rather artificial and contrived.

To overcome these problems, Smith argues that in an advanced economy, while labour may no
longer be regarded as the source of value (a labour-cost or labour-time theory), it can still
function as the measure of value (a labour-command theory), which seems an awkward step.
After all, if Smith is sincere in wishing to relinquish the idea that relative labour cost determines
relative price, he has to abandon his ambition to explain long-run natural prices as well – such
prices being explicable in terms of cost of production only. Moreover, labour as a measure of
value (the labour-command theory) seems superfluous, since that function is already
adequately performed by money. In short, Smith wrestled somewhat unsuccessfully with the
problems inherent in the idea that relative labour time used in production determines relative
market price. While labour time, or cost of production in general, can undoubtedly have an
influence on market price, it is difficult to maintain that it is the only determinant of market price,
whether nominal or relative. We will find Ricardo and Marx wrestling with similar problems.

The textbook (2007:74-78) subsequently discusses Smith’s theories about wage, profit and rent
determination. Wage, profit and rent are also called factor rewards, because they are supposed
to be the rewards for the contribution towards wealth creation made by the various production
factors (labour, capital and land), which also represent the three main classes in society
(workers, capitalists and landowners). Similarly, the wage rate (wage per unit of labour), profit
rate (profit per unit of capital) and rent rate (rent per unit of land) are collectively referred to as
factor prices. Now, the classical writers presupposed that, once they had developed a theory of
factor prices, they had thereby established a theory of the functional distribution of income as
well, that is a theory about how the total national income is distributed over wages, profits and
rent and thus over workers, capitalists and landowners. But for this to be true, the total amount
of real productive contributions and the general price level need to be fixed and unaffected by
the factor prices established; in other words, the size of the cake must remain the same
irrespective of how it gets carved up. Workers must work equally hard irrespective of the wages
they get paid, tenants must cultivate the land equally well irrespective of the rent they must hand
over to their landlords, and entrepreneurs/capitalists must be equally enterprising and take
equal amounts of risk irrespective of the profits they receive. All this seems unlikely, especially
in the medium to longer term. As the textbook (2007:139) notes in chapter 8 while discussing
Mill (see study unit 3):
[P]roduction and distribution are interrelated and ... interference with one involves
interference with the other. [There is no] mass of goods already produced. They appear as
a continuous flow that gets produced through the incentives provided by payments to the
 36

factors of production.

RELEVANCE FOR TODAY:

Even in modern-day South Africa, many people have a view of the nation’s wealth as if it were a
treasure chest which is somehow always filled to the brim with wealth (a “mass of goods already
produced”). Hence they envision that getting wealthy is merely a matter of getting hold of the
key to the treasure chest – the key representing some kind of political or economic power by
which its possessor can channel wealth towards him- or herself.
This view of how to get wealthy is, of course, not entirely without merit. The possession of
political or economic power can indeed be an important determinant of people’s wealth: political
influence can be used to seek rents (see “rent seeking” as discussed under the previous study
unit), and market prices can be manipulated by monopolistic or oligopolistic power. But the view
is also flawed in that wealth is not solely obtained through the exercise of political or economic
power, if only because wealth needs to be produced. Treasure chests are not automatically
filled with wealth.
Basically, wealth creation involves the investment of energy, skill, saved-up resources and
entrepreneurship through a cooperative effort between both the owners of firms and their
worker-employees. Therefore, if some section of society seeks to channel wealth towards itself
in such a way that the investment of effort, skill, saved-up resources and entrepreneurship is
compromised, production shrinks and everybody suffers. The inescapable reality is that, if some
get rewarded beyond their productive contribution, others must have put in a productive
contribution without getting duly rewarded for it. To some degree, people tolerate making
productive contributions without being rewarded for them, also because it is always difficult to
gauge objectively what exactly one’s due reward is. Nonetheless, there is a limit to such
forbearance. If that limit is reached, the continued manipulation of economic outcomes by
means of political or economic power will eventually drive an economy towards break-down.
Any system can endure a certain amount of abuse, but there will come a point where the extent
of the abuse is such that structural damage occurs. The wealth and employment creating ability
of an economy will then be compromised to the detriment of all – but especially those with the
least resources and skills (others can escape to seek their fortune elsewhere). The South
African economy may still be fairly far off breaking point, but it may be a good idea not to push
the system too close to that point. Note that this warning is directed at the powerful in both the
private and the public sector.

As for the general price level, the classics simultaneously assumed that a more or less given
total amount of money in circulation would guarantee a stable general price level, which is the
substance of the quantity theory of money first formulated by Hume (see the paragraph of the
textbook [2007:55], beginning “Hume did not believe ...”). With the general price level (and
productive contributions) being the same, an increase in the nominal profit rate would have to
go at the expense of a decrease in the nominal rent or wage rates and vice versa. In the
modern world, however, increases in nominal wage rates need not be accompanied by
decreases in nominal profit rates but can also lead to inflation, that is, a rise in the general price
level. The reason is that suppliers (whether they be workers as suppliers of labour or producers
as suppliers of goods) are nowadays in a position to pass on their cost increases in the form of
higher wages or prices. Moreover, in modern economies the total money supply is more flexible
and can, therefore, more easily adapt itself to the economy’s increased money needs due to
higher prices.

A further troublesome aspect of the classical theory of distribution is that it is unclear which
production factor is rewarded in the form of profit. While it is reasonably clear that wage is the
reward for contributing labour (at least, in blue-collar form involved in physical production) and
rent is the reward for contributing land, profit seems to contain a mix of rewards for making
various factor contributions, not only that of furnishing capital. In actual fact, profit is the reward
 37 ECS3705/1

which accrues to the ownership of a firm. So whatever the owners happen to have contributed
to wealth creation is what profit rewards. Because (to be able to own the firm) an owner must at
least have supplied some of the necessary capital and entrepreneurship, profit must contain at
least a reward for both these contributions – in proportions which are difficult to determine. But
owners, especially of smaller firms, sometimes do some of the actual productive, blue-collar
work themselves as well, in which case profit will also contain a reward for labour. In fact, we
can only separate the contributions of the various production factors and determine a separate
market price for them, when these production factors are externally supplied by non-owners.

To sum up, the classics worked with only three production factors: labour, capital and land.
Labour is rewarded in the form of wage, capital in the form of profit and land (which provides
raw material) in the form of rent. Owners of firms were thereby implicitly regarded as
contributing only capital, with the result that the classical concepts of profit and interest were
somewhat hazily defined and often, and mistakenly, used interchangeably, and that the
productive contribution of entrepreneurship tended to be overlooked or undervalued.

While studying Smith’s wages fund theory in the context of his theory of wages (2007:74), it may
be useful simultaneously to consult the textbook’s (2007:139-140) criticism of the wages fund
theory in its discussion of Mill. The theory seems to be applicable only to a predominantly
agricultural society, which Britain still was in Smith’s days – although the contribution of
commerce was not insignificant and manufacturing was rapidly advancing as a result of
increased industrialisation. The peculiarity of farming, especially at the time, is that it mostly
yields only one crop per year. A single production round per year implies that all the input cost
incurred during the year, the greatest proportion of which will be wages, must be financed
ahead of selling the crop. In other words, because farming has only one production round per
year, a large proportion of its capital goes towards paying wages. So the total amount of capital
available in society becomes an important determinant of aggregate wages paid. However, in
manufacturing, one production round probably does not take more than a week and output is
continually sold, with the result that the capital requirements to finance wages ahead of sales
are much smaller. Moreover, in modern economies, workers get paid at the end of each month,
which allows significant time for some or all of that month’s production to get sold. Hence,
modern manufacturers can finance a significant part of their monthly wage bill out of the
proceeds from selling the same month’s production. Wage payment thus requires a much
reduced amount of working capital, and the constraining influence of total available capital on
wage payments is thus much smaller too – also because, in modern economies, firms can much
more easily and quickly supplement their working capital requirements by access to banks or
financial markets. In their discussion of Mill later on in the book, Grant and Brue (2007: 140)
sum up the weakness of the wages fund doctrine well:
The wages fund concept was erroneous because there is no predetermined proportion of
capital that must go to labour. The idea of a fund arose because the harvest of one
season was used to provide the subsistence for labour for the following year. But once a
business gets established, wages are paid not from an advance fund of so-called
circulating capital but rather from a current flow of revenue derived from the sale of the
output. [Hence] .. the decision to hire a worker is based not on the availability of past
revenue, but rather on the prospective revenue that the firm will receive by selling the
output that the worker helps produce.
Nonetheless it remains true that, for a given amount of total revenue (total sales), the more firms
pay in wages the less they make in profit, and vice versa. Hence if workers were to push up
their wages so far that firm owners are no longer reasonably compensated or are threatened
even to lose money, employment will suffer. Such is the real limit to wage payment.

Smith saw as “the wealth of nations” not the total amount of money within their borders (as the
mercantilists did) but the total amount of useful goods (“necessities and conveniences”) which
they produced within a certain period, which is indeed a more correct view of things. But note,
however, that Smith excluded services from these useful goods. So Smith did not regard
 38

doctors, lawyers, politicians or comedians as contributing towards the total national product.
Note also how Smith’s view about wealth as constituting useful goods does not sit comfortably
with his disregard for utility as a determinant of value.

Smith’s opposition to bullionism leads him to underestimate the importance of money and the
contribution it does make towards wealth creation. Bullionism is indeed fallacious; wealth should
be equated with useful goods not with money. But that does not mean, as Smith appears to
argue, that money is productively sterile. Money may not be a production factor: it does not
directly contribute to production in same way that raw material, tools, labour or machinery do.
But money does indirectly contribute towards the productivity of society by making it easier to
trade. Recall how increased labour specialisation (an increased division of labour) must be
accompanied by an increased intensity of trade. When everybody bakes their own bread, builds
their own homes, grows their own wheat, and makes their own clothes, there is little need for
trade. But as soon as people start to specialise, trade necessarily intensifies. Bakers must trade
with builders, farmers, and tailors, etcetera. The absence of money, by frustrating trade, will
thus frustrate labour specialisation too. Hence the productivity gains attributed to increased
labour specialisation and the use of machinery (capital) should also, partly, be attributed to
money. Similarly, money may indirectly contribute towards wealth creation by allowing the
easier accumulation of saved-up resources over time (money as a “store of wealth”), in order to
finance capital-intensive production processes in the future.

Observe how Smith is in favour of bank money (notes and deposits) replacing commodity
money (gold and silver coin) because it allows for the cheaper and easier production of money.
But be aware that Smith was still in favour of a convertible currency, meaning that the bank
notes and deposits were still to be fully convertible into gold and silver coin – even if they may
no longer be fully backed by gold and silver coin. Smith did not envision anything like a modern
fiat money system in which currency is no longer convertible into anything. For more about that,
see our discussion of Malthus in the next study unit.

Note that Smith’s objection to public debt runs along very much the same lines as that
advanced by modern Chicago school economists (see study unit 7): that public borrowing could
crowd out private borrowing via higher interest rates, while private borrowing is regarded as
more productively and usefully invested.

The key idea in Smith’s theory of economic development (2007:79-81) is that the extent of the
division of labour is limited by the size of the market, as already discussed in detail above. As
markets grow, the scope for productivity gains through mechanisation can, therefore, grow too.

ECONOMICS IN ACTION: LOOKING BACK

The 19th century was a century of tremendous cultural optimism. Smith’s liberal ideas typical of
the Enlightenment had basically triumphed. There was a solid and steadfast belief in “Progress”.
All social problems were regarded as solvable through the application of human reason.
Technology and science, including economic science, would be able to bring heaven down to
earth.

Now that you are more familiar with Smith’s ideas, does the Enlightenment worldview
(“modernism”) remain equally attractive and inspiring to you? Your lecturer has to admit that he
still finds the Enlightenment worldview, despite its weaknesses, tremendously inspiring. It
should never be rejected wholesale, even if it needs to be seriously qualified. While the limits of
human reason need to be acknowledged in certain contexts (especially the area of ultimate
meaning and responsibility), and while science and technology cannot in themselves bring down
heaven to earth (and, in fact, have had some seriously negative side-effects), it would be
disastrous if people came to reject human reason altogether, abandoning themselves to instinct
and intuition, as some strands of “postmodern” thought appear to advocate. Then we truly
 39 ECS3705/1

regress to the darkest of Dark Ages. The overstatements and partial failures of the modernist
agenda do not justify us to go back to pre-modern worldviews. Both reason/observation and
intuition/instinct have a role to play in our search for truth, and we should never entirely abandon
the one for the sake of the other. They need to keep each other in tension.
 40

STUDY UNIT 3
Malthus, Ricardo and Mill

Study the following prescribed material in the textbook:

• all of chapter 6

• chapter 8: only the section “Say's law of markets” (pp. 128-131)

• all of chapter 7, excluding “The currency question” (pp. 101-102), “Rent at the
intensive margin of cultivation” (pp. 104-105) and “7-1 Past as prologue” (pp. 109-110)

• chapter 8: only the section “John Stuart Mill” (pp. 135-146, excluding “The law of
international value” pp. 142-143)

STUDY OUTCOMES

When studying this unit, you should aim at gaining knowledge and understanding of the
following:

For Malthus and Say:

• Malthus’ population theory: the assumed geometric growth in population and the
arithmetic growth in agricultural production.
• Malthus’ preventative and positive checks to population.
• Malthus’ views on the Poor Laws and their relation to his population theory.
• The relevance of Malthus’ population theory for today.
• The meaning of Say’s law and on what basis the classical authors, Say in particular,
thought the law would hold.
• Malthus’s particular arguments against Say’s law, and how he thought aggregate
demand failure (a general glut) could be overcome.
• The background to Malthus’ support for the Corn Laws, the landlords’ support for the
Corn Laws and the business class’ opposition to the Corn Laws.
• The reasons why Say’s law has less chance to hold in a modern fiat money economy
than in the commodity money economy of classical times.

For Ricardo:

• Ricardo’s “abstract reasoning” and his deductive method as opposed to the inductive
method.
• The nature of rent.
• How rent emerges at the extensive margin of cultivation in Ricardo’s theory of rent.
• Why “rent is price determined, not price determining” in Ricardo’s theory of rent.
• The focus in Ricardo’s theory of exchange value on relative price rather than absolute
price, and on long-term natural price rather than short-term market price.
• How, in Ricardo’s theory of value, the long-term natural price is determined by supply
factors (cost of production as measured in labour hours) and the short-term market
price by both supply factors (cost of production) and demand factors (utility).
• The role which Ricardo’s (contrary to Smith’s) theory of value assigns to utility.
 41 ECS3705/1

• How Ricardo’s (contrary to Smith’s) theory of value includes capital and raw material in
the cost of production measured in labour hours.
• The problem of differing capital-labour ratios in Ricardo’s theory of value.
• The problem of differences in labour quality in Ricardo’s theory of value.
• Why changes in the wage rate, profit rate and rent rate do not affect relative exchange
value in Ricardo’s theory of value.
• Why profits and wages vary inversely in Ricardo’s theory of value.
• The determinants of the natural wage rate, and the reasons for its long-term tendency
towards subsistence level (the “iron law of wages”) – in Ricardo’s theory of income
distribution.
• The determinants of the natural profit rate, its tendency towards equality in all sectors,
and the reasons for its long-term decline – in Ricardo’s theory of income distribution.
• The determinants of the natural rent rate, and the reasons for its long-term rise – in
Ricardo’s theory of income distribution.
• Graphical illustration of the long-term tendencies in the wage rate, profit rate and rent
rate.
• How Ricardo’s theory of income distribution suggests a conflict of interest between
workers and capitalists as well as between landlords and the rest of society.
• Why, according to Ricardo, the introduction of a tax on rent does not raise the price of
agricultural output, and how this idea was taken up by Henry George.
• Ricardo’s opposition to the Poor Laws and the Corn Laws.
• Ricardo’s views on the benefits of free international trade.
• Ricardo’s theory of comparative advantage and the role which the concept of
opportunity cost plays in it.
• Ricardo’s views on the influence of mechanisation on real wage and employment
levels, and why they are largely incorrect.

For Mill:

• Mill’s views on the productive contribution of labour, capital and land, and the extent to
which they put limits on wealth creation.
• The interrelatedness of production and distribution in Mill’s theory of income
distribution.
• Mill’s views on the wages fund.
• The weakness of the wages fund doctrine in general.
• Mill’s anticipation of demand and supply schedules as well as of the concept of price
elasticity, as later more fully developed by Marshall.
• Mill’s views on the falling rate of profit and why he thought a falling rate of profit need
not constrain investment and wealth creation.
• Mill’s concept of a “minimum necessary rate of profit”.
• Mill’s views on competition and socialism.
• Mill’s views on the role of government, both positive and negative.

MALTHUS

• All of chapter 6, and chapter 8 only the section “Say’s Law of markets” (pp. 128-131)

When you read the chapter on Malthus, be prepared for the possibility that Malthus’s ideas will
upset if not infuriate you; 18th century people were often quite fierce and forthright in the
expression of their ideas and Malthus is a prime example. It is hard not to be stirred by
Malthus’s words and arguments, not only because he says such heartless things but also
 42

because the unrelenting growth in the world’s population is an issue of enormous concern.

ECONOMICS IN ACTION

Consider the following contemporary perspectives on Malthus’s population theory and the
problem of population growth in general.

Population: An Underlying Theme in Addressing Some of the World’s Most Challenging

Problems

Source: The Population Media Centre,

http://www.populationmedia.org/issues/population/?gclid=CMySk63qi64CFVE8fAodtFGa4w
19 March 2012.

The world’s population is now [2010] more than 6.8 billion [7 billion was reached in 2012] and
continues to grow by 83 million people per year. During the last half-century, the world’s
population more than doubled. Between 1960 and 2010, the world population rose from 3 billion
to 6.8 billion. In other words, there has been more growth in population in the last fifty years
than the previous 2 million years that humans have existed. Currently the rate of population
increase is 1.2% per year, which means the planet’s human population is on a trajectory to
double again in 58 years.

The true enormity of a “billion” is important to understand when thinking about human
population. For example, if a person is fined a million dollars and ordered to pay $100 dollars
per day towards the total due, it would take 27.4 years to pay off the debt. If however, the fine
were a billion dollars, the time required to pay off the debt would be 27,397 years. When
discussing a billion of anything, one should take a moment to appreciate the titanic size
involved.

The extreme growth in human population – now counted by an additional billion people every 12
to 13 years — is mortally taxing the Earth and its resources. Each individual person has a
unique impact on the planet’s environment. Some people may be relatively less damaging than
others, but no living individual is without an ecological footprint. In other words, each person
needs basic resources and almost all people aspire to utilize significantly more resources than
are required by their basic needs. As these needs and aspirations are multiplied by a factor of
6.8 billion, day after day and year after year, the stability of the planet’s ecosphere has been,
and will continue to be, severely compromised.

As a result, the Earth is attempting to impose its own checks on human population. We can
witness these “checks” in the form of widespread disease and the emergence of new disease
strains, food and water shortages, poor harvests and violent and destructive weather caused by
climate change. While it should be obvious that the Earth is a finite sphere and cannot endure
infinite growth by any single species, we should also remember that Earth’s current web-of-life
is the result of billions of years of complex evolution. It is irreplaceable.

Beyond the dour environmental implications of current and future global population growth,
there is a human tragedy in process as well. When we look forward to the next 40 years, the
most significant population increases will take place in the areas of our world where natural
resources and the infrastructure of modernity are already the scarcest. Ninety-five percent of
human population growth is occurring in countries already struggling with poverty, illiteracy and
civil unrest. In fact, developing countries are in need of approximately $1 trillion per year in new
infrastructure (school rooms, for example) to accommodate the dramatic increases to their
populations. This figure is effectively impossible to meet, which means the continued expansion
of human population will result in an increase in the number of people living in poverty,
unemployment and with inadequate health care.
 43 ECS3705/1

The median projection of population size by the U.N. Population Division suggests that
population growth rates will decline over the coming several decades, with a possible
stabilization around the year 2050. But achieving this will take an enormous amount of hard
work, creativity and financing – it is by no means a fiat accompli. And, even if population is
stabilized between 8 and 9 billion, a scenario which becomes less likely with each passing day,
the increase to human population will still be between 20% and 30%.

That magnitude of this increase, coming on top of the unprecedented growth that has occurred
in the last half-century, will be felt in all aspects of life. It will further stress already strained
ecological systems and worsen poverty in much of the developing world, thus aggravating
threats to international security.

Population growth is not the only threat facing humanity, but it will be a major contributor to the
crises that await us and the planet in the coming century. Overpopulating the planet puts us all
at risk of extreme environmental and social consequences that we are beginning to witness
today.

The Malthusian Catastrophe (excerpt)

Source: Wikipedia, 19 March 2012.

At the time Malthus wrote, and for 150 years thereafter, most societies had populations at or
beyond their agricultural limits. After World War II, mechanized agriculture produced a dramatic
increase in productivity of agriculture and the so-called Green Revolution greatly increased crop
yields, expanding the world’s food supply while lowering food prices. In response, the growth
rate of the world’s population accelerated rapidly, resulting in predictions by Paul R. Ehrlich,
Simon Hopkins, and many others of an imminent Malthusian catastrophe. However, populations
of most developed countries grew slowly enough to be outpaced by gains in productivity. By
1990, agricultural production appeared to begin peaking in several world regions.

By the early 21st century, many technologically developed countries had passed through the
demographic transition, a complex social development encompassing a drop in total fertility
rates in response to lower infant mortality, more education of women, increased urbanization,
and a wider availability of effective birth control, causing the demographic-economic paradox.
Developed and developing countries follow two distinct paths. Most developed countries have
sufficient food supply, low fertility rates, and stable (in some cases even declining) populations
[while the opposite path applies to developing countries].

David Pimentel and Ron Nielsen, working independently, determined that the human population
as a whole has passed the numerical point where all can live in comfort, and that we have
entered a stage where many of the world’s citizens and future generations are trapped in
misery. There is evidence that a catastrophe is underway as of at least the 1990s; for example,
by the year 2000, children in developing countries were dying at the rate of approximately
11,000,000 per annum from strictly preventable diseases. These data suggest that, by the
standard of misery, the catastrophe is underway. The term ‘misery’ can generally be construed
as: high infant mortality, low standards of sanitation, malnutrition, inadequate drinking water,
widespread diseases, war, and political unrest.

Regarding famines, data demonstrate the world’s food production has peaked in some of the
very regions where food is needed the most. For example, in South Asia, approximately half of
the land has been degraded such that it no longer has the capacity for food production.

On the assumption that the demographic transition is now spreading from the developed
 44

countries to less developed countries, the United Nations Population Fund estimates that
human population may peak in the late 21st century rather than continue to grow until it has
exhausted available resources. Some have expressed doubt about the validity of the UN
projections, claiming that they are below the projections by others. The most important point is
that none of the projections show the population growth beginning to decline before 2050.
Indeed, the UN “high” estimate does not decline at all, even out to 2300, indicating the potential
for a Malthusian catastrophe.

A 2004 study by a group of prominent economists and ecologists, including Kenneth Arrow and
Paul Ehrlich suggests that the central concerns regarding sustainability have shifted from
population growth to the consumption/savings ratio, due to shifts in population growth rates
since the 1970s. Empirical estimates show that public policy (taxes or the establishment of more
complete property rights) can promote more efficient consumption and investment that are
sustainable in an ecological sense; that is, given the current (relatively low) population growth
rate, the Malthusian catastrophe can be avoided by either a shift in consumer preferences or
public policy that induces a similar shift. However, some contend that the Malthusian
catastrophe is not imminent. A 2002 study by the UN Food and Agriculture Organization
predicts that world food production will be in excess of the needs of the human population by
the year 2030; however, that source also states that hundreds of millions will remain hungry
(presumably due to economic realities and political issues).

Another way of applying the Malthusian theory is to substitute other resources, such as sources
of energy for food, and energy consumption for population. (Since modern food production and
logistics is energy and resource intensive, this is not a big jump. Most of the criteria for applying
the theory are still satisfied.) Since energy consumption is increasing much faster than
population, and most energy comes from non-renewable sources, the catastrophe appears
more imminent, though perhaps not as certain, than when considering food and population
continue to behave in a manner contradicting Malthus's assumptions.

Retired physics professor Albert Bartlett, a modern-day Malthusian, has lectured on “Arithmetic,
Population and Energy” over 1,500 times. He published an article entitled “Thoughts on Long-
Term Energy Supplies: Scientists and the Silent Lie” in Physics Today (July 2004). For a
response to Bartlett’s argument, see two articles on energy and population in Physics Today,
November 2004, and following letters to the editor. A further way of analyzing resource limitation
is the dwindling area for storage of soil contaminants and water pollution. The high rate of
increase in toxic chemicals in the environment (especially persistent organic chemicals and
endocrine altering chemicals) is creating a circumstance of resource limitation (e.g. safe potable
water and safe arable land).

Ester Boserup wrote in her book The Conditions of Agricultural Growth: The Economics of
Agrarian Change under Population Pressure, that population levels determine agricultural
methods, rather than agricultural methods determining population (via food supply). A major
point of her book is that “necessity is the mother of invention”. Julian Simon was one of many
economists who challenged the Malthusian catastrophe, citing (1) the existence of new
knowledge, and educated people to take advantage of it, and (2) “economic freedom”, that is,
the ability of the world to increase production when there is a profitable opportunity to do so.
The economist Henry George argued that Malthus didn't provide any evidence of a natural
tendency for a population to overwhelm its ability to provide for itself. George wrote that even
the main body of Malthus’ work refuted this theory; that examples given show social causes for
misery, such as “ignorance and greed... bad government, unjust laws, or war,” rather than
insufficient food production.
 45 ECS3705/1

CONTENT

Chapter 6 on Malthus is clearly written and you should have little difficulty understanding it. A
possible exception is the section on Malthus’ theory of market gluts (his rejection of Say’s law),
for which we will provide some additional explanation. Do pay particular attention to the
historical background of the Corn Laws (2007:86; follow up further references to the Corn Laws
in the index). We will come back to the Corn Laws in our discussion of Ricardo in the next
section.

The weakness in Malthus’s “dismal” population theory was, of course, that he seriously
underestimated the potential for productivity increases in agriculture. When we talk about the
productivity gains of industrialisation and mechanisation, we are inclined to think that these were
mainly confined to manufacturing. But this was by no means the case. Mechanisation also
revolutionised agriculture. For instance, the introduction of mechanised ploughing and sowing in
the course of the 19th century made large-scale agriculture on the vast American plains
possible, which improved productivity enormously. In more recent years, better seeds,
fertilisation, irrigation and pest control has also dramatically improved productivity (the Green
Revolution), although it has also made agriculture more capital intensive and therefore more
risky (which is particularly problematic in the unstable climatic conditions of South Africa) as well
as more dependent on fossil fuels. Malthus did not foresee and could not have foreseen such
trends. Generally speaking, it has been the staggering increases in agricultural productivity over
the years which have enabled the earth to sustain its alarmingly increasing population. There is,
however, reason to believe that the scope for increased productivity in agriculture will at some
stage get saturated, which would mean that Malthus may, after all, be proven right. See the two
readings in Economics in Action above.

You should study the section in chapter 8, “Say’s law of markets” (2007: 128–131),
simultaneously with Malthus’s theory of market gluts. Malthus was of the opinion that aggregate
effective demand could fall short of aggregate supply, thus leading to a contraction in aggregate
output (a market glut). By contrast, the French classical economist, Jean Baptiste Say, argued
that aggregate effective demand would always be sufficient to buy up aggregate supply (total
production), an idea which Keynes (1936) attributed to Say and hence labelled “Say’s law”.
Most of the classical authors, including Ricardo and John Stuart Mill, subscribed to Say’s law
(2007:116). The current opinion among historians of economic thought is that Keynes was
incorrect in attributing the law to Say. It was in all likelihood not Say, but John Stuart Mill’s
father, James Mill, who first formulated the law. We explore the meaning of Say’s law in
somewhat more depth, because it still plays an important role in contemporary debates on
macroeconomic issues.

The law is most commonly expressed as “supply creates its own demand”, meaning that total
income created during a given production round is sufficient to buy up the production of that
same production round. Notice that Say’s law does not claim that the very act of supplying an
individual good will create a demand for it. That would mean that producers are always
guaranteed of selling whatever they produce, which is nonsensical. No, Say’s law applies only
to the aggregate level. It claims that aggregate supply creates its own aggregate demand, which
may not be quite so nonsensical. To appreciate the logic of Say’s law, call to mind the circular
income-spending stream of your first-year macroeconomics textbook. Take as your starting
point all those in the economy who, at a given moment, spend money to buy goods. Their
spending will create income for the sellers of these goods. If these sellers subsequently spend
their entire recently earned income on buying goods again, total demand for goods will sustain
itself at an unchanged level. If that level were originally sufficient to buy up total production and
there was no increase in output (no economic growth), the re-spending of all income would
guarantee that there will be no market glut. Say’s law holds. While the demand for some
individual good may be more than what is supplied and the demand for another individual good
less than what is supplied, overall demand for all goods will be more or less sufficient.
 46

The problem comes in when people do not fully respend their income, which would mean that
they hoard more money or spend more money on non-recently produced goods (second-hand
goods, secondary financial assets, existing real estate or imported goods). These would
constitute a leakage from the recently produced goods circulation, causing total demand for
recently produced goods to fall and Say’s law to fail. The classical economists like Say were
aware of the possibility of increased hoarding. But they reasoned that total hoarding would
never increase indefinitely. Because people do not hold money for its own sake but to buy
goods with it, hoarding levels would at some stage come down again, and total spending would
be restored to its original level (Grant and Brue 2007: 130-131). While Say’s law may thus fail in
the short run, it will hold in the medium to longer term. Another possible failure of Say’s law
would be that the growth in the money stock would not keep up with the growth in total output
and the total volume of trade. The classics would then reason that economic growth would not
be so fast that coin production (gold and silver mining and minting) could not keep up with it.
And even if coin production could not keep up, a shortage of money would cause a fall in the
general price level, thereby effectively increasing the real supply of money. Large increases in
the volume of trade in non-recently produced goods were probably also unlikely in classical
times, because financial markets were still relatively small and trade volumes in real estate low.
Hence in classical times under a commodity money system, Say’s law was not such an
unreasonable proposition.

A modern fiat money system is different from the commodity money system of classical times.
Under a commodity money system, money consists of commodities, mostly gold or silver coins.
Bank money, the notes and deposits issued by banks, can also feature in a commodity money
system, but will be convertible into gold or silver coin, although bank money may no longer be
100% backed by gold and silver coin. Under a modern fiat money system, by contrast, the
money issued by the central bank (bank notes and token coin) is no longer convertible into gold
or silver coin, but does function as legal tender. Hence the legal tender is now inconvertible.
However, the money issued by commercial banks (bank deposits), which makes up the bulk of
the total money stock (often more than 90%), is convertible. But commercial-bank deposits are
not convertible into gold or silver coin, but into the legal tender (notes and token coin) issued by
the central bank, which is inconvertible. Almost all money, under a modern fiat money system, is
created when commercial banks grant credit to the nonbank sector, in the process of which they
issue more deposits to nonbanks. If you want to understand more about such issues, pursue a
course in monetary economics or in money, banking and financial markets.

There is a much reduced likelihood that Say’s law holds under a modern fiat money system than
under the commodity money system of classical times. The reason is that, under a modern
system, the income-spending stream is subject to more, and larger, injections into it and
leakages from it. Money gets created when banks grant credit to the nonbank public, which
would be an injection. But money gets destroyed again when the public services its loans (pays
interest and repays principal), which would be a leakage. Hence when there is a net increase in
bank lending (people take up more bank loans than they repay) the money stock increases,
which is an injection. And when there is a net decrease in bank lending (people repay more
bank loans than they take up bank loans – as recently happened during the subprime crisis) –
the money stock falls, which is a leakage. The main point is that the public’s desire to demand
credit from banks depends largely on inherently unstable future expectations; people take up
more bank loans when they are optimistic about the future, but repay more of their bank loans
when they are pessimistic about the future. This dependency on unstable future expectations
causes the total money stock to fluctuate more strongly under a fiat money system, which will
also cause total spending to be more unstable. Another potentially important leakage under a
modern fiat money system is formed by increases in the volume of trade in non-recently
produced goods, including secondary financial assets, second-hand cars, and existing real
estate, which can be quite large and variable. A deficit on the balance of payments will equally
reduce the money stock and form a leakage, just as a surplus on the balance of payments will
form an injection.
 47 ECS3705/1

The fact that Malthus is right in claiming that Say’s law does not necessarily hold and that
market gluts can occur, does not mean that his reasoning as to why Say’s law fails and how
market gluts can be avoided, are necessarily correct.

When they reasoned about Say’s law, the classical economists, Malthus included, tended to
picture the economy as having perfectly synchronised production rounds of equal length. In
other words, all firms start producing at the same time, pay wages at the same time, and start
selling their finished output at the same time. It would then appear that the finance to buy up the
output of the current production round consists of nothing more than the wages paid out during
the current production round. If so, entrepreneurs are prevented from making any profit even
when workers spend their wages in full (no leakages). Because these wage payments are a
cost of production for firms, the following must hold for the firm sector as a whole: aggregate
demand for goods = cost of producing these goods. If so, firms can at best earn back what they
previously paid in wages and demand is never sufficient for firms to make a profit (profit = 0). As
a result of not making a profit, firms would not be inclined to invest and economic activity would
stagnate. That was the problem as Malthus saw it. We will notice below how Marx saw a similar
problem. According to Malthus, the only way for firms to make a profit and to avert stagnation
was to find a source of demand for their goods, which is not a cost of production for them. A
good candidate is the demand financed out of the rent income of landlords (2007:91–95). Hence
the higher the rent income of landlords, the better the chances that Say’s law holds and that
total spending in society is sufficient to buy up total production and leave a profit for firms. That
was the solution as Malthus saw it, and the background to his support for the Corn Laws.

Malthus’s argument fails on several counts. First, the relevant finance to buy up current output
consists not only of wage income but also of realised entrepreneurial profit. When production
rounds are seen as perfectly synchronised, these profits are less visible because realised by
selling the output of a previous production round. In the more realistic situation of a large
number of unequal production rounds beginning and ending at any time, profits continually
become available as finance for spending. When these profits together with wage incomes are
fully respent, there is obviously enough demand to buy up current output and leave an equal
amount of profit – provided we abstract from output growth. Second, there is no such thing as
income which is not also a cost of production for the firm sector. Given that land cultivators are
part of the firm sector (they too run business enterprises), the rent they pay to landlords is also a
cost of production for the firm sector. Thirdly, what contributes towards aggregate demand is not
the spending of income-which-is-not-a-cost-of-production (such income does not exist), but (1)
reductions in aggregate hoarding levels, (2) reductions in spending on non-recently produced
goods (second-hand goods and assets), and (3) increases in the total money stock. The total
money stock increases (a) when additional gold or silver coins are produced (no longer
relevant), (b) when credit extension by banks to the nonbank sector (including government)
increases, and (c) when there is a surplus on the balance of payments.

The possible failure of Say’s law and the resultant occurrence of insufficient aggregate demand
is, of course, mainly what modern Keynesian macroeconomics is about. The main aim of
modern monetary and fiscal policy is indeed to try to counteract the various monetary
disturbances so as to ensure that Say’s law does not fail, or fails minimally, and that aggregate
demand is maintained at more or less the level of aggregate supply (no “output gap”).

The textbook’s (2007:95-97) “Assessment of Malthus’s contributions” neatly sums up the strong
and weak points in Malthus’s various arguments. Have a careful look at it.
 48

ECONOMICS IN ACTION: LOOKING BACK

Malthus’s economics is disturbing. He says some very rude and uncomfortable things. But it
does seem that, when it comes to population growth, his ghost is still hovering over us. A world
of limited space and resources cannot sustain an exponentially growing population, especially if
a third of that growing population is starting to industrialise for the first time, as China and India
now do. At some stage we are bound to hit some hard limits. What will happen then? Nobody
knows for certain, but the best estimates do not look attractive.

RICARDO

• all of chapter 7, excluding “The currency question” (pp. 101-102), “Rent at the intensive
margin of cultivation” (pp. 104-105) and “7-1 Past as prologue” (pp. 109-110)

ECONOMICS IN ACTION

In Ricardo’s days, the Industrial Revolution was in full swing and busy changing the social
landscape of England. One of the questions which Ricardo addressed was whether the
introduction of increasingly sophisticated machinery is in the interest of workers, that is, whether
it raises wage rates and employment levels. This question has obviously never lost its relevance
and controversial edge. As an introduction to the topic, consider the following fictitious
discussion between two Unisa economics students, John and Tandi, who are enjoying some
drinks on the terras of a restaurant while basking in the African sun.

John: I hear you are enrolled in a course on the history of economic thought. How are you
finding it?

Tandi: Fascinating and boring in parts. One of the more interesting parts is about this English
dude called Ricardo who has been dead for a century and a half.

John: Gee, if he has been dead for so long, how can he be interesting? By the way, I am having
another drink. Would you like to join me?

Tandi: No thanks, not now; I may have later. No, he is interesting, although some of his stuff
takes some time and effort to get to grips with. For example, he discusses the very question
which we were talking about the other day, namely whether machines replace people and so
take away their jobs.

John: Correct, I just heard of a firm which built a brand new bottling plant which produces
millions of beer and cool drink bottles a year but is operated by only six people sitting behind
computers. The rest is all conveyor belt, machinery and robots. Not even that long ago the
production of that number of bottles would probably have given employment to at least a
hundred workers. Clearly, machines replace workers, all because the bosses want more money.
And mechanisation has the added advantage for these fat, cigar-smoking capitalists that
machines do not go on strike, so that they do not have to bother with unions. It is all too cynical!

Tandi: Hey John, be careful not to offend some of your own heroes. Is Fidel Castro not also
somewhat heavy around the middle and does he not also smoke cigars? Jokes aside, I
understand your sentiment. But the issue is just more complicated than what you make it out to
be. First, that new bottling plant easily halves the cost of producing a bottle, so that the drink
which you just ordered for yourself is now cheaper. You have already benefitted from the new
technology! Second, can anybody stop technological advancement? I mean, your brother is
studying engineering. You can’t prevent clever people from thinking up better ways of doing
 49 ECS3705/1

things, can you?

John: No, I suppose not. But why should clever people necessarily think up the type of things
that reduce employment, spew more CO2 in the air and raise the dominance of big corporates
over our lives? Why can’t they apply their clever minds to things that increase employment,
make the production process cleaner, and raise the advantage of the small operator with less
capital resources over the big corporation with access to limitless amounts of capital? It is
invariably the big corporations that buy and utilise these new technologies, increasing their grip
over on lives ..

Tandi: You are getting a bit carried away now, John. But, in fact, there are recent technological
developments that do make it easier for smaller companies to challenge the bigger guys. An
example is the ever cheapening and more powerful PC. But let’s not go there now; you can
entertain your engineering brother with that issue. Let’s return to the main question: is this
seemingly unstoppable trend towards mechanisation and automation to the detriment of
workers? You seem to say: definitely it is. I say: it depends.

John: On what?

Tandi: Well, it depends on various things. The point is that techno advances both create jobs
and destroy jobs. They destroy jobs because machines can replace workers – we already
established that. But they also create jobs because they open up new markets and arouse new
needs in people.

John: Yes, typically capitalist … big companies forcing stuff on people that they don’t really
need ..

Tandi: Well, yes and no (that’s what an economist would say, wouldn’t she?). Take television
and motor cars. I know you enjoy your TV soapies and your leftist leanings have never
prevented you from positively lòòòòving fast cars. A century ago virtually nobody was employed
in the motor industry and complementary industries like repair workshops, the oil industry, and
road construction. And virtually nobody was employed in the electronics industry as well as the
entertainment industries that create content for TV. There you have technologies which created
enormous numbers of new jobs. But, mind you, at the time they also destroyed jobs. The advent
of the car probably meant that many a horse breeder and ferrier (horseshoe-maker) lost his
livelihood. Come on John, did the big corporates really create your desire for fast cars and TV
entertainment? These desires were certainly latent in you!

John: Granted. But not all techno advances open up new markets by meeting new needs, such
as cars and TVs did. Most new technologies merely save labour in the production of existing
products which serve existing needs, like that new high-tech bottling plant that I mentioned. In
that case, there are only job losses – no job creation at all. Have there recently been any techno
advances that actually opened up entirely new markets by meeting entirely new needs, like the
motor car or the TV did?

Tandi: There have not been many, but the IT revolution was certainly a highly significant recent
one. It created all sorts of new jobs like software writers, website designers, PC skills trainers, IT
managers, and the like. These jobs meet needs that previously did not exist at all. Definitely a
case of a new technology opening up an entirely new market, otherwise referred to as a
“technological revolution”; so there was a motorcar revolution, a household electronics
revolution and now an IT revolution. And even if, like in case of your bottling plant, the techno-
advances are not revolutionary and do not open up new markets, the monetary savings that
people make in buying cheaper bottles means that money is freed up to be spent on other
things, like restaurant visits, further education or weekends away, which will create additional
jobs elsewhere. I mean, money needs to be spent on something! Automation and
 50

mechanisation may destroy jobs in the manufacturing sector, but new jobs may spring up in
other sectors, like services. As long as there is enough money to go around, other jobs will
emerge. Furthermore, many economic activities do not lend themselves to mechanisation and
automation and will always be fairly labour intensive, like construction (building houses, roads
and the like), agriculture, mining, and services like entertainment, hospitality, education, tourism
and the like. Without any need for technological revolutions, employment in these sectors can
keep on steadily growing as long as there is enough money and demand keeps on growing at a
sufficient pace.

John: Now it is my turn to show off some of my economics knowledge: that growing demand
requires that Say’s law holds (no serious net leakages from the circulatory income-spending
stream) plus that the money stock grows at a pace which keeps up with productive capacity.
This raises further issues about how to grow the money stock without it being inflationary and
without people getting into too much debt, which I will leave for now. The question remains
though: will it be enough? Will we, as a country, be able to create enough employment?

Tandi: Well, again, it depends. Three factors probably play a role: (a) how well educated, (b)
how flexible and (c) how entrepreneurial the population is. Obviously, every new technology
makes new and often greater demands on the skills of its workforce. Lets discuss them in turn.
As for education, if our country is to benefit from any new technologies, we must make sure that
our people become better educated, especially in the science, technology and engineering
fields. Otherwise South Africa loses out and the jobs go elsewhere. Whether we like it or not
(and it does not help crying about it): in this globalised world economy, you have to stay with the
best or you are left behind. As for flexibility, this is important because the pace at which old
types of jobs will be lost and opportunities for new types of jobs will emerge, will probably
increase. People must increasingly be able and willing to redirect, relocate and re-school
themselves. And entrepreneurship is important, because in an increasingly changing world, one
needs even more alert and astute entrepreneurship. As you will remember from your Economics
I course, an entrepreneur is somebody with the willingness and ability to create jobs for more
people than only him- or herself. The entrepreneur does so by developing a vision for a new
selling opportunity (either an entirely new market or a gap in an existing market), and by
bringing people and resources together in such a way that this opportunity is realised at a profit.
You may not like the idea of profit (for you lefties, it sounds too much like greed), but nobody
can be expected to lose money in the process of creating jobs for others.

John: Yes I do worry about the greediness of business, but I take your point. And there is
something else: a very large section of our people is low- or unskilled. You are not going to turn
them into medium- or high-skilled people overnight. It will take an entire new generation! What
are you going to do about them?

Tandi: Paradoxically, most job opportunities for low- or unskilled workers still lie in the
manufacturing sector: the sector that makes things, commonly with machines. Somehow we will
need to find ways of making it profitable and worthwhile for businesses to move into
manufacturing and compete successfully in our own and foreign markets with foreign firms.

John: Yeah, and that means that you will probably want to create sweat shops where people
work long hours for hardly any money – like what happens in China.

Tandi: That is a bit of a caricature, John. Be fair: far from all Chinese manufacturing is done in
sweatshops. Nonetheless, I take your point. The problem is, if developing countries without a
high-tech manufacturing base want to compete on world markets, they often have no choice but
to pay low wages and concentrate on low-tech, labour-intensive manufacturing. That is often the
only way to get a foot in the door. Once such countries have established themselves and have
accumulated more capital and skills, they can gradually move into more high-tech
manufacturing which will then allow them to pay higher wages too. In other words, a low-wage
policy may just be a necessary but temporary phase. Countries like Japan and Korea have
 51 ECS3705/1

shown how economies can move beyond that phase into more high-tech and higher wages.
China seems to be fast moving in that direction too.

John: I do not, for now, have an argument to counter you, but I just do not like the sound of that
at all. Low wages will further increase the gap between rich and poor in this country, which is
already unacceptably wide. There must be other ways.

Tandi: You may be right. But that will mean that South Africans will just have to up their game
and be more resourceful and entrepreneurial. They will have to find new ways of doing business
in this ever changing world, new ways of creating employment without putting their workers in
sweatshops. Come to think of it, that actually fills me with hope. South Africans of all races have
a history of rising to the challenge when the chips were down. Necessity is the mother of
invention. We may just have what it takes, although it will not be easy.

John: I agree.

Tandi: Finally some agreement! Let’s drink to that. You can order me that drink now.

CONTENT

Some of you may find the chapter on Ricardo (chapter 7) slightly more challenging than other
chapters, so we will attempt to clarify a few things in a bit more detail.

The textbook (2007:99) refers to Ricardo as having “demonstrated the possibilities of using the
abstract method of reasoning to formulate economic theories”. What is the abstract method of
reasoning? Roughly speaking, it is the method whereby the theorist stylises real-life human
behaviour in such a way that it becomes completely regular and determinate, meaning that a
certain change in the circumstances of the relevant people will always have the same definite
and predictable effect on their behaviour. This stylisation involves two things. First, it requires
the “restrictive assumption” (2007:101) that only one aspect in the environment of the relevant
people changes, and that all other aspects remain the same. As a result, there is no external
interference with the assumed causal mechanism: a certain effect is attributed to only one
cause, whereby all other possible causes are assumed unchanged (the so-called “ceteris
paribus” clause). For example, when the abstract method attributes a change in price to a
change in demand, change in all other possible variables that can potentially influence price
(like changes in income or in the price of complementary goods) are overlooked. Second, the
stylisation involves assuming that the change in people’s environment, say a change in
demand, has a uniform effect on their behaviour, which is that they change the price they set.
What this requires, among other things, is that people are uniformly motivated by only profit or
utility, and that they are completely rational and perfectly knowledgeable about how to pursue
that motive. In other words, they behave like what has come to be known as “the economic
man” or homo economicus. Because in the real world the ceteris paribus clause cannot always
be relied upon and people do not strictly behave like economic men, the results of the abstract
method must be treated with a degree of caution. This does not mean that abstract theory is
completely useless or unrealistic. Changes in demand may still have the predicted effect on
price, but it is just that demand may not have changed very much, that other influences on price
have overshadowed it, or that demanders have been motivated by other things besides
maximising their utility. When it comes to their behaviour in the market place, people are roughly
and broadly motivated by profit or utility, even if they may not maximise it to the absolute limit.
We come back to these issues in study unit 5 when discussing neoclassical economics.
 52

The textbook (2007:100-101) mentions the difference between inductive and deductive
reasoning. Inductive reasoning argues from the specific to the general. For example, by
observing many specific instances of elephants, we could on the basis of inductive reasoning
arrive at the general conclusion that all elephants have trunks. By contrast, deductive reasoning
draws logical implications from general principles which are then applied to specific
circumstances. These logical implications are considered valid by virtue of the assumed validity
of the general principles from which they were drawn. For example, on the basis of the general
rule (or law) that all elephants have trunks (and that no other animals have trunks) the validity of
which is taken for granted, it could safely be inferred that any specific animal with a trunk is an
elephant. Ricardo favoured the deductive style, in that he was inclined to argue from some
sweeping general law which he took as almost self-evidently true. Nor was he shy about
applying such a law to any specific historical case. But because these laws were often obtained
by a high degree of abstraction (see previous paragraph), they were unfortunately not always
generally applicable, although they may have been applicable to the specific historical case for
which Ricardo used them.

The section on the Currency Question is not prescribed.

We move on to Ricardo’s Theory of Diminishing Returns and Rent (2007: 102-104). In order to
understand this theory, you must have a clear grasp of the meaning of the concept of rent. Rent
refers to land rent: it is the productive value of land expressed as a monthly or annual income
which land owners can extract from their land. As such, rent would also be the money which
tenant-cultivators pay to the landlords for the right to till the land. Such tenant-cultivators would
normally not be in the employ of landowners. They would be independent farmers with their own
farming businesses, except for the fact that they rented the land and some of its infrastructure
from landowners.

Rent thus reflects the value and relative scarcity of land’s productive contributoin. As a result,
when land is in superabundant supply, rent would be zero. As an example of land
superabundance, imagine the situation of a large uninhabited island where a limited number of
settlers first set foot on land. In such a situation of land superabundance, the price of agricultural
products grown on land would merely contain the cultivators’ input cost as well as a reward for
their labour, but no rent. However, settler-farmers would obviously start to cultivate the best land
first – land which is most fertile and closest to their market. That best land would, therefore,
soon become scarce, which means that it would start to earn rent.

The logic of how the scarcity of the best land causes it to earn rent goes as follows. As the
colony grows and the demand for agricultural products increases, all the best land would soon
be used up and settler-farmers would need to bring second-best land under cultivation – land
which is less fertile and/or further away from the market. But the lower fertility or greater
distance from the market of that second-best land means that its production costs for a given
unit of output are higher. This increase in cost of production would necessitate a rise in the price
of agricultural output if the second-best land is to be put under cultivation. Such a price rise,
however, implies that agricultural products grown on the best land, which have lower production
cost, now earn additional profit – profit in excess of the cultivators’ input cost and a normal
reward for their labour. That additional profit is rent. Given the competitive relations between
landowners and their cultivator-tenants, that rent is presumed to end up in the hand of the
landlords as rent payments rather than as additional profit for cultivator-tenants.

The textbook explains the principles of Ricardo’s rent theory with reference to the extensive and
the intensive margin of cultivation, which are quite similar. The case of rent at the intensive
margin of cultivation (2007: 104-105) is not prescribed. You can concentrate on the case of
rent at the extensive margin of cultivation, which is illustrated by Table 7-1 (2007: 103).

This table may appear complicated at first inspection, but it really just illustrates the logic of rent
as explained in the previous paragraph. The various rows show different prices of wheat per
 53 ECS3705/1

bushel, ascending from $0.50 to $2.50 per bushel. The various columns show different grades
of land, grade A being the best land and grade E the worst. The inputs into the harvest of each
grade of land are the same: they cost $10 including an amount of “normal” profit. But these
same inputs yield different outputs, 20 bushels per acre for grade A land descending to 4
bushels per acre for grade E land. Now look at the row which represents an output price of
$0.50 per bushel. On the best land (grade A), farmers will make 20 x $0.50 = $10, which is just
sufficient to cover the input cost of $10 which includes normal profit. Hence farmers of grade A
will just break even, and their excess profit = 0 as indicated. At that price no lower grade land
will be cultivated at all, because it will make a loss; hence no numbers are indicated for lower
grade land. Take the next row when the price is $0.66⅔. The sales income of farmers on grade
A land will then be 20 x $0.66⅔ = $13.33. Subtracting the input cost of $10, these farmers will
earn an excess profit of $3.33 as indicated on the table. That excess profit is rent. At the price of
$0.66⅔ per bushel, farmers on grade B land will realise a sales income of 15 x $0.66⅔ = $10,
which is just sufficient to cover input cost (and a small amount of normal profit). No excess profit
and hence no rent. Cultivation of lower grade land (C, D and E) will not happen at that price
because yielding a loss. You can repeat the same exercise for the rows representing an output
price of $1.00, $2.00 and $2.50 per bushel. As the price rises you will notice how intra-marginal
land earns an increasing amount of excess profit (= rent), but how marginal land just breaks
even (rent = 0).

To sum up, the main points of the table are these: (a) rent is excess profit (profit over and above
normal average profit) on intra-marginal (better) land, (b) as populations increase and more land
needs to be put under cultivation to feed more people, the price of agricultural output must
increase to induce the cultivation of lower grade land, (c) as the price of agricultural output rises,
rent on intra-marginal, higher grade land increases. Ricardo was the first of the classical
economists to recognise the importance of the marginal principle, witness the roles which
marginal land (least productive, non-rent earning land) and intra-marginal land (more
productive, rent earning land) plays in his analysis.

Take note of the central conclusion of the Ricardo’s rent theory, which enters crucially into the
discussion surrounding the Corn Laws: “Rent is price determined, not price determining. That
is, high rents are explained by high grain prices; high prices cannot be explained by high rents.”
How could Ricardo arrive at this conclusion? In its final assessment of Ricardo, the textbook
(2007:118) argues that Ricardo could ignore the influence of rent on price, because he
(Ricardo) assumed a single use of agricultural land, say grain production. There being no
alternative uses, the opportunity cost of grain production is zero. As an opportunity cost of land
use, rent is therefore zero; so it cannot influence price. This reasoning seems questionable.
Opportunity cost, as you know, is the benefit foregone on the next best application of a scarce
resource. As such, it may determine the decision on how a scarce resource is to be allocated in
preference to its alternative uses. But because it is not an actual cost incurred (it is a profit
foregone), opportunity cost does not normally enter into the cost of production, in which case it
will anyhow not influence output price. As the textbook confirms in its discussion of opportunity
cost (2007:247, not prescribed): “[I]t is not at all clear that this idea [ie opportunity cost] explains
anything fundamental about exchange value [ie price].” If it is granted that opportunity costs do
not influence price, the fact that they are zero has little to do with why rent has no influence on
price.

The real reason that rent does not influence agricultural price is much simpler. It is that Ricardo
assumes “marginal cost pricing” of agricultural products (price = marginal cost), while rent is not
part of the marginal cost of the land cultivator. Rather it is a fixed cost, which remains the same
for the land cultivator, irrespective of how much he produces on his parcel of land. But, as
standard price theory teaches us, marginal cost pricing presupposes perfect competition in the
relevant market, with suppliers having no influence over price (see your second-year
microeconomics textbook). If, however, the market for some agricultural crop were less than
perfectly competitive, the cultivator-suppliers in that market may be able to exercise some
 54

influence over price, which will then be determined on the basis of “average cost plus mark-up”
rather than marginal cost. Because rent is reckoned as part of average cost (total cost divided
by quantity produced), rent then impacts price.

Moreover, in Ricardo’s theory, rent is really a kind of producer surplus (see Grant and Brue, p.
287, Study Unit 5, or any second-year micro textbook), which, assuming perfect competition in
the output market, accrues to the producer: in our case, the land cultivator. In Ricardo’s theory,
rent accrues not to the land cultivator but to the land owner. The implicit assumption thereby is
that land owners have such a strong competitive position vis-à-vis land cultivators that the latter
cannot earn more than just an average, normal profit. All excess profit, which is what rent is, is
presumed to be extracted by land owners. One could, however, also imagine situations where
land cultivators do have some bargaining power vis-à-vis land owners, so that at least some of
the rent-as-excess-profit goes to them as well.

Ricardo and Smith’s theories of exchange value are quite similar. Both wished to explain the
long-term natural price of a good, rather than its short-term market price. And both intended
their theory to explain relative rather than nominal prices, i.e. not why a cup of tea costs R2 and
a cup of coffee R3 but why the price of a cup of tea relative to coffee is 2:3. Ricardo, however,
used the labour theory of value, not so much to explain relative price ratios themselves but
changes in relative price ratios, or in the textbook’s terms “changes in exchange values over
time” (2007: 106). Hence when the price ratio between a cup of tea and the cup of coffee
changes from 2:3 to 2:2 (or 1:1), it means that the number of labour hours which go into
producing tea relative to coffee has decreased such that it now takes the same number of
hours.

Many of our comments on the weakness of Smith’s labour theory of value in the previous
chapter are applicable to Ricardo’s as well. There are, however, a few differences (2007:105-
108).

First, while Smith denies that utility can have any influence on exchange value, Ricardo ack-
nowledges that the possession of utility (use value) is a precondition for a good to have
exchange value, even if utility is not a measure of that value. As a result, the greater usefulness
of a good still does not, according to Ricardo, mean that its exchange price will be higher. Only
the value of non-reproducible goods can be so influenced by utility, simply because the supply
of such goods is fixed, with the result that demand factors (utility) will have to determine value.
But for reproducible goods, Ricardo maintains that supply factors (cost of production as
determined by labour cost measured in labour hours) will be the dominant force determining
exchange value. Bear in mind, however, that Ricardo’s theory was intended to explain long-term
natural prices, which are indeed likely to be mainly determined by cost of production, as we also
indicated in our discussion of Smith’s theory of value in the previous study unit.

Second, Ricardo had a somewhat different way of dealing with the problems posed by a labour
theory of value. Once again, these problems stem from the fact that labour is obviously not the
only production factor and, therefore, not the only source of production cost. Because capital
and land can also contribute towards production, they can also create cost and, as such,
influence price. How does Ricardo get round these problems? The answer is: with great
difficulty.

Ricardo attempted to include the cost of machinery and raw material by valuing their productive
contribution in labour hours too, that is, the labour hours that went into producing that machinery
and raw material. We will see in the next study unit how Marx follows Ricardo in this respect,
calling the labour embodied in machinery and raw material “dead labour” and the labour
embodied in existing workers “life labour”. For example, if a coffee-roasting machine costs 300
hours to produce and the roasting of 1 kilo of coffee causes wear and tear on that machine of
one thousandth (1/1000) of its lifetime, then this machine would add 0.3 labour hour to the value
of 1 kilo of roasted coffee. The implicit assumption is that the productive contribution of a
 55 ECS3705/1

machine is exactly proportional to the number of hours that went into producing it, which does
not seem obvious at all. Similarly, if the average 1kg of raw coffee beans costs 0.5 labour hours
to farm and transport to the roasting factory, then the raw material of coffee will add 0.5 hours to
the value of 1kg of roasted coffee. The problem with this treatment of raw material is that coffee
beans are not entirely produced by farmers and transporters, but also by nature: the soil, the
sun, and the miracle of spontaneous growth in plants. The contribution of land (or nature in
general) cannot be reduced to the contribution of labour only.

The textbook mentions a couple of further problems with Ricardo’s theory of exchange value.

First, goods which require the same amount of labour time to produce, but are produced with
differing amounts of capital, yield differing profit rates (profit/capital). You, the student, may react
with: so what? The problem is that the existence of differing profit rates conflicts with another
part of classical theory, making classical theory internally inconsistent. That other part, upheld
by both Smith and Ricardo (and Marx), is that profit rates should tend towards equality in all
sectors. Grant and Brue (2007: 106-107) use an example to illustrate how profit rates may differ
in Ricardo’s value theory, which seems unnecessarily complicated. There is a reason for this
complicatedness, which need not be further explained here. The possibility of differing profit
rates in Ricardo’s theory can be illustrated in a much simpler way. Imagine two different goods,
a car and a (small) house. These two goods are obviously produced in different sectors with
different amounts of capital used, but they happen to have the same Ricardian value: 25 labour
hours, which is made up of 20 hours of production cost plus 5 hours of profit. When the car
manufacturer has a larger balance sheet (uses more machinery) than the builder, their profit
rates (profit/capital) are obviously different. Differing capital/labour ratios thus lead to differing
profit rates, which is a problem if profit rates should tend towards equality.

Second, the textbook (2007: 107) also mentions the fact that a labour hour need not reflect the
same amount of productive effort and skill in all sectors. And these differences in effort and skill
need not be perfectly compensated for by differences in the wage rate.

All in all, Ricardo’s labour theory of value requires many qualifications, assumptions and
amendments for it to be applicable. Such is what happens when the basic premise of your
theory is already wrong: in Ricardo’s case, that market price is determined by cost of production
measured in labour hours. If you start with the wrong premise and then wish to make your
theory applicable to real-world situations, you need lots of qualifications, assumptions and
amendments.

The whole aim of Ricardo’s value theory was then to show how changes in relative prices reflect
changes in relative labour time, whereby changes in the profit rate, wage rate or rent rate do
not influence the relative prices thus established (2007: 107-108).

Changes in the profit rate do not cause changes in relative prices if the average profit rate and
the average capital-labour ratio are the same in all sectors – as Ricardo assumes. To illustrate
Ricardo’s reasoning, take the example of the cost of producing 1 kg of tea and 1 kg of coffee.
Their relative price is, for argument sake, ⅔, meaning that the number of labour hours spent in
the production of 1 kg of tea is ⅔ of the number of labour hours necessary to produce 1 kg of
coffee. The cost of producing 1 kg of tea and 1 kg of coffee can be expressed as CoPtea and
COPcoffee respectively. CoPtea and COPcoffee include the depreciation, measured in labour hours,
on machinery attributable to the production of the tea and coffee, the cost of raw coffee beans
and tea leafs (the raw material extracted from nature) measured in labour hours, and the
number of actual labour hours used up in turning raw tea and coffee into the finished product as
bought in the shops. The relative price of tea in terms of coffee will then be: CoPtea/CoPcoffee =
⅔. If one adds the wage rate per labour hour (w), the formula becomes: w.(CoPtea)/w.(CoPcoffee)
= CoPtea/CoPcoffee = ⅔. Because w appears in both the numerator and the denominator, it
cancels out. The relative price remains unaffected at ⅔. Hence, assuming that the wage rate is
 56

the same in all sectors, changes in the wage rate do not influence relative prices. Similarly if we
were to include the profit rate (p = profit/capital) and we assume that the capital/labour ratio (c)
is the same for all sectors and can be defined as c = capital/CoP, the relative price of tea versus
coffee can be calculated as: (1+p).c.w.CoPtea/ (1+p).c.w.CoPcoffee = CoPtea/CoPcoffee = ⅔. Again,
because (1+p).c.w is in the numerator and the denominator, it cancels out. The relative price
remains unaffected at ⅔. Therefore, according to Ricardo, changes in the profit rate also do not
influence relative price.

Ricardo furthermore argues that an increase in the wage rate will reduce the profit rate (and vice
versa), but does not influence exchange value as determined by relative labour hours:
CoPtea/CoPcoffee. The underlying assumption seems to be that the value of (1+p).c.w is
presumed fixed and given. In that case, if the profit rate (p) increases, the wage rate (w) must
correspondingly decrease, so that the value of (1+p).c.w remains unchanged. Of course, for a
given sales volume, it is in any case true that a raise in the wage bill will reduce profits, and vice
versa. We already noted this in the context of Smith’s wages fund theory.

Changes in the rent rate do not cause changes in the cost of production, because, according to
Ricardo, rent does not influence exchange prices of agricultural as well as non-agricultural
output. It’s rather the other way round: exchange prices influence the level of rent.

It is thus shown how changes in the profit rate, wage rate or rent rate do not influence relative
prices, which are solely determined by the relative amount of labour hours used up in production
(2007: 107-108).

The textbook’s (2007:108-113) discussion of Ricardo’s theory of distribution is clear enough, but
do revisit our remarks on the classical theory of income distribution in study unit 2 above. Note
especially how the classics assumed that total real production and the general price level
remain unaffected by factor price changes (wage rate, profit rate and rent rate). This is borne
out by the fact that, in figure 7-1 (2007:113), the total product curve is given by technological
factors (decreasing marginal returns) only. The wage, profit or rent rates have no influence on
total product, but only on how it is distributed over landowners, workers and capitalists. Take
note of the main ideas of Ricardo’s theory of income distribution, which is that there is a conflict
of interest between
(a) workers and capitalists (which is further developed by Marx, on which we comment in
detail under the next Study Unit) and
(b) landlords and the entire rest of society.
The first conflict follows from the fact that an increase in the wage rate lowers the profit rate and
vice versa. But it must then be assumed that changes in the wage or profit rates indeed have no
influence on total production, which can thus be treated as fixed and given. Irrespective of how
much workers are paid, they remain equally productive. And irrespective of how much profits
they make, firm owners are equally enterprising. The second conflict results from the fact that
rent rates must increase at the expense of profit and wage rates, because food prices are
bound to rise under the influence of scarce land, unchanged agricultural technology and an
increasing population.

Carefully consider the three main Policy Implications (2007: 113-114) of Ricardo’s theory of
income distribution: (1) wages should not be regulated by law, (2) a tax on rent would not
increase the price nor lower the quantity of agricultural production, and (3) opposition to Corn
Laws.

The first policy implication presumes that labour markets are indeed “fair and free[ly]”
competitive, which need not be the case. In modern economies were firms tend to be larger
corporations, the individual worker would indeed be in an “unfair” bargaining disadvantage vis-à-
vis his or her large corporate employer. But bear in mind that most business enterprises in
Ricardo’s time were not yet large corporations, but relatively small proprietorships and
partnerships. It is indeed significant that labour only started to organise itself into unions in order
 57 ECS3705/1

to enhance its bargaining power vis-à-vis employers, once the average firm size has grown
because of the predominance of the corporate form, which happens in the late 1800s, early
1900s. From then on, it became a matter of “big business” bargaining against “big labour”.

The second policy implication is interesting in relation to Henry George’s proposal to tax rent
and redistribute the revenue over all citizens (see also the section on the physiocrats). Modern
advocates of a Georgian tax often mention the advantage of such a tax in that it has no
detrimental effect on prices or production volumes of agricultural products. This advantage does
not, however, depend on the validity of Ricardo’s rent theory. It follows from marginal cost
pricing and the fact that rent payments are a fixed cost for land cultivators. Insofar agricultural
markets are freely competitive and individual farmer-suppliers cannot influence the price there,
these advocates of Henry George’s policies would be right: the tax on rent would not push up
food prices nor negatively affect food production.

With reference to the third policy implication, make sure you know what the Corn Laws are and
why Ricardo was against them. If you don’t, follow up the references to the Corn Laws in the
index (also see our discussion of Malthus above).

As to Ricardo’s theory of comparative cost in international trade, the textbook’s (2007:114-116)

discussion should again be sufficiently clear. Of course it remains surprising how a country can
gain from international trade when it has no absolute advantage at all and is less efficient than
other countries in all of its sectors. The reason, according to Ricardo, is that scope for mutually
beneficial trade arises not only in countries who have absolute efficiency advantages over each
other in different goods (Portugal can produce wine more efficiently than England and England
can produce cloth more efficiently than Portugal), but also in countries who have comparative
efficiency advantages over each other (the difference in efficiency in wine relative to cloth
production is greater in Portugal than in England). If we apply this principle to persons rather
than countries, it may become more intuitively understandable.

If John is better at baking bread and his brother Peter is better at making shoes, both could gain
by specialising in what they are better at. John could spend all his time baking bread and Peter
could spend all his time making shoes, and they could trade to cater for each other’s bread and
shoe requirements. This is basic Adam Smith. Now along comes David Ricardo. Even if John is
better than his brother Peter at both shoemaking and baking, there may still be scope for
specialisation and interpersonal trade - that is, when the difference between John’s baking and
shoemaking skills is greater than the difference between Peter’s, for example when John is
enormously better in baking bread but only marginally better in making shoes than his brother
Peter. Under these circumstances, the bread production foregone in making shoes (the
opportunity cost of making shoes) could be greater for John than for Peter. As a result, John
would spend his time better by baking only bread and leave shoe production to his brother
Peter, even if he is a more efficient shoe producer than Peter. Ricardo merely applied this
principle to countries. Note, however, the fairly restrictive assumptions which underlie Ricardo’s
theory, which may cause it not to be generally applicable to all real-world situations (again, an
instance where Ricardo’s laws may not be generally applicable): capital and labour are perfectly
immobile between countries but perfectly mobile within countries without loss of productivity,
and there are no quality differences between goods produced in different countries.

In the context of Ricardo’s views on unemployment (2007:116-117), note Ricardo’s stance on

Say’s law and compare it with Malthus’s. With the aid of our discussion of Say’s law above, you
should have an improved ability to assess the merits of both their arguments. In the same
section (Ricardo on Unemployment), also note Ricardo’s ideas about technological
unemployment and the use of machinery.

In the first two editions of Ricardo’s main book (Principles of Political Economy and Taxation),
he argued that mechanisation (the increased use of machinery in production) was in the interest
 58

of all classes of society, workers, capitalists and landlords. Improved productivity and the
resultant lower unit cost of goods produced would reduce prices and thus increase the real
incomes of all. Aggregate employment would also not fall, because the technological
unemployment (that is, unemployment due to the replacement of men by machines) in some
sectors would be compensated for by the increased employment in other sectors. In other
words, the job losses in some outdated sectors would be offset by the job gains in the new
sectors which serve new markets. Ricardo thereby implicitly assumed a “technological
revolution”, as we used the term in our fictitious discussion between John and Tandi in the
Economics in Action section above.

But in the third edition Ricardo changed his mind somewhat, arguing that the introduction of
machinery may harm the interest of workers – at least in the short run. Ricardo based his
argument on the fact that investment spending reduces the wages fund, which would reduce
nominal wages. In the long run, however, Ricardo reasoned that falling prices due to
productivity gains would more than compensate for the fall in nominal wages, so that workers
would eventually gain too.

This argument does not seem strong. Mechanisation may damage employment in the short run,
but not for the reason advanced by Ricardo. We already noted in our discussion of the wages
fund in the previous study unit (on Adam Smith) that hardly any capital is needed to finance
wages in manufacturing because (a) the production round is fairly short (about a week or so)
and (b) workers are usually paid at the end of the week or month when a significant part of the
output produced during that week or month is probably already sold and has already generated
an income for the firm out of which wages can be paid. Moreover, firms can always borrow
funds externally from banks or through financial markets, which need not affect their ability to
pay wages. So the wages fund argument seems false.

The textbook’s (2007:117-118) final assessment of Ricardo is useful and important.

ECONOMICS IN ACTION: LOOKING BACK

The discussion about the influence of mechanisation on the interest of workers is by no means
settled, even among modern economists. Valid reason can be advanced in support of both
sides of the argument – that it damages the interest of workers and that it favours these
interests. The problem is that countries often have no choice but to accept the increased use of
machinery in production, whether it improves employment and wage payment or damages
them. Rejecting mechanisation will often mean that countries become less able to compete on
the international scene, which may have an even greater negative impact on employment and
wage payment. It is often a matter of choosing the best of two bad situations.

MILL

• chapter 8: only the section “John Stuart Mill” (pp. 135-146, excluding “The law of
international value” pp. 142-143)

ECONOMICS IN ACTION

Among other things, John Stuart Mill addressed the issue of wage determination and the scope
for bettering the position of workers through wage increases. As in introduction to this issue,
consider the following continuation of the imaginary discussion between John and Tandi.
 59 ECS3705/1

John: And what about poverty? Many of our people are low- or unskilled workers. Would it not
be an effective way of poverty alleviation if the unions demanded significantly higher wages for
the workers in all industries and let firms give up a bit of their overly high profits?

Tandi: Again, it depends …

John: You are using this phrase “it depends” a bit too often for my taste. I am getting a bit tired
of it. Why be so tentative? Why not say “definitely yes” or “definitely no”? Don’t be a fence sitter,
show a bit of character and stand for something!

Tandi: John, that is just what economic reality is like. Things like the welfare of workers, the
level of employment, depend on many factors, all of which need to be considered. It is just a
matter of being careful and responsible in one’s economic reasoning. Whether demanding
significantly higher wages is feasible and in the long-run interest of workers does depend on a
number of factors.

John: Okay then, what factors?

Tandi: Well, among other things, it depends on the profitability of the affected firms. If their
actual and expected profits are already meagre, having to pay significantly higher wages may
mean that profits fall below what makes it worthwhile for them to continue operating at current
production levels, let alone investing in additional production capacity and employing more
workers. Whether you like it or not, it is when firms expect good profits that they are inclined to
invest and create jobs. So by squeezing the profitability of firms too much, you may actually
damage the interest of workers by sacrificing the number of jobs. Nonetheless, there may also
be instances where firms pay unreasonably low wages and make unreasonably high profits, so
that there is scope to pay the workers better without compromising current or future
employment.

John: Does this not create a problem? I mean, unions cannot demand different wage increases
from different firms, depending on their different current or expected profitability? Surely, unions
cannot condone that people who do the same job earn different wages in different firms?

Tandi: I know this is a problem. Nonetheless, the difficulty remains that firms are not equally
capable to afford the same wage increases. What may be affordable for the one firm (or sector),
may be crippling for the other.

John: But are firms ever “crippled” by wage increases? Can they not simply increase their prices
in order to make up for increased wage cost, and so maintain their real profitability?

Tandi: Again, it depends. If the relevant firms face tough competition from abroad, increasing
their prices in order to maintain profitability may mean they lose business to foreign firms. And
when they lose business, they will eventually have to cut back production and shed jobs. Not in
the interest of workers, I’d say.

John: Yes, but in my international finance and trade course I learned that when the exchange
rate simultaneously falls (the rand loses value vis-à-vis foreign currencies), the increased rand
prices translate into more or less the same dollar or euro prices, so that these firms do not
become less competitive as compared to other foreign firms ..

Tandi: But then you still sit with the problem of inducing more inflation; recall from your
international trade and finance course how a falling value of the rand has a strong inflationary
impact on local prices in a small open economy like South Africa which is particularly dependent
on imported capital goods (machinery and implements). And inflation will soon wipe out the
 60

initial gains from the higher wages. When both wages and prices increase, there is no benefit
for workers! And there is the added complication of having to get rid of the inflation again, which
is always a hard and painful process accompanied by interest rate increases. By the way, I
learned from my course in the history of economic thought of this concept called the “wages
fund”. An old economist named John Stuart Mill claimed that, with the wages fund fixed in the
short run, firms do not have the money to finance wage increases unless they reduce
employment.

John: This sounds an odd idea to me. Surely, if firms were a bit less greedy and prepared to
accept some reduction in profit, they would have the money to pay for higher wages. Even so, I
accept that lower profits may mean that firms have less money to invest in new production
capacity which may jeopardise future employment. But are there not other ways of financing
investment apart from retained profits (savings) by firms? Can’t they borrow from households?

Tandi: Sure they can, but that may cause a reduction in consumption expenditure by
households, which may compromise their sales and thus their profits again.

John: Okay, but they can also borrow from the banks. I learned from my course in monetary
economics that bank credit amounts to money creation.

Tandi: You are right, they can - and often do - borrow from banks. Even so, firms don’t like to
borrow when they don’t have to (unless they wish to increase their profitability through
increased gearing). And the fact remains that the wage cost in this country needs to be
comparable to what overseas companies pay their workers, taking productivity into account.
Otherwise, the competitiveness of our local economy is compromised and we may battle to sell
our products on the local and international markets. If the local economy sells less, employment
for our local population will be less too. As I said before: in this highly competitive international
economy, you cannot afford to be out of line with what happens internationally, otherwise you
lose out. The business goes elsewhere.

John: This Mill character, has he said anything else that is interesting?

Tandi: Yes he has. But I will need to do some extra studying before I can talk to you about that.

Question: Study the economics of John Stuart Mill and imagine yourself explaining things to
John.

CONTENT

Mill is the last of the great classical economists. He did not contribute a great deal that was new;
he mostly systematised and popularised the teachings of his predecessors, particularly Smith
and Ricardo. Yet in his own right Mill had considerable stature, not only as an economist but
also as a social philosopher. He did make some important original contributions to economics
as well.

Mill distinguished three production factors, labour, capital and land, and the textbook devotes a
separate section to Mill’s views on the contribution of each.

In the section on labour, note that Mill regarded wealth as useful material goods. By implication,
the provision of services was unproductive labour, unless these services indirectly contributed to
the production of material goods. Modern economists regard both material and immaterial
goods as productive. Easting an ice cream or listening to an entertainer may be equally useful
for consumer and hence equally contribute to their “wealth”.
 61 ECS3705/1

Mill defines capital as accumulated material goods which are used as in input into production.
He also posits that “capital ... limits the extent of industry”, which is still true today. Assuming a
capital-intensive mode of production, there cannot be wealth and employment creation without
investment in machinery and implements. Also note Mill’s implicit endorsement of Say’s law:
“Thus the limit of wealth is never deficiency of consumers, but of producers and productive
power.” In other words, there always is enough demand for all production to be sold. Therefore,
investment in additional production capacity need not be held back by worries about future
aggregate demand being unable to take up the additional production. While investment need
not be limited by insufficient future demand, it can be limited by insufficient saving to finance it.
Nonetheless Mill thought that saving would, as a rule, be sufficient to finance all planned
investment. Moreover, investment is less likely to be curtailed by insufficient saving in a modern
fiat money economy, where saving can to a greater extent be supplemented by bank credit
(money creation) as an additional form of finance for investment.

According to Mill, the real barriers to increased production were the limited extent of land (the
supply of land is fixed in a country) and the decreasing return to scale in agriculture. Like
Malthus, Mill did not anticipate the huge productivity gains in agriculture due to the various
“Green Revolutions” we have had.

When studying the section on distribution (2007: 138-139), reread our comments on the issue in
study unit 2 on Adam Smith.

When going through the section on the wages fund concept (2007: 139-140), also reread our
critique of that concept in study unit 2, which corresponds with this section’s critique of it. In fact,
we quoted a fairly large part of this section in our assessment of the wages fund doctrine in
study unit 2.

Also pay attention to Mill’s more sophisticated theory of exchange and value (2007: 141-142), in
which he foreshadowed the marginalist/neoclassical revolution by giving recognition to demand
and supply schedules as well as to price elasticities of demand and supply. Indeed, already in
his lifetime the classical consensus was beginning to crumble and economists were starting to
desert narrow cost-of-production theories of value, in favour of theories which gave equal
recognition to both the demand and the supply side in price determination and which recognised
the roles of marginal cost and marginal revenue in price determination. Such are, of course, the
pillars of the neoclassical/marginalist school of thought, as we will see in study unit 5.

The section on the law of international value is not prescribed.

In the section on dynamics in the economy, the textbook (2007:143) summarises some
interesting thoughts of Mill, which betray typical 19th century cultural optimism: “More security,
less destruction by war, reduced private and public violence, improvements in education and
justice - all these would reduce the risk of investment and thereby reduce the minimum
necessary rate of profit.” But why are these considerations important? The reason is that, while
having the advantage of being more productive, a capital-intensive industrialised economy has
the disadvantage of making wealth and job creation more subject to risky investment. A climate
of socio-political safety, stability and security is, therefore, of greater importance to such an
economy. Also, when the economic environment is safer and more stable, the profit rate
required to entice entrepreneurs to take risks will come down, leaving more for payment of
wages. These ideas are still worthy of consideration today.
 62

RELEVANCE FOR TODAY

At the time of writing this guide, South Africa seems to be entering a phase of increased socio-
political and economic instability. Nobody should be surprised that the added uncertainty
damages the economy. In a modern industrialised economy, wealth and job creation requires
investment. Because investment is earned back in the future, people are inclined to invest only
when they have a high degree of confidence in the future. If that confidence falters, investment
declines. Nobody can be expected to risk their money if there is no good chance of earning it
back. And with declining investment, there is also less wealth and employment creation.

In the same section, it is interesting to consider Mill’s sober attitude towards competition in a
liberal-capitalist society. On the one hand, he was not “charmed with the idea ... that the
trampling, crushing, elbowing, and treading on each other’s heels ... are the most desirable lot
of industrial progress” (2007:144). On the other hand, he also realised that this is probably still
preferable to “full-blown socialism, which by disparaging competition would promote monopoly”
(ibid). The point is that a liberal society is not ultimately based on competition but on personal
freedom, which includes both the freedom to compete and the freedom to cooperate. We tend
to think of cooperation in positive terms and of competition in negative terms, which is not right.
Both competition and cooperation have an attractive and an ugly side to them. Competition may
be ugly in that it allows suppliers to “trample, crush and elbow” each other, but it is also
attractive in that it gives demanders a choice between alternative suppliers and so avoid
possible exploitation by suppliers. The attractive side of cooperation is that, when people
cooperate for a good cause, they can achieve more good. But its ugly side is that people can
also create more harm when they cooperate for a bad cause, such as when they collude to form
a monopoly to exploit their demanders.

The idea of Mill’s liberal society is that, by allowing the freedom to compete as well as the
freedom to cooperate, the potential evil of both competition and cooperation can be kept in
check. This will by no means create a perfect society, but it may just create the society that is
potentially the least bad, given that people are not always inclined towards the good. “Full-blown
socialism”, as Mill realised, tends to fall victim to the evils of unchecked cooperation, because
the state (and the state officialdom behind it) have guaranteed monopoly power. These issues
will be developed further in the next study unit.

The “popular dictum [that] people understand their own business and their own interests better,
and care for them more, than the government does, or can be expected to do” (2007: 145)
captures the quintessentially liberal sentiment. While your lecturer broadly agrees with this
“dictum”, note that Mill could not apply it without exceptions. He still had to make some
significant concessions to it.

ECONOMICS IN ACTION: LOOKING BACK

How do we improve the lot of the mass of low- or unskilled workers in South Africa? What can
we learn from Mill and the other classical economists in this regard? The first thing that we need
to admit is that better wages and more employment can be realised only when business is
successful. Business must be making money if it is to spend money on wages - whether by
increasing the wage rate or by employing more people at the same wage rate. Of course, when
business is successful it has more money both to pay higher wages and to distribute more
profits to owners. We may justifiably complain that too great a proportion of this money goes to
profit and too small a proportion to wages. But such complaints take nothing away from the
inescapable fact that business must be successful if it is to earn the money to pay for either
more wages or more profits.
 63 ECS3705/1

The next question is: how can we allow business to be successful and make the money needed
to finance higher wages/profits? Again, we may justifiably complain about the justice of the
current globalised world economy. But we are, for now, forced to treat it as a given; South Africa
itself cannot change the world. Given this globalised world economy, an important way to
ensure business success is to ensure that local firms are competitive: their prices and quality
must be such that their products form an attractive proposition for local and foreign buyers. This
requirement has a number of implications. First, it underscores the importance of maintaining
macroeconomic stability in the local economy: low inflation, a steady growth in local demand
and an exchange rate which is not overvalued. Second, it underlines the importance of socio-
political stability: stable, effective and non-corrupt government. Third, it highlights the
importance of education in the technical, engineering and commercial fields. Fourth, it requires
some strategic thinking in order to concentrate our efforts on areas where we potentially have a
comparative advantage over other countries. However, there also is a domestic non-tradable
sector which includes activities like transport, trade, construction, hospitality, financial and other
services and which does not directly compete with foreign firms. That sector may effectively be
stimulated locally, provided there is enough money in the economy. Government spending on
infrastructure may be a case in point. Nonetheless, recent research has shown that stimulating
manufacturing (or the non-resource, tradable sector) remains of crucial importance in
stimulating employment, which may require ensuring that profitability in manufacturing does not
suffer – as it has done over the last decade or so.

All this presupposes that the pursuit of profit, while possibly being given undue emphasis in
current capitalist practice, is at least not considered inherently iniquitous. There is, of course, a
school of thought that does regard the profit motive as irredeemably objectionable. That school
of thought is the subject of the next study unit.
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STUDY UNIT 4
Socialism and Marx

Study the following prescribed material in the textbook:

• chapter 9: only the section “Overview of socialism” (pp. 149-155)

• all of chapter 10

STUDY OUTCOMES:

When studying this unit, you should aim at gaining knowledge and understanding of the
following:

• The nature of the various types of socialism, their differences and similarities.
• An alternative classification of types of socialism: dogmatic state socialism
(collectivism), pragmatic state socialism, interventionalist socialism, worker
participation socialism, and welfare state socialism.
• The nature of collectivism and why it leads to state absolutism.
• Why collectivism tolerates no unions and no worker participation.
• Collectivist sharing versus capitalist greed.
• Marx’s confusion between two opposites: collectivism versus laissez faire, and
industrial production versus handicraft production.
• The influence of Ricardo, the utopian socialists, Darwin, Hegel and Feuerbach on
Marx’s thought.
• The forces of production, the relations of production, and the internal contradictions of
capitalism (class struggle) which inevitably lead to revolution.
• The six stages of capitalist production which eventually culminate in communism.
• The similarities and differences between Marx’s and Ricardo’s labour theory of value.
• The foundational idea of Marx’s theory of exploitation: only labour is productive.
• The degree to which capital, entrepreneurship and nature (land) can be regarded as
unproductive.
• Marx’s concept of “socially necessary labour time”, and its components.
• Marx’s concepts of “labour power” and “labour time”, and how the value of labour
power is determined.
• The extraction of surplus value by capitalists: their power to set the length of the
working day.
• The fact that Marxian exploitation is not indicated by capital making excessively large
profits because paying labour excessively small wages, but indicated by capital
making any profit at all – however large or small.

• The rate of surplus value, and the ability of capital to increase this rate by lengthening
the working day or by reducing the value of labour power through raised productivity.
• The determinants of the rate of profit.
• The organic composition of capital as a measurement of the degree of capital intensity
of production.
• The transformation problem: the contradiction between equal profit rates in all
industries and different profit rates between industries according to different degrees of
capital intensity.
 65 ECS3705/1

• Why, according to Marx, the profit rate falls when the degree of capital intensity rises.
• Why, according to Marx, capitalists may still have an incentive to mechanise even
when the rate of profit falls.
• How a falling rate of profit due to mechanisation can be temporarily offset by other
forces.
• The merits and demerits of Marx’s arguments against Say’s law.
• Marx’s views on the centralisation of capital: how large capital destroys small capital.
• Marx’s views on the intensification of class conflict and the inevitability of revolution:
increasingly concentrated capital is confronted by increasingly concentrated and
desperate labour.
• Marx’s accurate prediction of rising inequalities within countries as well as between
countries.
• Marx’s accurate highlighting of the possibility of technological unemployment
(machines replacing workers).
• Marx’s accurate prediction of capitalism’s proneness to cyclical instability, be it that the
reasons which Marx gives for this instability are questionable.
• Marx’s inaccurate prediction of falling profits and wages.
• The harmony as well as the conflict between labour and ownership.
• The dangers of collectivism inherent in Marx’s policy proposals.
• The naïvity of Marx’s ultimate communist heaven which has no government and no
private property.

ECONOMICS IN ACTION:

As an introduction to the topic of this chapter, consider the following excerpt from a speech by
Cosatu secretary general, Zwelenzima Vavi, delivered on the 9th December 2007 on the
occasion of the 90th anniversary of the Russian Revolution of 1917.

The October Revolution was the most important event in modern history. It marked the first
victorious revolution of the working class since the Paris Commune. It showed the world that the
system of power built on the working class and the poor was possible and more progressive
than bourgeoisie democracy. The victory of the working class in Russia ushered in a
revolutionary epoch that set the world on a path towards social justice. It laid the foundation for
the liberation of colonised people from the imperialist yoke and many in Asia and Latin America
chose the socialist path.

It [also] contributed to the creation of favourable conditions for the struggle of national liberation
movements and dismantling the colonial system. It created a living alternative economic and
political system. It revealed and laid bare the weaknesses of capitalism and proved that
capitalist development will not resolve the comprehensive structural crisis that has afflicted the
world, since this pattern of development is replete with social, political contradictions, conflicts,
and polarisation.

The victory of the October revolution provided hope to the poor. It offered support for the
peoples of developing countries, including our own people, in their aspirations for freedom and
social progress. It tilted the world balance of forces and created new favourable conditions for
the peoples of advanced capitalist countries and the struggles of their workers to achieve more
social and economic gains.

The Soviet people under the leadership of the [Communist] Party embarked on an ambitious
programme to build socialism and to surpass the achievements of capitalism. Indeed, albeit with
 66

serious flaws, the soviet society invested heavily in industrial and scientific development to a
point where the USSR was the first country to launch a rocket to the moon. This from a country
that had an underdeveloped feudal-capitalist system. In human terms the Soviet Union built an
egalitarian society, which satisfied the basic needs of its people.

Despite later distortions, it goes without saying that the Soviet achievement in science, industry,
education and human development were unparalleled. Even the World Bank had to grudgingly
concede the enormous achievement of the socialist bloc. Cuba today has the best health care
system based on the needs of its people and has more doctors per capita even exceeding most
developed countries.

We stand here today with pride and with great emotion to salute and pay tribute to the heroes
and heroines who contributed to the realisation of this victory, which was the first genuine
victory of the working class.

What is the record since then? Capitalism remains a crisis-ridden system based on profit for a
few. The divisions between the rich and the poor have widened both within and between
nations. Rich countries are forcing poor countries to open their markets in search of profits,
cheap labour and markets. This is in response to the crisis of profitability faced by capitalism in
the rich countries.

Mass impoverishment has become the order of the day as neo-liberalism has shattered social
welfare systems and destroyed the public sector in many developing countries. Simultaneous
with the restructuring of the working class, profits have soared for the local and international
bourgeoisie. In short mass impoverishment coexists with high levels of profit.

At the same time we have seen a spectacular revolution in the productive forces in areas like
communication, transport and bio-medical science that suggest that we have the means to
address problems of poverty, poor health care etc. Yet as Marx predicted, a system of private
property prevents the application and use of these huge modern resources for the greater good.

For as long as this alarming reality lives with us, a case for a socialist revolution exists. Neo-
liberalism has been challenged throughout the world and more forcefully in Latin America. In
this context we salute the wave of leftwing parties coming to power in Latin America .. The
South African working class has also forcefully challenged the neo liberal dogma and this year it
has sent the message to the bosses that the party is over!

What are the implications for the South African Revolution? We must see our struggles as
interlinked with the global struggle against neo-liberal globalisation. Our challenge is to
radicalise the current path of the National Democratic Revolution. This means building the
power and the confidence of the working class to challenge the hegemony of capital. That
requires a reversal of the flirtation with the neo-liberal dogma by the democratic government. It
also requires that we consolidate and deepen the leftward shift in economic policy.

Source: www.cosatu.org.za, 11 March 2008.

Question: What can you conclude about the type, or the types, of “socialist revolution” which
Vavi advocates in this address? To what extent are these types of socialism likely to benefit the
poor and the workers?
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SOCIALISM

• Chapter 9 only the section “Overview of Socialism” (pp. 149-155)

We tend to think of socialism as a single vision or idea. But there are, and have always been,
many different shades of socialism. The textbook’s “Overview of socialism” is useful in
highlighting that diversity.

All forms of socialism are concerned with the poverty and powerlessness of the working class
and the power and wealth of the business class. The way in which they wish to address these
concerns, however, may differ. These differences centre around the following:

(a) Is the state part of the problem or part of the solution? State socialism, Marxian socialism,
revisionism and guild socialism argue the latter, while anarchism and syndicalism argue
the former.
(b) Is the problem caused by the evil in people (their lack of solidarity with, and concern for,
the poor and downtrodden) or by the evil in the system (the institutions of private property
or coercive government). To put the same question differently, is the evil innate in people
or does the evil lie in the negative social conditioning of people? Utopian socialism and
Christian socialism would be inclined to argue the former, while state socialism,
anarchism, Marxian socialism, and communism believe that, given the right system, the
ethical standards of people should rise to such an extent that social victimisation (people
taking advantage of each other) virtually disappears.
(c) Is the problem solved by a radical overthrow of the old order or by gradually reforming it?
State socialism, anarchism, Marxian socialism, communism and syndicalism prefer
revolution, while revisionism and guild socialism favour more gradual reform.
(d) Are the interests of workers and business owners inherently conflicting, or are they
potentially reconcilable? State socialism, anarchism, Marxian socialism believe that class
struggle is inherent, while utopian socialists, Christian socialists, revisionists and guild
socialists reject the inherent antagonism between classes.

Take note of the “communalities of socialism” (textbook, p. 153). The textbook emphasises as
the common elements (i) class struggle, (ii) opposition to laissez-faire (iii) rejection of Say’s law
(the inherent macroeconomic instability of liberal capitalism), (iv) the perfectability of man when
the system is right, and (v) support for some form of collective action or public ownership.

Your lecturer wishes to suggest an alternative, more insightful way of classifying the various
forms of socialism. We distinguish four basic types:

(1) Collectivism or dogmatic state socialism. This type of socialism regards private ownership
of business firms as the root of the problem. For that reason, collectivism advocates the
complete abolition of private property in the means of production. All business enterprises are to
be nationalised, that is, put in the hands of the state. No private business is to be allowed at all.

(2) Pragmatic state socialism. This type of socialism does not insist on private ownership of
business firms being the root problem with capitalism. Accordingly, pragmatic state socialism
allows some (smaller) business enterprises to remain in private hands. Nonetheless, in order to
curtail the power of private business and to pursue social ends, it wishes to nationalise some
key, strategic industries, like mining, transport or communications. Julius Malema’s insistence
on nationalising the mining sector would mark him out as a pragmatic state socialist, although
he obviously likes to use the language of a dogmatic state socialist (collectivist) too.

(3) Worker participation or industrial democracy socialism. The point of this type of socialism
is that workers should have a significant say in the running of the firm, which can happen when:
 68

(a) the firm is predominantly managed as well as owned by the workers, or

(b) the firm is predominantly managed but not necessarily predominantly owned by
workers; it can be privately owned by non-workers or publicly owned by the state.

Option (a) conflicts with “liberal” free enterprise principles only to the extent that government
enforces majority ownership for workers. Option (b) contradicts with “liberal” capitalist principles
in a different way. In the traditional capitalist view of things, ownership implies decision making
power over what is owned. If you own a house or a car, you have the right to decide what
happens with that house or car. Option (b) overrules that principle when it comes to the
ownership of productive enterprises: workers now have a decisive say in the management of
the firm but do not own it. The state or private people own the firm. Worker participation
socialism should be distinguished from unionism. Unions do not seek the power to manage the
firm. They want to oppose management when it is perceived to act contrary to the interest of
workers, but they definitely do not want to manage firms themselves.

(4) Interventionist socialism. This type of socialism does not seek to tackle the problems of
capitalism at the level of ownership forms or the power to manage. For interventionist socialism,
it does not matter whether firms are privately or publicly owned, worker-managed or owner-
managed. Instead, what matters is that the state institute laws which forbid or prescribe certain
behaviours on the part of business firms, with a view to protecting the interests of workers and
consumers. Unionism falls within this category of socialism. It is due to interventionist legislation
that firms are obliged to negotiate with unions in decisions affecting the interest of workers.

(5) Welfare state socialism. For this type of socialism, it also does not matter whether firms
are privately or publicly owned, or whether workers have a significant say in its management or
not. Welfare statism merely advocates that the state tax the profit and incomes generated by
business enterprises to finance programmes to reduce poverty and inequality, like the provision
of health care, education, housing, old-age pensions and unemployment and disability grants.

In this categorisation, there is only one opposite to socialism, namely a system where all
production enterprises are privately owned and have full freedom to organise their production in
any way they want, and buy and sell what they want at the price that they want. We could label
this logical antipode to socialism laissez-faire (a French term coined by the physiocrats; see
study unit 1). It is clear that modern “neo-liberal” capitalism mixes laissez-faire with fairly high
doses of socialism varieties 2, 3, 4 and 5 above, although pragmatic state socialism (variety 2)
is ostensibly on the wane given the inclination of modern states towards the privatisation (de-
nationalisation) of previously state-owned enterprises. A degree of pragmatic state socialism,
worker participation socialism (though small), interventionist socialism, and welfare state
socialism has become integral to the modern liberal-capitalist ethos, while private enterprise and
freedom of exchange obviously remain dominant. Hence the only uncompromising form of
socialism is collectivism/dogmatic state socialism (variety 1), because it is inherently
antagonistic towards the private ownership of productive resources (private enterprise) and,
therefore, irreconcilable with any degree of laissez-faire.

Any significant degree of worker participation has proved difficult to apply in practice. Ironically,
worker participation has been equally unpopular among liberal capitalists and more radical
socialists with collectivist leanings. The problem for liberal capitalists is that workers do not
generally have the capital to acquire ownership so must be given it – free, gratis and for nothing.
And when ownership is given for free, it is usually much less appreciated and hence much less
carefully managed. Such firms tend to lose money and eventually go bust fairly quickly. Should
workers get decision-making power without ownership (option (b)), the problem is that they
need not personally carry the consequences of their decisions: the profits when things go well
and, possibly even more importantly, the losses when things go awry. This also means that the
firm is likely to be less carefully managed. Worker participation is just as unpalatable for more
radical collectivists, because it means that power is divested from the state to the workers. And
under collectivism/dogmatic state socialism, the state – not the workers – rules supreme.
 69 ECS3705/1

In order to understand why this is so, it is necessary to acquire a deeper understanding of

collectivism/dogmatic state socialism, which is often not well understood. It is interesting how
collectivist ideas tend to impregnate the sloguns of many a contemporary socialist, like Vavi or
Malema, even if they do not necessarily propose to nationalise all business enterprises. Rather,
they merely prefer to throw more pragmatic state socialism, worker participationism,
interventionism, and welfare statism into the liberal capitalist mix. Collectivist sloguns are
attractive because they stir the crowds. But the question is: do they stir the crowds with truth.
Let’s pursue the issue.

In essence, collectivists do not trust private individuals with the economic power and freedom
which capitalism (to varying degrees) gives them. There may, of course, have been good
reason for this mistrust. Capitalist systems have regularly given (and may still give) too much
power and freedom to particular sectors of society, such as the merchant, the king, the landlord
or the corporate capitalist. This privilege has often led to abuse and the exploitation of
economically weaker classes, in particular the workers. Undoubtedly, the science of political
economy ultimately aims to conceive of a system that is free of institutional bias and privilege (if
such a system exists), meaning that economic power, opportunity and freedom are evenly
spread over all members of society. Collectivism, however, does not spread power, opportunity
and freedom - it altogether removes them from the reach of private individuals (whether they be
capitalists, landlords or workers) so as to invest them in the collective.

Now comes the crucial problem: who is the collective? Is it the common people as a group of
private individuals? No, because collectivism does not trust individuals with the power,
opportunity and freedom of private ownership. But if not a group of private people, who then is
this collective to which all the power belongs?

Collectivist and communist systems of thought really have no answer to this question. The
solution they come up with is to identify the collective with the state and its government (state
officialdom). That is how collectivism collapses into dogmatic state socialism. The will of the
people becomes identically equal to the will of state officialdom. For that reason, government
leaders who are inspired by communist ideology will tend to claim to speak the will of the
people, even when they simply speak their own private will as inspired by their own private
interest (as the kings of old were inclined to do, see study unit 1). Ironically extreme collectivism
thus tends to degenerate into an extreme form of individualism, namely the individualism of the
autocrat who claims to represent the collective. At no time in history has the power of heads of
state been so absolute as the power of the heads of communist states have been – with the
possible exception of the pharaohs of ancient Egypt.

In short, the central naivety of collectivist thinking is contained in the idea that the collective is
represented by the state rather than by the mass of ordinary citizens. For example, traditional
Marxism teaches that by nationalising all industries a “dictatorship of the proletariat” will be
established, in which workers become owners of capital (2007:184). But this is clearly not the
case: state officials become the capitalists and workers remain workers, with as little power as
before. Rather than a “dictatorship of the proletariat”, Marxism establishes a “dictatorship of
state officialdom”. Similarly, during the Russian and Cuban revolutions, the revolutionaries
gained the much needed support of the peasantry by promising them their own land. The
peasants were betrayed in both cases. Land previously owned by the Cuban and Russian
landlords was not distributed among peasants but nationalised; instead of allowing peasants to
run their own farms on their own land which could have empowered them, they were forced to
work for large, state-owned farming collectives. They simply moved from virtual servitude under
the landlord to virtual servitude under state-run farming collectives, not gaining much in the
process - neither in terms of civil liberty not in terms of material betterment. When the peasants
in Russia subsequently revolted against this betrayal, they were systematically murdered by the
communist Russian state under Stalin – in their tens of millions, easily the biggest genocide the
 70

world has ever seen. The point is: collectivist systems do not give power to the collective as a
group of individual people but to the state and its officials. Intoxicated by misleading collectivist
slogans, many followers of collectivist revolutions have misunderstood this, to their peril.

RELEVANCE FOR TODAY

Socialist sympathisers in modern-day South Africa need to be asked the question: “Does your
vision of a socialist revolution empower the people by giving them ownership and a personal
stake in the production apparatus, or by nationalising all means of production (land and firms)
so that the state virtually owns everything and the people virtually own nothing?” The question is
crucial, because communists have historically been less than entirely honest about this issue. It
seems clear that the only way to empower people is to create opportunities for spreading the
private ownership of the means of production as evenly as possible, and to educate people so
as to give them the technical and business skills to seize these opportunities. Collectivist
nationalisation does not give power to people but concentrates all power in the hands of the
state. Where people may previously have been in virtual slavery to the capitalists, they will then
be in virtual slavery to the state and its officials. It is a matter of debate which is worse.
Socialists may be justified in criticising current capitalism for failing sufficiently to spread the
benefits of ownership, ownership in both firms and land. We do need a socialist revolution of
sorts, but a revolution which truly spreads ownership and power, not one which concentrates
ownership and power in the hands of the state and its few exceedingly privileged officials.

Having lost their freedom, opportunity and power, the people as ordinary private citizens have
also less incentive to be productive and innovative in the economic sphere. Why should they?
Private citizens under a collectivist system are not personally rewarded for their productivity and
innovation, nor do they personally bear the losses incurred by unproductivity and lack of
innovation. Not only that, private citizens have also become defenceless against state
officialdom’s abuse of power. Because the collective is absolute and state officialdom is claimed
to represent the collective, the position of state officialdom becomes untouchable and their
power absolute. Whoever contradicts the will of the government, contradicts the will of the
people, which is the ultimate authority. Any opposition against government becomes treasonous
by definition. Communist ideology forces communist states to tolerate no dissent. And so
Russia, Cuba, China and East Germany squashed political dissent with unparalleled
ruthlessness (China still does). “The people have spoken”.

One may argue that parliamentary control by democratically elected representatives would be
able to keep a check on the power of state officialdom under collectivism. But in practice
collectivist systems have never managed to be democratic, and predictably so. Collectivism
makes the benefit and privilege of controlling the state so great that the temptation simply to
seize and retain control becomes virtually irresistible – the more so because control over the
state is the only route to freedom and prosperity in a system where ordinary private individuals
lack all opportunity for economic advancement. Control of the state provides the only access to
the “good life”. In addition, many communist leaders berated “bourgeoisie democracy” stating
that democratic elections were unnecessary. As Fidel Castro used to say: “The people have
spoken already”, by which he meant “at the time of the Cuban Revolution”. Because the
collective gets equated with government officialdom and Castro represents that officialdom, he
embodies the will of the people. Hence, according to collectivist logic, there indeed is no need to
consult the actual people.

Another naivety of collectivism is contained in the suggestion that it is characterised by the

virtues of cooperation and sharing, while capitalism is supposed to be characterised by the
vices of competitive conflict and self-interest. And so the misleading suggestion is created that
collectivism is merely about sharing between all in the communal interests of all, while
capitalism is merely about conflict and the greedy individual interests of some. The suggestion
 71 ECS3705/1

is misleading for two basic reasons.

1. Competition in the sense of rivalry between, say, suppliers can be fierce under capitalism,
the sight of which is not always pretty - as a proponent of capitalism like Mill frankly
admitted (see study unit 3). But competitive conflict is not an unqualified social vice. It has
the clear social advantage of giving demanders a choice between various suppliers, which
enables them to escape possible exploitation by these suppliers. As mentioned in our
comments on Adam Smith above (study unit 2), liberal capitalism’s greater respect for the
freedom of disassociation provides greater protection against the possible harm of
association and cooperation. Collectivism does not recognise this as a merit of liberal
capitalism, because it does not recognise the possibility that association and cooperation
between people can ever be harmful. In essence, therefore, collectivist ideology regards
association and cooperation as an absolute good, which can thus be enforced and
coerced by state power without any risk of harm to people.

Just as competition and disassociation are not unqualified social virtues, so also are
association and cooperation not unqualified social virtues either. Cooperation between
people to help the needy or increase productivity may a good thing, a great deal of which
is already happening under capitalism: people cooperate to form mutual aid societies (like
church-based societies, or AA groups) or they cooperate to form a partnership in business
to increase their productive effectiveness. But cooperation to gain monopoly power in a
certain market (collusion) or cooperation to form a secret society like Freemasonry or the
Broederbond are bad things (why in the world would you want to do things (semi-)
secretly?).

So the point of capitalism is not competition at the expense of cooperation, but the
freedom to either cooperate/associate or compete/disassociate - both of which are
potentially vicious and virtuous, depending on the goals and values of those involved.
While capitalism allows for both competition/disassociation and cooperation/association,
collectivism permits only cooperation/association. The kind of cooperation/association
which it permits, however, is likely to be predominantly vicious, because it is coerced and
comprehensive, covering all economic activities of all citizens. Because there is no
freedom of disassociation/competition, everybody is wholly locked in (“no exit”). When the
state becomes sole supplier of all goods and all jobs, state officialdom once more obtains
absolute monopoly power in all markets over all people, which is bound to lead to abuse
of power. Lord Acton can be quoted once again: “Power tends to corrupt and absolute
power corrupts absolutely”.

Hence the increased bargaining power which private individuals may gain by “standing
together” is in conflict with collectivism. In communist nations like Russia, Cuba, East
Germany and China, individuals were denied the right to form associations outside of the
state. After all, Marxist ideology demands that the state is the only true collective, the only
true representative of the will of the people which, therefore, permits no rivals. That is why
former communist Russia, Cuba, East Germany and China did not allow the private
formation of trade unions, churches or even sports clubs. For a similar reason, collectivist
states will only recognise the virtues of sharing and self-sacrifice when they further the
aims of the collective as represented by the will of government officialdom. Self-sacrifice
and sharing to further particular interests as determined by the people themselves are
considered subversive. Private interest groups like trade unions are, paradoxically
enough, a typical liberal-capitalist phenomenon, since only liberal capitalism gives people
the freedom of association and disassociation. Vavi’s Cosatu would not have been
allowed to operate in Vavi’s beloved Marxist Russia! Unionism is incompatible with
dogmatic state socialism.
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2. Similarly, while economic players under a capitalist system can be exclusively self-
interested (and as such greedy), capitalism is not essentially based on self-interest, as
noted in our discussion of Adam Smith too. Rather capitalism’s essential philosophy is the
maintenance of individual freedom (within certain important limits), whereby this freedom
can be used to pursue either self-interest or sharing (if all is well, hopefully a bit of both).
Once again, it all depends on the goals and values of the people themselves, although the
modern corporate form of capitalism has probably magnified the drive towards profit
making and in that sense made the system more greedy (see the articles mentioned in
footnote 4 below). Capitalism allows for both self-interest and sharing, but collectivism
permits only sharing, which again is all-embracing and totally coerced. The state
coercively gathers all income and wealth, and the state distributes it again to whom it
pleases. The problem with this kind of coercive sharing is again that state officialdom, as
the agent for the collective, inevitably obtains a large amount of discretionary power over
how the wealth is to be distributed, which is likely to benefit them the most.

All this is not to say that there is no place for a degree of state-enforced cooperation and
sharing under liberal capitalism. After all, there can be no rule of law without everybody
agreeing to cooperate by obeying the law. Welfare state socialism, which is not irreconcilable
with capitalism, is essentially enforced sharing: some of the wealth of the rich is taxed away to
make financial provision for some of the schooling, health care and old-age pensions of the
poor. Moreover, there may be a case to find mechanisms to share the benefits of a nation’s
natural resources, like its land, more evenly, while taking care not to compromise the productive
use of that land. In this regard, the ideas of the above-mentioned Henry George may be worth
some further investigation.

Generally speaking, socialist and collectivist sympathisers tend to be too uncritical in accepting
that the communal concern of state ownership is always better than the greed of private
ownership. While private business can indeed often be greedy, especially when organised as
impersonal corporate entities (see the articles mentioned in footnote 1 above), it is not
automatically so that more state involvement would serve the interest of the nation better. To
start with, state officials are not immune to greed and corruption either, especially when their
power is unchallengeable, as it is under collectivist-communist systems. And the profit motive
plays an indispensable role as an incentive for productivity and efficiency, even if a degree of
interventionism may be necessary to keep it within proper bounds. There is just less motivation
for state officials to be productive and innovative as they do not personally receive the monetary
rewards of productive success nor personally carry the monetary loss of productive failure.

To be sure, there are also negative sides to the profit motive. It may, but need not always,
degenerate into rank greed and selfishness (see our comments on Adam Smith in study unit 2
above). If it does, the weak may indeed be victimised: they may be charged unacceptably high
prices or may be paid unacceptably low wages. Moreover, if we rely exclusively on profit-driven
private initiative, many a worthwhile but unprofitable project will not be undertaken. That is why
the state often does take the initiative to build schools, hospitals and roads in poorer areas -
areas, which may not be able to bear the cost themselves. But it should thereby be remembered
that such state initiative still remains dependent on the profit motive, since it still needs to be
financed by tax, which ultimately comes out of private sector incomes. If the private sector is not
sufficiently profitable, there may not be sufficient tax to finance all the schools, universities,
hospitals, infrastructure and social grants, which we, as a society, may find desirable to provide
to our people irrespective of their income. In short, it is difficult to dispense with the profit motive
altogether.

In certain forms of socialism (like the textbook’s “utopian socialism”, “Christian socialism” and
“guild socialism”) the cooperation and sharing may be voluntary, in which case the above-
mentioned problems with collectivism do not apply. When a collective is voluntary, its members
can always protect themselves against the collective representatives’ abuse of power or
mismanagement by leaving or refusing to join, just as you leave a church or soccer club when
 73 ECS3705/1

you don’t like how it is run. Voluntary collectivism, in fact, presupposes a liberal-capitalist rather
than a collectivist context, because only in a liberal-capitalist order are the freedoms of
association and disassociation respected. Again, the essential problem with collectivism is that
its cooperation and sharing are completely coerced. “No Exit”. People had to risk their lives to
flee communist Russia, East Germany and China.

MARX

• All of chapter 10

The prominent historian of economic thought, Mark Blaug, once commented that “most of
Marxian economics thrives in a cloud of terminological confusion ...”3. As an introduction to the
central terminological confusion underlying Marxian economics, consider the following
opposites:

(1) Collectivism versus laissez-faire. The meanings of these terms were explained above
and should already be familiar to you. In essence, this dichotomy describes opposite systems of
property and economic planning. Collectivism represents state ownership of all productive
resources and centralised public planning, while laissez-faire is characterised by private
enterprise and decentralised private planning.

(2) Handicraft production versus industrial production. (“simple production” versus “extended
production”, in Marx’s terms). This dichotomy concerns opposite methods of production.
Handicraft production is the method whereby most of the productive work is done by the hand of
a single craftsman or craftswoman. As a result, handicraft production allows most workers to be
self-employed, in which case there is no employer-worker relationship. Workers can be their
own bosses. By contrast, industrial production means that the production process is highly
mechanised, done by machines, which obviously presupposes a greater degree of labour
specialisation than under handicraft production. Because mechanisation requires production on
a large scale, society’s needs for a certain product can only be served by a limited number of
large production units. Hence, industrial production will inevitably lead to a situation where there
are relatively few employer-owners of production enterprises and relatively many employee-
workers. The owner-worker relationship is a typical manifestation of industrial production.

It is clear that laissez-faire is not essentially linked to industrial production. One can have
laissez-faire with either handicraft or industrial production, just as one can have collectivism with
either handicraft or industrial production.

The most important terminological confusion in Marx’s economics can now be identified as
follows: Marx does not make it clear whether what he calls capitalism refers to a mode of
production (industrial production) or to a system of property (private ownership under laissez-
faire). For example, you will discover shortly how Marx’s theory of exploitation is based on the
idea of capitalism as industrial production, that is, the inherently exploitative nature of the
owner-worker relationship. But the owner-worker relationship has, strictly speaking, nothing to
do with whether the firm is privately or publicly owned. If the firm is publicly owned, the state
would become the exploitative employer according to the strict logic of Marx's theory. Still, Marx
offers collectivism (public ownership of all firms) as the interim solution to the ills of industrial
production, which seems incongruous. We speak of an “interim” solution here, because Marx's
ultimate solution was what he called “communism”, the content of which he never fully worked
out. Roughly, it involved some kind of anarchist utopia in which there was neither private
ownership nor government, which is difficult to conceive in a situation where resources are
scarce. See the textbook (2007:151-152) for a fuller description.
3
Mark Blaug (1996 [2002]) Economic Theory in Retrospect. Fifth edition. Cambridge: Cambridge
University Press, p. 216.
 74

The above consideration can also help us understand the historical background to socialist
concerns in general and Marx’s concerns in particular, some of which are legitimate. Since the
start of the Industrial Revolution around 1790, the mercantilist economy, dominated by
commerce, agriculture and handicraft, was increasingly supplanted by an economy dominated
by industrial manufacturing, which was a genuine revolution in the sense of creating real social
upheaval. Among other things, it rapidly generated an underclass of urbanised, often
unemployed poor, who had no safety net or bargaining power whatsoever. Previously, a
significant proportion of poverty had been rural, where a network of relatives or even the
landlord regularly provided at least some sort of voluntary relief and many of the rural poor had
access to small parcels of land to cultivate on the so-called “commons”. In addition,
governments had not yet worked out the necessary legal framework to protect the industrial
workers, for example by setting standards on maximum working hours, minimum working age,
safety of the work environment, as well as facilitating the formation of labour unions able to
bargain for better wages and provide a minimum safety net. As a result, the plight of the working
classes in early 19th century capitalism was often (though far from always) deplorable. In that
sense, the socialists and Marx were right.

With time, however, the working classes have come to be more effectively protected and their
standards of living have significantly improved. In fact, it is in precisely those economies where
industrialisation and capital accumulation have progressed the furthest that workers enjoy the
highest standard of living and the fullest employment – in clear contradiction to Marxist theory.
Nonetheless, this state of affairs is by no means solely a result of laissez-faire because
interventionism and welfare statism have also played important roles in improving the lot of
workers. One thing is clear: the increasing poverty and unemployment of workers predicted by
Marx has simply not materialised, at least not in the most advanced industrialised nations.

While industrial capitalism has made major strides forward in eradicating absolute poverty in the
most advanced industrial nations, it has not made any progress towards reducing inequality. In
fact, as correctly pointed out by many communist sympathisers, the gap between rich and poor
within nations as well as between nations has widened considerably, which is worrying. South
Africa is in the unenviable position that both absolute poverty and inequality have hardly been
reduced at all, which is even more worrying.

Always bear in mind that perfect equality of income is impossible and that a degree of inequality
may even be desirable and beneficial. First, inequality is the inevitable correlative of giving
those people with entrepreneurial talent and drive the incentive to create wealth and
employment for many others besides themselves, which is in the interests of wider society. If we
want a vibrant, growing economy with lots of jobs, we will have to allow those with
entrepreneurial drive and skill to do more than averagely well for themselves; otherwise we
won't have the growth and the jobs. Second, the industrial mode has the advantage of being
very productive. But that advantage has to be bought at the price of greater inequality, because
the industrial mode can accommodate fewer production units whose owners must then earn
above-average incomes, as already explained before. Third, some particularly unpleasant kinds
of work deserve better remuneration, as do kinds of work requiring exceptional talent and skill.
Otherwise people would have little incentive to do unpleasant work or to develop exceptional
talent and skill. Where would Bafana Bafana or the Springboks be, if we did not allow
exceptional rewards for exceptionally talented and skilful players?

Even so, it could still be argued that the present extent of inequality and concentration of
economic power is unhealthy and excessive. Large-scale production and bigness have
somehow gone too far, which is not to say that private property is all to blame and collectivism is
the logical alternative. Collectivist systems have a poor track record. Somehow, we will have to
be more creative and look for “third ways”, although the recent trend towards globalisation
leaves countries little room to manoeuvre. If we want an open economy and the benefits of
trade, we have little choice but to follow the standard model of modern Western-style corporate
 75 ECS3705/1

capitalism. But enough about that - back to the technicalities of Marx’s analysis.

Take note of Marx's philosophy of history called “dialectic materialism” (2007:172-175). Again,
Marx uses somewhat odd terminology to describe his philosophy. There are what he calls the
“material forces of production” which capture the techno-material side of production: the state of
technology, the types of implements or machines used, workers’ skills, raw materials required,
and so on. These material forces are supposed to have an influence on the “material relations of
production”, which refer to the socio-economic system, that is the extent of private property
allowed, the degree of government intervention in the economy, the social classes these
interventions favour or harm, and suchlike. Now, the material forces are supposed to be
dynamic and, therefore, to continually put pressure for change on the material relations. More
particularly, change in the material forces (the modes of production) creates internal
contradiction in the existing material relations (the socio-economic system) which shows up in
the form of class conflict. The material relations will be able to temporarily resist change
because they are bolstered by a superstructure of science, culture and religion which is
inherently conservative, seeking to protect the interest of the prevailing ruling class. However,
the class struggle will eventually put so much pressure on the socio-economic status quo that it
will be overthrown by revolution. Thus classical slavery gave way to feudalism, feudalism to
merchant capitalism, merchant capitalism to industrial capitalism, and industrial capitalism
would finally be succeeded by communism. History would then, according to Marx, reach its
final heavenly culmination, mainly because the need for class struggle would have evaporated.
Marx was, however, vague and noncommittal about the precise nature of that final communist
heaven, so we are left in the dark on how class conflict was to have been avoided. Although
Marx was against religion (“the opiate of the people”), you notice how his philosophy of history
carries some faint religious undertones.

It interesting to note that communist practice invariably got stuck in the penultimate stage of
Marx’s historical dialectic where the state, as an interim measure, nationalises all productive
resources. Communist states like the Soviet Union, China or Cuba never moved beyond that
stage towards the final communist heaven, which Marx described in vague anarchistic terms as
having no government nor private property. It has often been pointed out that anarchism,
understood as the total absence of government, is workable only when there is superabundance
of all goods. As soon as there is scarcity of goods, some people get what they want only
because other people do not get what they want. Scarcity necessarily implies rivalry. And this
rivalry needs to be resolved through some institutional mechanism. In anarchic systems without
any form of government (no law, no judicial system, no police, no army), the rivalry over scarce
goods is all too easily resolved through violence: the biggest bully gets what he wants. Non-
anarchic systems use the coercive power of the state to institute mechanisms through which the
rivalry is resolved. Liberal capitalism uses the coercive power of government to allocate and
protect private property rights – property rights in people’s own labour (their body) as well as in
productive resources like land or equipment. People subsequently use their labour and
resources to produce goods and sell these goods to others for an income. Let’s call this “market
income” because it is generated through market exchange. Under liberal capitalism, it is
people’s market income which enables them to lay claim to the scarce goods of their
preference, whereby those with the largest market incomes are able to acquire the largest share
of the scarce goods. Non-collectivist forms of socialism use the coercive power of the state to
amend, in various ways, market incomes. Pragmatic state socialism does so by nationalising
some strategic industries, interventionalism for instance by regulating certain prices, and welfare
statism by taxing market incomes and reallocating them to those it deems worthy of support.
Collectivism, by contrast, uses the coercive power of the state not to amend market incomes,
but altogether to eradicate them. The output of the nation is entirely appropriated by the
government, with its officials deciding to channel that output to whom they favour. Whatever the
case may be, the mere existence of scarcity needs some way of resolving who gets what – if it
is not the violence of the bully, then it must be some institutional arrangement backed up by the
government’s coercive power. Justice, it seems, means that the government uses its power in a
 76

just way, in accordance with just laws rather than the arbitrary whim of state officials. Anarchism
as the absence of government makes justice impossible. There is only the law of the jungle.

In order to understand why, according to Marx, class conflict arises in industrial capitalism, you
have to understand Marx’s theory of exploitation. Before going into the detail of this theory, its
foundational idea is simple: only labour is productive and only labour, therefore, deserves a
reward. Entrepreneurship, capital and land are implicitly assumed not to make any productive
contribution at all. Hence, whenever owners of business enterprises do make a profit, they more
or less steal it from the workers, who are thus exploited to the full extent of the profit made.
Marxian exploitation is, therefore, not indicated by excessively high profits at the expense of
excessively low wages, but by the mere fact that capitalists make a profit at all – however much
or little that profit may be. There may be variety in the degree of exploitation according to how
large the profits of the capitalist are: they exploit much when their profits are large, and exploit
little when their profits are little. Even so, the mere making of profit, much or little, is already
sufficient to prove exploitation in the eyes of the Marxist.

Because Marx, like Smith and Ricardo, measures value in labour hours, he explains exploitation
with reference to labour hours too. The profits which capitalists “steal” from the workers is then
not measured as an amount of money but in a number of hours, namely the hours which are left
(in, say, a working day) after workers have worked back their wages, as will be more fully
explained below.

But it is clear that entrepreneurship, capital and land do make productive contributions, which
would thus merit a reward for entrepreneurs, capitalist and landowners in principle. It may be
useful to reiterate what these contributions are.

The contribution of entrepreneurship is twofold. First, it contributes the idea about a profit
opportunity. Entrepreneurs recognise the original “gap in the market”, with which all production
initiative must start: a new or improved product or service, a better production technique, a
better marketing approach and suchlike. Alternatively, in the case of going concerns,
entrepreneurs check whether the status quo still optimally meets the needs of the market and
that no “gaps in the market” are left for competing entrepreneurs to exploit. Second,
entrepreneurship provides the necessary leadership to ensure that the promise of profit is
indeed realised. Entrepreneurs mobilise and coordinate labour, material and implements in such
a way that the eventual product can actually be sold at a profit. Without the contribution of
entrepreneurship, there is no reason to suppose that the fruits of labour will be sold at a price
which more than covers cost. Contrary to what Marx contends, labour in itself does not create
value; only labour whose fruits can be sold at a cost-covering price creates value. To produce
stuff is not necessarily to create wealth; to produce stuff that can be sold at a cost-covering
price is to create wealth. The skill and effort required to ensure that the fruits of labour can
indeed be sold at a profit is contributed by entrepreneurship. It is obvious that the owners of a
business enterprise must contribute at least some of that entrepreneurship. Marx implicitly
regarded owners of productive enterprises solely as providers of capital, and not as providers of
entrepreneurship too. In Marx’s eyes, to be a business owner was merely to be a capitalist, that
is, a provider of money. As we saw, the other classical writers similarly underplayed the
productive role of entrepreneurship.

It is also evident that land (or nature in general) makes a productive contribution. While land
yields its rewards only in cooperation with labour, these rewards cannot be attributed solely to
labour. Nature also makes a productive contribution in its own right. As mentioned in study units
2 and 3 when discussing the physiocrats and Ricardo, the unique attribute of land (or nature in
general) is that it gives a reward to its owners, for which they have not laboured.

It also seems clear that capital makes a productive contribution. Viewed as “money capital”,
there is always risk involved in devoting capital to production. Because cost precedes benefit,
one can never be sure at the time of incurring costs that future benefit will be sufficient to recoup
 77 ECS3705/1

these costs. Investors, at the moment of investing, cannot be sure that they get their money
back. In case the capital is tied up in machinery whose payback time can stretch many years
into the future, the risk is especially marked. Since nobody can be expected to risk his or her
money for nothing, the provision of capital does seem to merit a reward. An important aim of
Marx's was to disprove the classical notion of profit as a reward for contributing capital (waiting
and risk taking, see 2007:178-179). While Marx was right in that profit is not only a reward for
contributing capital (it is also a reward for contributing entrepreneurship and land), it certainly
still contains an element of such reward. Obviously, at least part of the capital necessary to run
a business enterprise must be supplied by the owners of the firm.

If it is agreed that owner-employers of business enterprises do make a productive contribution

as entrepreneurs and capitalists, they do not necessarily exploit workers when they make a
profit. Workers who have not paid for the machines, tools and buildings in the factory in which
they work, who spend no time and effort making sure that what they produce gets sold at a
profit, and who do not need to pay for losses when production does not get sold at a profit -
these workers do not deserve to get the total value of output as wages. Owners deserve at least
some profit for their entrepreneurial effort and for the risk they take.

All this is, of course, not to say that firm owners cannot exploit their workers at all. Wages may
certainly be excessively and unreasonably low, especially because individual workers are often
at a bargaining disadvantage vis-à-vis big corporate employers, which is exactly why the labour
union movement came into being. However, given that owner-employers make a productive
contribution, the mere fact that they receive profit is not proof positive that they exploit their
workers.

According to the strict logic of Marx’s theory, exploitation can only be avoided if workers receive
the full value of their productive contribution in wages, in which case there is no incentive to
employ people at all! By implication, Marx removes all incentive for employing people. The fact
that Marx ends up denying workers the advantage of jobs is understandable in terms of his
belief that the interests of the economic classes are irredeemably in conflict with each other;
workers cannot, therefore, benefit from cooperation with capitalists by exchanging their labour
for an income.

The reality is that there is both conflict of interest and harmony of interest between workers and
owner-employers. There is conflict over wage: the higher ceteris paribus the wage for workers,
the lower the profit for business owners, and vice versa. But there is potential harmony too:
workers need an income which business owners can give them, while business owners need
labour which workers can give them. Without their cooperation both would be worse off: workers
would have no paying job and business owners would have to do all the productive work
themselves, which would obviously severely limit their productive effectiveness (everybody
would be forced back into handicraft). It remains, therefore, in the interest of both workers and
employers not to push their demands so far that their potential cooperation is put in jeopardy,
which is in fact what both unions and employers are careful to do when engaging in the hard
bargaining over wage and working conditions. One suspects, however, that some hard-core
Marxist unionists in fact do wish to “kill the goose which lays the golden eggs”, because they
imagine these eggs to be rotten!

Viewed purely as a critique of industrial production rather than of laissez-faire, Marx’s theory is,
of course, not without merit. Nobody doubts that industrialisation has its drawbacks. As already
mentioned, mechanisation caused the demise of handicraft production, which has made labour
more mindlessly repetitive and “alienating” (although mechanisation has progressed now so far
that relatively few workers are needed to operate the machines); it meant too that incomes and
economic power had become more unevenly spread. But as with just about all economic
phenomena, there are both pros and cons. Things are seldom wholly good or wholly bad. Even
so, there is obvious merit in the view that the world seems to have gone too far down the road of
 78

mechanisation, corporate bigness and extremely high levels of productivity - the inequalities and
the concentration of economic power seem just too great. In the opinion of your lecturer, the
corporate form of enterprise has something to do with this4.

As for the specifics of Marx’s labour theory of value (2007:175-176), exchange value is
determined by labour cost measured in labour time, just as in Smith and Ricardo. Because Marx
assumed that capital and land (and entrepreneurship) do not make productive contributions, he
saved himself the trouble of having to justify excluding the cost of capital and of land use (and
entrepreneurship) from the total cost of production - something which took up a great deal of
Smith's and Ricardo’s attention. Nonetheless, to justify measuring labour cost in labour time,
Marx also had to take on board some of the same unrealistic assumptions as Smith and Ricardo
did: one hour of labour time must represent the same amount of effort and skill; if not, wage
rates would have to compensate perfectly for differences in effort and skill, so that the same
wage would apply to a standard amount of labour (“socially necessary labour time”). Moreover,
an hour of labour time had to be equally productive in all its applications, which meant that equal
capital-labour ratios in all industries had to be assumed as well. The only important difference
from Ricardo and Smith is that Marx intended to explain absolute rather than relative prices. For
example, if a bicycle requires 10 hours of socially necessary labour time to produce and the
wage rate is R3, then this bicycle should, according to Marx, sell for R30. Notice, however, that
this R30 is, just as in Ricardo and Smith, a long-term natural price around which short-term
market prices are allowed to fluctuate.

Once again Marx introduces some off-beat terminology. “Labour power” is the ability, the work
potential of a labourer for one day. It refers to labour as a traded commodity: that is, what the
capitalist buys when he hires a worker for a day. The value of this commodity is obviously
determined by its “cost of production” measured in labour hours: that is, the number of hours a
worker must work to earn back the day’s wages paid to him. This value must, however, be
distinguished from the value of labour for the capitalist, which is “labour time”. Labour time
refers to the number of hours this worker is able to work for the capitalist. Incidentally, Marx sets
wages at a subsistence level, not on account of overpopulation (as in Malthus and Ricardo) but
on account of the continual unemployment created by capitalism itself (2007:177).

Surplus value is created when the value of labour power (the time a worker needs to work back
his wage) is less than the labour time (the full working day he works for the capitalist). Hence
capitalists realise a surplus for themselves by buying the only commodity that can create more
value than its own. In line with his labour-time theory of value, Marx does not describe
exploitation in terms of capitalists paying their workers less than the value of their work, but in
terms of capitalists letting workers work longer hours than they need to earn back their wages,
as illustrated by figure 10-1 (2007:178). The figure represents a single 12-hour working day, 6
hours of which are necessary for workers to earn back their wages (left column), leaving 6
hours for the capitalist to extract surplus value out of his workers (right column). It may seem
strange on first inspection that both columns represent 15 shillings of value (their height is 15),
while the value of labour power (the wages paid to workers) is only 3 shillings. The reason is
that wages paid to current workers are not the only cost of production for the capitalist. During 6
hours of cotton spinning, workers also use up 10 shillings’ worth of raw material in the form of
cotton and 2 shillings’ worth of capital depreciation in the form of used-up spindles. While the
cotton and spindles also represent labour time, it is “dead labour” expended in the past to
produce the cotton and spindles, which were sold to the current capitalist at that price. Marx is,
however, concerned only with the exploitation of “life labour” by the current capitalist, which is
why the surplus value created during the latter 6 hours is not equal to the total value of
production during that time (15 shillings) but only the value over and above the cost of “dead
labour”, embodied in cotton and used-up spindles (3 shillings). The figure, incidentally,
measures labour hours in shillings, because it assumes a given wage rate in shillings and a
given amount of labour time to produce the gold or silver in a shilling.
4
For more on this, see references in footnote 1.
 79 ECS3705/1

At this stage, Marx once more introduces somewhat strange terminology. The value of the
“dead labour” invested in machinery and raw material he calls “constant capital” (c), while the
value of the “life labour” is called “circulating capital” (v). As figure 10-1 also illustrates, the value
of constant capital is directly transferred into the value of the final product without adding any
value, as an expression of the fact that capital is unproductive. Only circulating capital adds
value over and above its own cost in labour time (surplus value s), as an expression of the fact
that only life labour is productive.

Marx calculates a number of ratios. First there is the rate of exploitation: s’ = s/v, which for our
example would be 3/3 = 1 = 100%. For a given wage rate (1/2 a shilling in our example), the
rate of exploitation expresses the ratio between the time workers need to work back their wage
(6 hours in our example) and the remainder of the time left in the working day (6 hours in our
example): 6/6 = 1 = 100%. Then there is the rate of profit: p’ = s/(c+ v). Note that c refers to the
depreciation on machinery and the cost of raw materials (spindles and cotton) for the whole
working day (both columns), which is 24 in our example. The profit rate is then 3/(24+3) = 3/27
= 11,1%.

Now we come to the “transformation problem”. The five points mentioned by the textbook
(2007:180-181) are something of a simplification of the problem as Marx presented it. The
essence of the problem is contained in point 5: when profit rates are uniform and capital-to-
labour ratios differ among industries, commodities will not sell at their exchange price measured
in labour time. We encountered more or less the same problem in Ricardo’s theory of value. At
the root of the problem lies the fact that only labour adds value to output in excess of its cost of
production (surplus value), while capital cannot do so. Therefore capital, in the sense of
machinery, cannot create any profit, which seems somewhat unrealistic. In reality we do see
that a greater capital intensity of production (greater mechanisation) tends to create higher
profitability.

This brings us to the next issue. The crucial starting point in Marx’s views on capitalism’s
inexorable march towards self-destruction is that mechanisation leads to a reduced profit rate,
which immediately raises the question why capitalists would wish to mechanise at all. Marx’s
answer (see 2007:181-182) is that mechanisation can be beneficial to the individual firm even
though it will harm the industrial sector as a whole: it raises the profits of one firm at the
expense of the others within a sector, but the overall profits in the whole sector will eventually
decline. Moreover, mechanisation can reduce the necessary labour time (the time workers need
to earn back their wages), which creates greater scope for exploitation (a greater rate of
exploitation). Note however the various offsetting forces, as mentioned by the textbook
(2007:182), which may stave off a decline in profit rates for a time.

Marx then argues how capitalist accumulation will contribute towards the failure of Say's law
(Textbook, 2007:182-183). Interestingly enough, Marx acknowledges that Say’s law has a fair
chance to hold under handicraft production. Under such circumstances, households also
function as production units (workers are their own bosses), which Marx characterises as C →
M → C. Commodities (labour) are exchanged for money, which is again exchanged for
consumable commodities. Industrial production, however, leads to a divorce between
households and business firms. Business firms aim to make money rather than to consume
goods. As a result, their participation in the money economy can be represented as M → C →
M: money is exchanged for commodity inputs into the production process, after which the
commodity outputs are sold again to obtain money. If firms make a profit, the eventual money
received must be greater than the initial money invested: M → C → M’, with M’ > M. But this is a
logical error. As explained in the section on Malthus, firms also make a profit when M’ = M, be it
that the level of profit remains unchanged relative to the previous production round. M’ > M
indicates that profits are rising relative to the previous production round, not that profits emerge
from nothing. Marx then argues that the falling rate of profit rate due to increased mechanisation
 80

causes Say’s law to fail, which contributes to the crisis in capitalism.

Moreover, the mere fact that firms make a profit does not mean that wage income must have
decreased. If total production and profits remain unchanged relative to the past, wages can
remain unchanged relative to the past as well. Only when profits have increased and
productivity remains unchanged must wages fall. If productivity increases, there is scope for
both profits and wages to increase. All this is not to say that Say's law is inviolable. As already
mentioned in study unit 3, there is significant scope for Say's law to fail in a modern economy,
particularly due to an unstable net demand for credit (net money creation), unstable spending
on non-recently produced goods, unstable cash holdings (liquidity preference) and unstable
international monetary flows.

The rest of the textbook’s discussion on Marx (2007:184-190) should speak for itself. Note, once
more, that Marx was mostly wrong in his predictions: increased capital intensity has lead to
increased rather than decreased profit rates, to increased rather than decreased real wages
rates and also, although less obviously and with greater irregularity, to increased rather than
decreased employment. Capitalism has definitely not impoverished the masses. But Marx was
right on one important point: economic power has become more concentrated and income
distribution has become more unequal under capitalism. While capitalism has made everybody
better off, it has made some sections of society even better off than others. Viewing South
Africa’s exceptionally high unemployment rate, one may be tempted to regard this as an
instance of Marx’s growing “reserve army of the unemployed”. But remember that Marx’s
unemployment was due to the exchange of capital for labour (technological unemployment),
while it is debatable whether South Africa’s unemployment is solely or even mainly
technological in nature - a case of people being pushed out of their jobs by machines.
Moreover, in other more advanced capitalist countries, unemployment is generally quite low.

ECONOMIC IN ACTION: LOOKING BACK

Speaking in broad terms, the attraction of Marxist thought lies in the fact that it formulates some
valid criticisms of capitalist practice. The problem of Marxist thought, and indeed its danger, lies
in the fact that it proposes an alternative which does not offer a real solution. For instance,
Marxists rightly criticise capitalism for condoning an undue concentration of economic power in
the hands of a few, but the Marxist alternative seems to make things worse in this regard. There
is no greater monopoly than the monopoly of the state owning all productive resources.
Similarly, Marxists rightly criticise capitalism for leading to unduly large inequalities, but, again,
the Marxist alternative seems to make things worse in this regard. There is no greater inequality
than that between the officials in charge of the communist state which owns all productive
resources and the common people who own nothing and who have no civil liberties nor
democratic rights (no freedom of expression, no freedom of association, no freedom to start
one’s own company and no voting rights) to challenge state officialdom. In order to address the
problems of economic power concentration and inequality in capitalism, we will have to look
beyond traditional Marxism. There got to be better ways.
 81 ECS3705/1

STUDY UNIT 5
The marginalist/neoclassical school, Marshall and Walras

Study the following prescribed material in the textbook:

• chapter 12: only the section “Overview of marginalist school” (pp. 211-215)

• all of chapter 15, excluding “15-1 Past as prologue” (pp. 280-281), “15-2 Past as
prologue” (pp. 293-294), “Elasticity of demand” (pp. 283-284) and “Welfare effects of
taxes and subsidies” (pp. 296-298)

• chapter 18: only the section “Leon Walras” (pp. 347-351)

STUDY OUTCOMES

When studying this unit, you should aim at gaining knowledge and understanding of the
following:

• How the major tenets of marginalism/neoclassical economics are all the logical result
of (1) the mathematisation of theory, and (2) its consideration of the demand side
(utility) in the explanation of price.
• Rational economic behaviour: its meaning, realism and how it distorts Adam Smith’s
idea of self-interest.
• Microeconomic analysis (methodological individualism): its meaning and realism.
• Pure competition emphasis: its meaning and realism.
• Equilibrium approach: its meaning and realism.
• The law of diminishing marginal utility.
• Money as the measure of utility.
• Utility comparisons (of the same good between different persons, or between different
goods for the same person) and the utility of money.
• Equimarginal principle and the law of demand.
• Ceteris paribus and the law of demand: movements along the curve versus shifts of
the curve.
• Consumer surplus: meaning and measurement.
• Elasticity of demand: meaning and measurement.
• Supply in the immediate present, the short run and the long run.
• Producer surplus: meaning and measurement.
• Supply and demand as “the upper and the under blade of a pair of scissors that cuts
through a piece of paper”.
• The role of rivalry (“higgling and bargaining”) between buyers and sellers in reaching
the equilibrium price.
• Marshall’s concepts of “long-run normal price” versus “short-term market price”.
• Marshall’s theory of an optimal distribution of income: “At the margin of indifference
between two substitutable factors of production, their price must be proportionate to
the money value they add to total production”.
• Marshall’s theory of the wage rate: supply and demand curves for labour.
• Marshall’s theory of the interest rate: supply and demand curves for loanable funds
(saving and investment).
 82

• Marshall’s theory of profit.

• Marshall’s theory of rent (land = capital).
• Quasi rent as the return on existing capital, which is fixed in the short run.
• Marshall’s “representative firm”: the sole proprietor typical of nineteenth-century
manufacturing before the arrival of the joint-stock company (the limited liability
corporation).
• The life-cycle of business enterprise (as sole proprietorship).
• Internal versus external economies.
• Increasing versus decreasing returns to scale.
• The difference between partial equilibrium analysis (Marshall) and general equilibrium
analysis (Walras)

You will notice that marginalist/neoclassical economics is basically the microeconomics which
you studied in first and second year. So you should be familiar with this type of theory. On the
other hand, you will also notice that the textbook discusses marginalist/neoclassical economics
in a bit more depth than other schools, which may mean that you will put in a bit more effort to
master this part of the work.

ECONOMICS IN ACTION

As an introduction to neoclassical economics, consider the following overview provided on the

internet by the Open University in the UK.

The neoclassical school of thought and its rivals

Source: http://openlearn.open.ac.uk/file.php/2700/!via/oucontent/course/530/neoclassics.pdf,
15 March 2012.

Core neoclassical characteristics

One reason why neoclassical economics will seem to have something to say about
everything is that it is in many ways more a methodological programme than a single theory
that can be put to empirical test. We can pick out four core features of neoclassical
methodology: methodological individualism, rationality, equilibrium and the importance of the
price mechanism.

Methodological individualism
This is the methodological position that aims to explain all economic phenomena in terms of
the characteristics and the behaviour of individuals. Because everything ultimately reduces
to what individuals do, methodological individualism states that any theory of how the
economy runs should be built up from an understanding of how the individuals within it
behave. [The textbook’s (p.212) reference to “microeconomic emphasis” implies
methodological individualism.]

Its commitment to methodological individualism means that neoclassical economics puts

clear boundaries around what it is attempting to explain (since theories cannot explain
everything). It does not want to look at the influence of the economy on the characteristics of
individuals, on their tastes for example. Rather, it is concerned with the influence of
individuals on the economy. So neoclassical economists start their analysis by taking the
fundamental characteristics of individual economic agents, such as their tastes, as given.
This means that such characteristics are taken either to be fixed and unchanging or, if they
do change, this is due to factors that lie outside the economic field of enquiry. In the terms of
economic theory, these characteristics are said to be exogenous.
 83 ECS3705/1

Margaret Thatcher’s famous claim that there is no such thing as society, just individuals and
families, can be seen as a classic statement of the politics which is often seen to lie behind
an approach based on methodological individualism. And just as she recognized families as
well as individual people, neoclassical individualism embraces other individual units,
specifically firms and households. Strictly, a methodological individualist would want to
explain how households and firms behave by analysing the behaviour of the individual
people who make up the household or firm. Institutionalists reject methodological
individualism arguing that human behaviour, including economic behaviour, is fundamentally
shaped by its environment, in particular the social and economic institutions of society,
including social norms. Therefore, it does not make sense to talk of a pre-social individual
and to see society as an aggregate of the behaviour of individual agents [see next study unit
on the institutionalist school].

Rationality
Neoclassical theory assumes that all individual behaviour is ‘rational’ according to a very
specific definition of this term. Individuals are assumed to be self-interested and to have
well-identified goals that they pursue in the most efficient way possible. To do this, they
maximize something; usually consumers are assumed to maximize pleasure (utility) subject
to what they can afford, and firms are assumed to maximize profits subject to what it is
technically possible for them to achieve. Institutionalist theories criticize the assumption of
rationality from different angles [see again next study unit]. Evolutionary economists, for
example, reject the notion that agents can maximize their goals, and see behaviour as
aimed at the achievement of a satisfactory outcome through adaptation in response to
previous experience rather than a conscious effort to maximize. Other institutionalist theories
question whether we can see the goals of individuals as given, rather than being produced
by the economy, while more interdisciplinary approaches suggest that values beyond
pleasure and profit inform human behaviour; in particular, that people may also act out of
habit, a desire for status, a sense of obligation or concern for others.

Equilibrium
In order to build models which reduce the complexity of the real world economy and are
therefore manageable and easy to understand, neoclassical economics concentrates on the
analysis of equilibrium. These are situations where whatever aspect of the economy is being
modelled is at rest because no individual has any incentive to change what they are doing
(unless external factors change). A single market, for example, is in equilibrium when the
market price is such that all buyers can buy as much as they want and all sellers can sell as
much as they want at that price. This price is then the equilibrium price. In such a situation,
no buyer or seller has any incentive to change what they are doing and the status quo
persists, unless external forces alter anything.

Much of neoclassical theory is concerned with understanding the conditions under which an
equilibrium exists and whether those equilibria are unique and/or stable. A frequent next step
is the method of comparative statics, which compares the equilibrium that results in two
different situations, to see the effect of changing external conditions, say the cost of raw
materials, on output and price within a particular market. …

The importance of the price mechanism

The fourth main characteristic of the neoclassical school of thought is the central role it gives
to the price mechanism in connecting economic agents. In neoclassical models the main,
frequently the only, interaction between economic agents takes place through the price
system. Decisions are based on prices alone: individuals do not have any other information
in order to help them decide what to buy and sell. This means that neoclassical models
assume that prices contain all the information needed by buyers and sellers, and that they
provide agents with the necessary incentives to act (buy, sell, produce). In other words, the
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only information an individual has about the outside world is obtained through the market
and the prices encountered there.

All economists would agree that the price mechanism is a very powerful institution that has a
central role in markets. The neoclassical approach is distinguished by its almost exclusive
focus on prices in the analysis of markets. This applies to all kind of markets, irrespective of
the goods and services traded and the type of exchange between buyers and sellers.
Institutional economists, by contrast, believe that other social relationships and the
characteristics of the good or service exchanged in a market affect how market processes
work and the extent to which the price mechanism alone can co-ordinate a market [see,
once more, the next study unit]. In some markets, prices cannot carry all the information that
agents would wish to have: for example, employers often do not know how productive
employees they intend to hire will be. In these circumstances, there will be other non-market
signals about other people’s behaviour that agents take into account in deciding what to do.
The institutional approach, therefore, has theories about these and other circumstances in
which habits, trust, values and cultural norms inform and influence economic behaviour.

Another distinguishing feature of the neoclassical focus on the price mechanism is the
attitude it takes to ‘transaction costs’, the costs that are associated with market transactions.
There are a number of ‘costs’ that buyers and sellers incur in order to carry out a market
transaction. Some of these, such as search and monitoring costs, are a direct consequence
of the fact that agents do not have all the necessary information to carry out a transaction
effectively. Other transaction costs include the costs of bargaining and arranging contracts
and then enforcing them. Although many neoclassical economists would recognize that such
costs exist in the real world, in order to make their models simple and usable they treat
market transaction as costless. Many institutionalist economists feel that this simplification is
too unrealistic and so build theories that are based on the existence of transaction costs [see
again next study unit].

There are some economists who have no quarrel with the other characteristics of
neoclassical economics outlined above, but recognize that transactions are not costless and
that the information transmitted by prices may be incomplete. These ‘new institutionalists’
have put forward theories to explain how institutions developed in market economies cope
with the lack of full information and transactions costs. These economists are referred to as
‘new institutionalists’, because they focus on institutions beyond the price mechanism, but
unlike ‘old institutionalists’, they are similar to neoclassical economists in that they are
methodologically individualist, assume rationality and focus on equilibrium, and they do not
consider wider societal factors such as social values and norms [see next study unit again].

Traditional neoclassical characteristics which are not core

In addition to the core features of the neoclassical approach, which have provided the main
areas of contention between neoclassical theorists and their critics, there are also a number
of additional non-core features that are often, but not always, present in neoclassical
theories. Three of these non-core characteristics concern: the extent of competition, the
degree of knowledge economic actors can be assumed to have, and the use of formal
modelling. The final one is the way that the different parts of neoclassical economics can be
amalgamated in one overarching theory, known as competitive general equilibrium theory.

Competition
A strong assumption of much neoclassical economics is that the power of individual
economic actors is sufficiently small that they can take their environment as given, without
thinking about the effects of their own actions on it. Specifically, given the neoclassical focus
on the price mechanism, this assumption means that all agents are assumed to be price
takers, reacting to prices which the agents do not believe that they themselves can
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influence. In real world markets, many agents have much more power than this and can
have significant effects on prices in the markets in which they buy and sell.

Agents’ knowledge
Traditionally, in neoclassical theory the unrealistic assumption is made that all economic
agents have perfect knowledge of anything in the past, present or future that might influence
their decisions; in particular, that they know all future prices. There are now modified
versions of neoclassical theory that allow for agents being uncertain about the future.
\
If the uncertainty about the future is about the decisions that other agents will take in the
future, and choices and outcomes are interdependent, then agents have to act strategically
in order to make the most of the situation. This happens, for example, in the case of
asymmetric information, that is, when some agents know things that are not known to others.
Situations where strategic behaviour is likely to occur are analysed using game theory.

The use of formal modelling

One of the characteristics of economics as compared with other social sciences is its
systematic use of formal models, models that abstract from the complexities of the real world
to concentrate on a few variables at a time, and then investigate very thoroughly the
relationships between these variables, sometimes using mathematical techniques to do so.
Neoclassical economics, in particular, uses a highly developed set of formal models. In
developing such formal models, certain abstractions have to be made and theories often
differ in what they see as the significant aspects of an economic problem. Because
neoclassical theory uses mathematical modelling a great deal, some of its abstractions are
designed to make the mathematics tractable.

Building up to competitive general equilibrium theory

As mentioned earlier, neoclassical economics should be seen more as a methodological
programme of how to do economics than a collection of particular theories. The theory of
competitive general equilibrium [see section on Walras in this study unit] can be seen as the
culmination of this neoclassical programme, building on all its features (both core and non-
core). Many economists would agree that it is the greatest achievement of the neoclassical
approach

In brief, competitive general equilibrium theory examines the conditions under which a
decentralized market economy, in which economic agents follow their own interests, will
reach an orderly outcome that is economically efficient. What is meant by ‘orderly’ is that all
markets are in equilibrium and by ‘efficient’ is that nobody’s welfare can be improved without
making things worse for someone else [Pareto efficiency].

Competitive general equilibrium theory represents the neoclassical school of thought in its
purest form. Its requirements go beyond the four core characteristics of the neoclassical
approach as it also needs the non-core assumptions of perfect competition and perfect
knowledge, and it is usually presented using formal mathematical models.

Competitive general equilibrium theory has not only had a great impact on economic theory,
but it also has strong policy implications. The result that, under some (admittedly restrictive)
conditions, a decentralized market economy can be coordinated through the price system
alone and achieve an outcome that is economically efficient is a very powerful statement in
favour of market economies and leaving economic policy to ‘the market’.
 86

Also consider the following criticism of neoclassical economics:

The Impasse in Economic Theory

Excerpt from Meir Kohn (2004) “Value and exchange”. Cato Journal 24(3), pp.303-307.

To understand the current difficulties of economic theory, we need to understand the goals of
the research program that guides it. That program has its origins in the work of two great
[neoclassical] economists—Paul Samuelson and John Hicks—and its goals grew out of theirs.
Samuelson’s goal was to reformulate economic theory in the language of mathematics ...
He believed that this would promote greater clarity and precision. And he hoped that
mathematization would lead to a formal unification of the whole of economic theory. He believed
this possible because he thought that all of economics could be formalized using essentially the
same mathematical approach.
While Samuelson’s goal was formal unification, Hicks’s goal was substantive unification.
Hicks believed that much of economics could be understood in terms of the theory of value—the
part of economics that seeks to explain the pattern of relative prices in an economy and the
resulting allocation of resources … The construction and refinement of the theory of value had
been the principal project of economics since Ricardo, and its major components were largely in
place by the time of the marginalist revolution of the 1870s [the subject matter of this study unit].
Its most ambitious formulation was the general equilibrium theory of Walras and Pareto that
addressed simultaneously all of the markets of an economy and their interconnections. It was
within this Walrasian framework that Hicks hoped to unify much of economic theory.
Samuelson’s goal and Hicks’s, while different, proved highly complementary. Samuelson’s
approach was to reformulate a piece of economic theory as a set of equations that jointly
determined the economic variables of interest. It was essential to his method that this set of
equations could be interpreted as describing an equilibrium of the system in question. The
theory of value was especially amenable to this method because the concept of equilibrium was
at its very core. Given the relative ease of mathematizing the theory of value, it was then only
natural to attempt to mathematize other parts of economic theory by reformulating them as
extensions of the theory of value. It turned out that advancing Hicks’s goal was a natural way to
advance Samuelson’s …
Increasingly, then, adherents of the Hicks-Samuelson research program came to see the
theory of value as being economics: they saw the two as identical and indistinguishable. This
view, which has come to dominate economic theory, goes far beyond the ideas of Hicks and
Samuelson themselves. I will call it the value paradigm.
The Hicks-Samuelson research program today is in trouble. Of course, in terms of its
dominance of economic theory, it has been an unqualified success. The “job description” of an
economic theorist today is the elaboration of mathematical models. Arguments not couched in
mathematical terms are dismissed as lacking in intellectual rigor.
The devotion to mathematics and the adherence to the value paradigm have not been
without cost. Mathematization has promoted a kind of sterile armchair theorizing. Many theorists
see little need to be acquainted with the details of real-world economies: almost exclusively,
they study each others’ models. Both mathematization and the value paradigm have induced a
significant narrowing of the theoretical agenda: economic phenomena that do not lend
themselves to mathematical treatment or that are impossible to reconcile with the assumptions
of the theory of value have become “uninteresting.”
While the costs of the Hicks-Samuelson program are clear, its benefits have been elusive.
It is difficult to see the payoff to this huge intellectual effort beyond some successes in the
theory of asset pricing (which really falls within the theory of value proper). In such areas as
money, fluctuations, and growth, the mathematical theory of value has contributed confusion
rather than illumination.
Most disappointingly, the Hicks-Samuelson research program has done virtually nothing to
assist in the formulation of economic policy. On the great issues of the day, it has been virtually
silent. The major improvement in the management of the domestic monetary system that
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occurred in the 1980s was the result of trial and error on the part of practitioners: economic
theory contributed virtually nothing. On transition [the transition from command to market
economies, which the former communist countries had to undergo] and economic development,
modern economic theory has again had nothing useful to say ... This is not to suggest that
economists as individuals have made no contribution. However, their advice has relied more on
economic common sense than on high theory. It is difficult to see how a 19th century economist,
or even one from the 18th century, would have made a less useful policy adviser than a tooled-
up modern theorist.
The failings of the Hicks-Samuelson research program have hardly gone unnoticed. The
principal response of mainstream economics has been increasingly to turn away from this
program in favour of an entirely different one—the application of econometric methods. While
econometrics was developed originally to test or to estimate the models devised by theorists,
today’s applied econometrics is largely atheoretical. Applied econometrics rather than
mathematical theory is today the high-status field in the best graduate schools and the one that
attracts many of the best minds.
Because the applied econometrics program is firmly empirical it has been much more
fruitful. Some interesting work has focused on an area particularly refractive to the Hicks-
Samuelson approach—the causes of economic growth and development. Shleifer and Levine
and their respective collaborators have used cross-country comparisons to explore the
significance for growth of legal and financial institutions. This work is highly suggestive, but it is
ultimately limited by its atheoretical nature. Yes, financial and legal institutions matter—but why?
For an answer, we need a theoretical understanding of the processes at work. More generally,
as this example shows, atheoretical applied econometrics avoids the problems of economic
theory but it does not solve them.

Question: After having studied the marginalist/neoclassical school, Marshall and Walras, would
you agree with Kohn’s assessment of the “impasse in economic theory”?

CONTENT

OVERVIEW OF THE MARGINALIST SCHOOL

• chapter 12: only the section “Overview of marginalist school” (pp. 211-215)

The textbook’s as well as the Open University’s overview (in the Economics in Action section
above) are quite comprehensive and mention many characteristics of this school of thought. As
a result you may fail to see the wood for the trees as far as the essential nature of the
marginalist/neoclassical school of thought is concerned. This school is basically about only two
things:

(1) The recognition that the demanders’ valuation of a good (its utility) plays a key role in
determining market price. The early marginalists like Jevons and Menger (whom you don’t have
to study for the exam) reacted to the classical position which one-sidedly emphasised the
suppliers’ valuation of the good (cost of production) as the main determinant of its price, by
embracing the opposite one-sided position that regards demanders’ valuation (utility) as the
main determinant of price. That is why the textbook (2007:213) mentions “demand oriented
price theory” and “emphasis on subjective utility” as main tenets of marginalism. However, the
subsequent neoclassical theorists, Marshall in particular, combined cost and utility (suppliers’
and demanders’ valuations) in determining price. Be aware that marginalist/neoclassical theory
is different from classical theory in that it wishes to determine the short-term market price rather
than the long-term natural price.
 88

(2) The mathematisation of theory. Preceding classical theory was inclined to regard
economic regularities (economic laws) as rough tendencies, in the style of “price tends to rise
when demand increases”, whereby the precise magnitudes of the increases in demand and
price were ignored. Classical theorists did not intend to be specific and exact about numerical
values, because they knew them to be irregular anyway: for a given increase in demand, price
could sometimes increase a little and sometimes a lot. But the skeleton of the regularity – that
price increases when demand increases – was considered to be generally applicable and,
therefore, of theoretical relevance. By contrast, marginalist/neoclassical theory did implicitly
intend to be precise and specific about the numerical magnitudes in economic regularities. For
example it expresses economic regularities like “price tends to rise when demand increases” in
mathematical language, like P = aQ + b. Although the parameters a and b in this supply function
remain unspecified, they are still assumed to be at a given and fixed level so that theory can
determine the precise numerical effect of Q on P.

Because neoclassical theory wished to be specific and precise about the numerical values in its
demand and supply functions, it also had to be specific and precise about the expected utility
which the acquisition of various quantities of good x will yield in the eyes of a demander or the
expected profitability of its planned production in the eyes of a supplier. Only if there is complete
certainty about these values on the part of agents can mathematically precise values of price
and quantity be established. Agents must, therefore, possess perfect knowledge about their
profit and utility opportunities, and they must be relentless maximisers of their profit or utility. It
would be “irrational” to let known profit and utility opportunities go unexploited. That is where the
marginalist/neoclassical assumption of “rational economic behaviour” (2007:212) comes from.
Moreover, profit or utility maximisation is achieved when marginal cost is equal to marginal
revenue, which explains the neoclassical “focus on the margin” (2007:212). Demanders and
suppliers make their consumption and production decisions at the margin, when they are
presumed to change their consumption and production quantities by one unit at a time. And they
change their consumption and production quantities by one unit at a time because their strict
rationality forces them to be pin-point precise about their decisions.

Be aware that the marginalist/neoclassical assumption of strict profit and utility maximisation
turned Adam Smith’s concept of self-interest into something which Smith never intended:
egocentrism and greed. Recall how Smith’s concept may be consistent with egocentrism and
greed, but is not synonymous with egocentrism and greed. Smith’s self-interest degenerates
into egocentrism and greed only if people are presumed to be exclusively concerned with their
own needs. But such a relentless and uncompromising pursuit of personal gain at the possible
expense of others is not necessary to Smith’s concept of self-interest at all. As noted in study
unit 2, Smith’s butcher, brewer and baker can strive to meet their own needs, even while being
considerate of the needs of others too; they are not compelled to push their own interest to the
absolute limit. But the neoclassical idea of the strict mathematical optimisation of profit and
utility does exactly that, thereby distorting Smith’s idea5.

When rational behaviour is maintained and agents always maximise their profit or utility, they
must find themselves on their demand and supply curves which, in turn, requires that price must
always be at the point of intersection between demand and supply curves. If price is not at the
point of intersection between demand and supply curves, then either the demander or the
supplier (or both) must be off their curve. Hence the marginalist/neoclassical “equilibrium
approach” (2007:213). Furthermore, only in a purely competitive market, understood as the
presence of many demanders and many suppliers in each market, will there be this tendency
towards demand-supply equilibrium where price clears the market, which explains the
marginalist/neoclassical “pure competition emphasis” (2007:212). Finally, a numerically precise

5
We also noted in study unit 2 how Smith’s concept of self-interest, while far from synonymous with
altruism, is not inconsistent with altruism. It may even be regarded as a precondition for altruism: only
those who have already provided for the minimum of their own needs are capable of caring for the needs
of others.
 89 ECS3705/1

analysis of production is greatly simplified if it can assume only the two production factors of
capital and labour, which is why marginalist/neoclassical theory was inclined to regard land as
a form of capital (“merger of land with capital goods”, 2007:213).

So you notice how just about all the “major tenets of the marginalist school” mentioned by the
textbook (2007:212-213) follow from the above two characteristics: (1) recognition of the role of
demanders’ utility in price determination, and (2) mathematisation of theory. The first seems to
have been an important step forward and the second an important step backward. The near-
complete supremacy of the mathematical method in modern economic theorising is, in the
opinion of your lecturer, unhealthy and damaging to the subject. It all started with
marginalist/neoclassical economics during the second half of the 19th century, although
Ricardo's abstract, deductive method can be interpreted as already betraying a certain bent
towards the wish to be numerically precise and specific in its theoretical pronouncements. All
this is not to say that mathematics has no role to play in economics. Mathematics is fine as long
as there are no pretensions to numerical precision, which means that its usefulness is confined
mainly to applied econometric analysis which accepts the variability of its model structure and
the instability of its parameter values, uses error terms and unashamedly adopts a pragmatic
approach.

Carefully study the textbook’s “Overview of the marginalist school” and keep its themes in the
back of your mind when studying Marshall.

MARSHALL

• all of chapter 15, excluding “15-1 Past as prologue” (pp. 280-281), “15-2 Past as
prologue” (pp. 293-294), “Elasticity of demand” (pp. 283-284) and “Welfare effects of
taxes and subsidies” (pp. 296-298)

Even though this chapter about Marshall basically covers the same material as second-year
microeconomics, students tend to find it difficult. We will, therefore, try to provide some
additional explanation. Occasionally we will also indicate paragraphs which you can ignore,
because they are unnecessarily obscure. Do try to get to grips with this chapter, though. It still
contains important and useful insights.

Take note of the difference between marginalism and neoclassicism as described by the
textbook (2007:275). The basic methodology of the two schools is the same, namely the
mathematical mode of analysis. Neoclassicism only extended marginalist analysis in a few more
directions. It is of course ironic that Marshall, who contributed significantly to the
mathematisation of economics, was sceptical about its value (2007:276).

In connection with the law of diminishing marginal utility (2007:277-278), Marshall implicitly
regards marginal utility as the change in total utility resulting from an infinitely small change in
the number of goods consumed, precisely so as to facilitate its use in mathematical optimisation
(utility maximisation). But this strictly mathematical view of marginal utility is not indispensable
for the law of diminishing marginal utility. That law can also be stated with reference to a kind of
“marginal” utility which merely expresses a change in utility resulting from the final addition to (or
subtraction from) the number of goods consumed, whereby this final addition (or subtraction)
does not necessarily need to be infinitely small. So even if we remove its mathematical
application, the law of decreasing marginal utility can remain a valid and useful theoretical
device. Something similar applies to the law of diminishing marginal returns in connection with
marginal productivity and marginal cost. Note Marshall’s two qualifications of the law of
diminishing marginal utility, which show some of its limitations (2007:277-279).

In the section entitled “Marginal Utility” (2007: 277-278), the third paragraph starting with “The
 90

utility approach of the Marshallian system …” to the end of the section can be ignored. These
paragraphs unnecessarily complicate a simple issue, namely that utility can be measured with
money. In its stead, the following paragraphs will attempt to explain, hopefully more simply, how
money can be used to measure the utility of goods.

Utility is obviously a subjective concept. It refers to subjective feelings and expectations, more
particularly an agent's subjective expectation about a good’s ability to meet a certain need in
him or her. For example, a loaf of bread has utility for me, because I expect it to have a nice
taste and to be able to satisfy my hunger. I estimate how this loaf can meet my needs for a nice
taste and for relieving my hunger sensation and I accordingly assign utility to it, depending on
how strongly felt the various needs are and the extent to which this bread is expected to meet
them. The needs which a good can satisfy do not have to be only physical, but can be
psychological as well. A fancy Mercedes has extra utility for people over and above its
usefulness as a reliable mode of transport, because it also has a certain snob value, which
meets some people’s needs to be esteemed and looked up to (see the discussion on Veblen in
study unit 5). Daimler-Benz knows this and can therefore ask a higher price for its cars. The
question is: Given that utility is subjective and immeasurable, how can it ever be regarded as
influencing price which is objective and quantitatively measurable?

The solution to this riddle lies in the fact that price is a ratio of two subjective valuations -
concerning the utility which an agent assigns to a unit of good x and the utility which he or she
assigns to a unit of money spent to procure x. While the utility of good x is purely subjective and
as such unquantifiable, its subjective dimension can be concealed by expressing it as a multiple
of the equally subjective utility of having command over a unit of money. This is effectively what
happens whenever monetary value is assigned to a good. For example, when my wife declares
that a mountain bike is worth R1 000 to her “and not a cent more”, what she is actually saying is
that, in her estimation, the utility of a mountain bike is a thousand times greater than the utility of
one rand spent to acquire it. Hence by expressing value as a dimensionless ratio of two utilities
(that of the good traded and that of the unit of money spent to acquire it), value can be
objectified without having to deny the subjectivity of its constituent utilities. This is what Marshall
recognised as well (2007:277-278).

Marshall furthermore suggested that if two people are willing to pay the same amount of money
for a certain good, say both John and Tandi value a mountain bike at R1 000, the utility they
assign to possessing a mountain bike is roughly equal. But this suggestion is valid only if John
and Tandi’s utility of one (marginal) rand spent to acquire the bike is roughly equal, which need
not necessarily be so. The utility which people assign to their money differs, among other things,
according to their income. Generally wealthier people assign less utility to their money than
poorer people. That is why a wealthier person will decide to buy a Mercedes and a poorer
person will not, even though both may assign equal utility to owning and driving a Mercedes.
The utility of money spent on a Mercedes is determined by the utility of the goods foregone that
could alternatively be bought with that amount of money, which is much higher for the poorer
than for the richer person. After all, the poorer person, when buying a Mercedes, is likely to
have to forego life’s necessities (food, clothing and shelter) which have a very high utility, while
the richer person’s needs for food, clothing and shelter are not at risk when spending money on
a Mercedes.

The utility of money is likely to be roughly the same for the same person, although the money
may be spent at different times under changed circumstances. That is why Marshall suggested
that if a person, say Lindiwe, is willing to pay the same amount of money for two goods whose
consumption yields different kinds of pleasures (say R1 000 to buy a mountain bike or R1 000 to
go on a pleasure cruise), the utilities of these different pleasures are probably rated the same by
Lindiwe. Marshall also suggested, which is perhaps more questionable, that we can assume the
same utility of money for whole sections of society with roughly the same income, or even for
society as a whole. Marshall’s underlying reasoning is that differences in preferences more or
less cancel out for a larger group of people, so that some sort of stable average set of
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preferences applies. If the utility of money can be viewed as roughly the same for the whole of
society, the amount of money spent on certain goods becomes a reliable indication of how
society values these goods.

The subsequent section on “Rational Consumer Choice” (p. 279) merely establishes the fact
that consumers maximise their utility. The section after that (“Law of Demand”, pp. 279-282)
discusses how Marshall employed the equimarginal principle to explain how consumers reach
maximum utility. According to this principle, a person maximises his utility, when the utility per
unit of money spent on the various goods available (A, B, C, etc) is equal: MUA/PA = MUB/PB =
MUC/PC and so on (2007:279)6. The equimarginal principle is just a particular way of expressing
the profit-utility maximisation condition (marginal cost = marginal benefit). It is applicable to
circumstances in which an agent spends a given amount of income over a limited number of
goods. Spending one rand more on good A will then require spending one rand less on any
other good, say good B. If the utility of this rand spent on A and B differs, say MUA/PB > MUB/PB,
the agent could increase his utility by taking one or more rands away from B and re-allocating
them to A. The loss of utility by withdrawing money from B will be more than compensated for
by the gain in utility when that money is rather spent on A. Hence what the equimarginal
principle, in effect, tells us is that all opportunities to increase total utility by re-arranging a given
amount of total income over various spending options has already been exhausted, so that
utility is maximised (if the textbook doesn’t help you understand this, go back to your first-year
or second-year prescribed book for microeconomics).

Note that the equimarginal principle presupposes that our agent exhaustively spends all his
income, exhaustively considers all spending options (goods available) at the same time and
has exhaustive and precise knowledge of the expected utility of all these options, which of
course rather takes things to the extreme. We do not walk around a shopping mall
simultaneously considering the utility and price of all goods available in all shops and
calculating a utility of the marginal rand spent on all of these items. To the extent that the
equimarginal principle describes something real, it obviously does so only very roughly and
approximately. It is true that we do very roughly equalise value for money on our purchases
(think about that). But, as said, because neoclassical theory wanted to be exact about numerical
values, it had to be exact and exhaustive about utilities and prices on all goods. Moreover,
agents do not necessarily spend ALL their income over a period. They may save a bit for later,
in which case the utility of future goods during future spending trips would need to be
considered too, which further complicates the neoclassical endeavour to be quantitatively exact
about buying behaviour.

Marshall then uses the logic of the equimarginal principle to derive an individual consumer’s
demand curve, say his demand curve of good A. When the price of good A increases (PA now
represents more rands), the utility of one rand spent on good A (MUA/PA) falls. If we assume that
the utility of one rand spent on all other goods (MUB/PB, MUC/PC, etcetera) remains unchanged,
the consumer will have an opportunity to increase his total utility by spending less money on
good A and more on other goods (B, C, etcetera). As the consumer buys less of A and more of
the other goods, the law of diminishing marginal utility dictates that MUA rises and the MUs of
the other goods fall. This process goes on until the MUs of all goods are brought back into
equality again: MUA/PA = MUB/PB = MUC/PC, etcetera. The same applies the other way around:
when the price of good A falls, the consumer will have reason to buy more of A and less on
other goods. This is the logic on which Marshall bases the negatively sloped demand curve
according to which an increase in price causes a decrease in quantity demanded, and vice
versa.

But you will notice that the demand curve, thus derived, assumes that only the price of good A

6
Recall that nominal prices (PA, PB, or PC) are amounts of money: R4, R121 or R0.60. Therefore,
MUA/PA, MUB/PB or MUC/PC indicate the utility of 1 rand spent on good A, B or C.
 92

(PA) changes, while the marginal utility of good A (MUA) as well as the marginal utilities and
prices of all other competing goods (MUB/PB, MUC/PC, etcetera) remain unchanged. And it also
assumes that the total income of this consumer remains unchanged; it was emphasised above
how the equimarginal principle presupposes a given amount of income. That is why the ceteris
paribus (“all other things equal”) assumption plays such an important role in Marshall’s
derivation of the demand curve. When one of these “other things” do change and the ceteris
paribus clause is violated, the curve shifts. For example, when the consumer’s income or the
utility which he or she assign to good B (MUB) changes, the demand curve of good A shifts.
Only a change in the price of A (PA) causes a movement along its demand curve; a change in
any other variable causes a shift of the curve. The language of the second paragraph of the
section entitled “Law of Demand” (p.279) starting with “Marshall illustrated the law of demand
…” may be a bit complicated. But this is its essential, fairly straightforward message.

Marshall’s use of the equimarginal principle in deriving his demand curve obviously also
assumes that the utility of one rand spent on the various goods (the utility of money) remains
the same. In the subsequent paragraph starting with “In formulating his theory of demand …”
(pp. 280-282), the textbook notices that the utility of one rand may, however, be influenced by
changes in the price of good A. This happens when the consumer’s spending on good A takes
up a large proportion of his total income. In that case, changes in A’s price will significantly
affect total income available to spend on other goods, which is then also likely to affect the utility
of one rand spend on the other goods. If you grasp this, you can otherwise ignore that
paragraph. It deals mainly with the distinction between the substitution effect and the income
effect, which you may still remember from your second-year microeconomics.

In the section “Consumer surplus”, the textbook (2007:282-283) refers to “the Austrians” and to
the “paradox of value”. These Austrians are Menger, von Wieser and von Böhm-Bawerk, whose
ideas you do not have to study for the exam. In the context of Austrian economics, the
textbook also discusses the paradox of value; you can also ignore that issue for purposes of
the exam too.

While the section on consumer surplus may appear somewhat complicated, the concept should
not be overly difficult to grasp. Recall from our introductory comments on price theory in study
unit 2 on Adam Smith, that the demander’s valuation of a good is a maximum cut-off price. If the
market price rises above this price, the demander is no longer interested in buying the good
because it costs him more than what it is worth to him. If the market price falls below this price,
the demander buys the good because it costs him less than what it is worth to him. The
difference is consumer surplus: market price minus demander’s valuation (maximum cut-off
price). When the market price is equal to the demander’s valuation, he is indifferent between
buying or leaving good A. There is no consumer surplus. The individual consumer’s demand
curve of good A is really a collection of his valuations (maximum cut-off prices) of good A as he
changes his quantity demanded. Under the influence of the law of diminishing marginal utility,
his valuation of successive units of A falls as he demands more of good A (the curve slopes
downwards). Hence, as the actual market price falls and the consumer buys more of A until the
point where market price equals maximum cut-off price, the intra-marginal units of A (the units
of A bought prior to the last one) start to earn him a surplus: they are worth more to him than
what he paid for them. Only the last bought unit (the marginal unit) will not earn him a surplus
because market price equals maximum cut-off price. If you add up all the surpluses on the intra-
marginal units bought, you get the total consumer surplus. Graphically it is the area below the
demand curve bordered on the south side by the horizontal line representing the market price
(see figure 15-1, p. 287 of the textbook).

Conceptual problems with the concept of consumer surplus arise when one moves from the
individual consumer’s demand curve to the market demand curve of all consumers of good A,
which is a horizontal addition of all individual consumers’ demand curves (see your first- and
second-year microeconomics). Calculating the market’s consumer surplus in the same way as
the individual’s consumer surplus presupposes that all consumers assign not only the same
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utility to the marginal one rand of their income, but also to all the money units spent on A. All
“one rands” spent on A must carry the same utility for all consumers. Otherwise one cannot add
up the money valuations of good A on the part of all the consumers. This problem is discussed
by the textbook in the last paragraph of the section starting with “A second problem associated
…”

You can ignore the second last paragraph of the section on “Consumer Surplus” starting with
“Marshall purposely selected …”.

The section on the “Elasticity of Demand” is not prescribed, mainly because it is really
straightforward second-year microeconomics stuff, with which you should already be familiar.
Just know that the concept comes from Marshall.

The same applies to Marshall’s theory of supply (2007:284-286) and his theory of equilibrium
price and quantity (pp. 286-288). But we left them in because these topics are foundational to
Marshall’s price theory. In the context of the theory of supply, do take note of the definition of
the market period and the shape of the supply curve in the “immediate present”, the “short run”
and the “long run” respectively. Grant and Brue’s (2007: 288) comment on Marshall’s treatment
of time is worth emphasising:
As a general rule, …, the shorter the period of time, the greater the influence of demand
on value. The reason is that the influence of cost of production takes longer to work itself
out than does the influence of changes in demand. … In the long run, therefore, the cost
of production is the most important determinant of price and value. In a stationary state …
cost of production would govern price and value. In a changing world, however, with
adaptations to change that are imperfect and gradual, both demand and supply are
important.

The logic of producer surplus is completely analogous to that of consumer surplus. The
supplier’s valuation of good A is really a minimum cut-off price. A market price below it will
cause the supplier to stop producing the good (he makes a loss on it), a market price above it
will cause him to make a surplus profit on it (which is producer surplus) and a market price
exactly at it will cause the supplier to be indifferent between producing or not producing the
good. The producer will make a surplus profit on the intra-marginal units produced, while this
surplus is zero at the marginal unit (the last unit produced before total profits start to decline). If
we add all these surpluses, we get the total producer surplus for a given producer of good A,
which can be graphically represented by the area above his supply curve bordered on the north
by the horizontal line representing the market price (see again figure 15-1, p. 287 of the
textbook). Producer surplus, of course, carries a strong resemblance to Ricardo’s rent, which is
also earned on intra-marginal land. Similar conceptual problems arise when a producer surplus
is calculated for all suppliers of good A, using its market supply curve. Such calculation similarly
presupposes that all suppliers assign the same utility to one rand earned in producing and
selling good A.

It is important to realise that, even if we may criticise the marginalist/neoclassical way of

providing theoretical underpinnings for the market demand and supply curves, these curves
may still be useful theoretical devices to explain the behaviour of price in a competitive market.
The planned quantity demanded for a given good will often vary inversely with price, just as the
planned quantity supplied will often vary positively with price. When factors like income change,
which causes the whole demand curve to shift, the amount traded and the price will often
change in the way predicted by Marshallian demand-supply theory. The same applies to
changes in factors which shift the supply curve, provided that the relevant market is reasonably
competitive - in other words there are many demanders and suppliers in the market.

As for Marshall’s theory of distribution (2007:289-292), note that his approach is similar to that
of the classical school because he also assumes that a theory of factor prices settles a theory of
 94

income distribution. But unlike the classics, Marshall does not assume that total real production
is determined independently from factor prices (wage rate, profit rate, interest rate and rent
rate). Recall how, in classical theory, factor prices merely determine how the cake is carved up
and distributed over the various economic sectors but do not influence the size of the cake. In
Marshall, factor prices also influence the size of the cake.

Marshall uses something like the equimarginal principle to determine the optimal distribution of
income. According to Marshall, the distribution of income is optimal when firms minimise their
costs for a given amount of output or, what amounts to the same thing, maximise their
production for a given amount of cost. And they achieve this when the marginal one unit of
money (say one rand) spent on the various factor inputs contributes the same marginal addition
to total income. In symbols: PO.MPL/PL = PO.MPK/PK, assuming only two factors, labour (L) and
capital (K), whereby PO is the price of output, MPL and MPK the marginal products of labour and
capital, and PL and PK the wages rate (price of labour) and interest rate (price of capital)
respectively. As Grant and Brue (2007: 289) put it in words:
At the margin of indifference between two substitutable factors of production, their prices
must be proportionate to the money value they add to the total product.
In other words, one rand spent on various production factors yields the same addition in nominal
output, which ensure that total nominal output is maximised for a given total cost, or total cost is
minimised for a given total output. In your second-year microeconomics text, this is the point
where the isoquant touches the isocost curve.

Needless to say, the classical authors did not determine an optimal distribution of income along
these lines. Note that the theory assumes that the various factors are completely substitutable
for each other, which is, of course, seldom the case. One cannot always substitute labour for
machines, or land for entrepreneurship, or machines for land.

Marshall’s theory of distribution is also different from classical theory in that it employs demand
and supply curves for the relevant factor inputs to determine their price. Hence factor price is
influenced not only by factor cost to the supplier but also by factor profitability (or contribution to
profitability) to the demander of the factor.

The demand for labour is downward sloping because of the decreasing marginal productivity of
labour (MPL), as you should recall from your second year microeconomics. The textbook (2007:
289) suggests that Marshall assumed a vertical labour supply curve indicating the size of the
total labour force. The wage rate is then determined at the intersection of the supply and
demand curves. You can ignore the section on the determinants of the wage elasticity of labour
demand (2007: 289-290).

Something similar applies to Marshall’s demand and supply curve of new capital (investment),
by which the interest rate is determined (pp. 290-291). The demand curve for new capital
(investment) is downward sloping because of the decreasing marginal productivity of capital
(MPK). The supply curve of new capital (saving) is upwards sloping because, ceteris paribus,
the higher the interest rate the more inclined people will be to postpone consumption and lend
out saved funds. The interest rate is obtained at the point of intersection between both curves.

Marshall treats land as capital. Rent is accordingly simply a return on money invested, that is an
interest rate. Land (or nature more broadly) is, however, unique among production factors and
unlike capital in a number of respects. Unlike machinery, land is in fixed supply, land is not man-
made but a gift of nature, and land values are partially socially determined by the value and
usefulness of surrounding land. We mentioned this earlier in our discussion of Henry George.

Because profit contains the reward for investing capital (“interest”), labour (“the earnings of
management”) and entrepreneurship (“the supply price of business organisation”) (2007:291), it
cannot similarly be viewed as determined by the demand and supply curve of some single
production factor. Marshall treats profit in a distinctly classical fashion by assuming that it tends
 95 ECS3705/1

towards some stable (“normal”) level in the long run. Long-run “normal” profit is then defined as
that level at which capitalist entrepreneurs do not wish to enter or leave an industry.

Marshall’s rent theory is distinctly Ricardian, since he similarly assumes that rent does not
influence price. In Ricardian rent theory, rent cannot influence price because price is determined
at the point where price equals marginal cost while rent is not treated as part of marginal cost.

Marshall argues that, in the short-run, the stock of existing real capital (machinery) is in fixed
supply. In that sense, it is like land, which is also in fixed supply. In the short run, therefore, the
return on the stock of real-capital is determined in the same way as rent on land. Marshall thus
calls it “quasi-rent”. In the longer term, however, the supply of capital goods is variable, which
means that its return is no longer determined in this way, but as the interest rate obtained by the
interaction of the demand and supply of investible funds (money capital, that is savings and
investment).

The textbook’s (2007:294-296) discussion of “The life-cycle of business enterprises”, “Internal

versus external economies” and “Increasing and decreasing returns to scale” should be
accessible enough. These Marshallian concepts are still useful and worth studying. Note,
however, that Marshall took the 19th century sole proprietorship as the typical form of business
enterprise (the representative individual firm), which was already becoming outdated in
Marshall’s lifetime. From the early 1900s onwards the limited liability corporation increasingly
became the preferred form of the manufacturing business enterprise, which had a profound
influence on capitalist practice. As noted in study unit 1, before the late 1800s incorporation had
to be done by special state grant and was conferred only on account of the enterprise serving
some clear public interest, such as public utilities (eg railroads). After 1870 any private business
firm could incorporate itself irrespective of whether it served some public interest, the state
automatically granting permission subject to certain minimal conditions7.

WALRAS

• chapter 18: only the section “Leon Walras” (pp. 347-351)

Walras is neoclassical and Marshallian in all respects except one: he relinquished a partial
equilibrium approach (2007:214) in favour of general equilibrium. Instead of studying one
market at a time, the aim of Walrasian general equilibrium analysis is to emphasise the
interrelatedness of markets, for the purpose of which all markets are considered simultaneously.
Once again the textbook’s discussion of Walras is lucid enough, thus needing no additional
explanation. You should be aware of the fact that the most sophisticated contemporary theory
takes the shape of Walrasian general equilibrium rather than Marshallian partial equilibrium
analysis.

ECONOMICS IN ACTION: LOOKING BACK

What do you think? Does Kohn have a point? One of the alternative schools of thought is
institutionalism, to which we now turn.

7
For more information on these issues, see the references as given in footnote 1.
 96

STUDY UNIT 6
The historical and institutionalist schools, Veblen and Galbraith

Study the following prescribed material in the textbook:

• chapter 11: only the section “Overview of the German historical school” (pp. 193-197)

• all of chapter 19, excluding “19-1 Past as prologue” (pp. 376-377), “Wesley Clair
Mitchell” (pp. 384-388).

STUDY OUTCOMES

When studying this unit, you should aim at gaining knowledge and understanding of the
following:

For the historical school:

• The meaning of the historical school’s evolutionary approach.

• The historical school’s nationalism as opposed to the classical school’s individualism.
• The historical school’s positive role of government as opposed to the classical school’s
broadly negative view of government.
• The historical school’s inductive-historical approach as opposed to the classical
school’s (Ricardo’s) abstract-deductive approach.
• The historical school’s way of counteracting socialism through moderate reform.

For the institutionalist school:

• The institutionalist school’s holistic, broad perspective.

• The meaning of institutions and their role in economic explanation.
• The institutionalist school’s evolutionary approach: how institutions change.
• The institutionalist school’s rejection of aspects of neoclassical economics: normal
equilibrium, pleasure-pain psychology (as inherent in “economic man”), and laissez-
faire.
• The institutionalist school’s emphasis on conflict of interest between sections of
society, and the need for government arbitration.
• The institutionalist school’s rejection of Marxism in favour of democratic reform.
• Veblen’s theory of the leisure class: its conspicuous consumption, its propensity to
avoid useful work, and it conservatism (beneficial changes being blocked by its
sheltered, privileged position).
• Veblen’s specific attacks on neoclassical economics: its assumption of consumer
sovereignty, its staticness, its assumption of an “economic man” which is driven by
hedonism and which is a completely rational (“lightning”) calculator of pleasure and
pain; its justification of the current distribution of wealth and income, and its neglect for
the fact that most markets are not perfectly competitive.
• Veblen’s instinct for workmanship and how it conflicts with the neoclassical view of
work.
• Veblen’s criticism of the firm’s increased inclination “to make money” for itself rather
than “to make goods” for society.
• How all Veblen’s criticism of the business world seem to presuppose the corporate
form of business organisation.
 97 ECS3705/1

• How, according to Veblen, difference in access to bank credit creates an advantage for
big business against small business.
• How Veblen was wrong in arguing that credit expansion (money creation) cannot
increase total output.
• The basic elements of the credit-driven business cycle.
• How, according to Veblen, technicians and engineers (“the soviet of technicians”)
could save corporate capitalism from itself.
• Galbraith’s criticism of neoclassical theory for being obsolescent.
• Galbraith’s criticism of consumer sovereignty.
• The meaning of the “technostructure” and Galbraith’s ideas about its purposes.
• Galbraith’s policy proposals to counter the excesses of corporate capitalism.

ECONOMICS IN ACTION

As an introduction to the historical and institutionalist schools, consider an interesting

contemporary perspective on the role of institutions in economic development by Harvard
economist Dani Rodrik. The article is somewhat dated (from 1999), but should still be
worthwhile reading for South African students.

Institutions For High-Quality Growth: What They Are and How to Acquire Them
(excerpt)
Dani Rodrik,
Harvard University. October 14, 1999.

Source: http://www.imf.org/external/pubs/ft/seminar/1999/reforms/rodrik.htm, 20 March

2012.

I. Introduction

The comparative experience with economic growth over the last few decades has taught us
a number of important lessons. One of the more important of these is the importance of
private initiative and incentives. All instances of successful development are ultimately the
collective result of individual decisions by entrepreneurs to invest in risky new ventures and
try out new things. The good news here is that we have found homo economicus to be alive
and well in the tropics and other poor lands. The … notion that the private sectors in
developing countries would fail to respond quickly to favorable price and other incentives …
has been put to rest by the accumulating evidence. We find time and again that investment
decisions, agricultural production, or exports turn out to be quite sensitive to price incentives,
as long as these are perceived to have some predictability.

The discovery that relative prices matter a lot, and that therefore neo-classical economic
analysis has much to contribute to development policy, led for a while to what was perhaps
an excessive focus on relative prices. Price reforms – in external trade, in product and labor
markets, in finance, and in taxation – were the rallying cry of the reformers of the 1980s,
along with macroeconomic stability and privatization. By the 1990s, the shortcomings of the
focus on price reform were increasingly evident. The encounter between neo-classical
economics and developing societies served to reveal the institutional underpinnings of
market economies. A clearly delineated system of property rights, a regulatory apparatus
curbing the worst forms of fraud, anti-competitive behavior, and moral hazard, a moderately
cohesive society exhibiting trust and social cooperation, social and political institutions that
mitigate risk and manage social conflicts, the rule of law and clean government – these are
social arrangements that economists usually take for granted, but which are conspicuous by
 98

their absence in poor countries.

Hence it became clear that incentives would not work or generate perverse results in the
absence of adequate institutions. …

The question before policy makers therefore is no longer "do institutions matter?" but "which
institutions matter and how does one acquire them?" …

II. Which Institutions Matter?

[T]he market economy is necessarily "embedded" in a set of non-market institutions. … The

rest of this section discusses five types of market-supporting institutions: property rights;
regulatory institutions; institutions for macroeconomic stabilization; institutions for social
insurance; and institutions of conflict management.

A. Property Rights

While it is possible to envisage a thriving socialist market economy in theory, as the famous
debates of the 1920s established, today's prosperous economies have all been built on the
basis of private property. … It stands to reason that an entrepreneur would not have the
incentive to accumulate and innovate unless s/he has adequate control over the return to the
assets that are thereby produced or improved.

Note that the key word is "control" rather than "ownership." Formal property rights do not
count for much if they do not confer control rights. .. Legislation in itself is neither necessary
nor sufficient for the provision of the secure control rights. In practice, control rights are
upheld by a combination of legislation, private enforcement, and custom and tradition. …

Moreover, property rights are rarely absolute, even when set formally in the law. The right to
keep my neighbor out of my orchard does not normally extend to my right to shooting him if
he actually enters it. Other laws or norms – such as those against murder – may trump
property rights. Each society decides for itself the scope of allowable property rights and the
acceptable restrictions on their exercise. … All societies recognize that private property
rights can be curbed if doing so serves a greater public purpose. It is the definition of what
constitutes "greater public purpose" that varies.

B. Regulatory Institutions

Markets fail when participants engage in fraudulent or anti-competitive behavior. They fail
when transaction costs prevent the internalizing of technological and other non-pecuniary
externalities. And they fail when incomplete information results in moral hazard and adverse
selection. Economists recognize these failures and have developed the analytical tools
required to think systematically about their consequences and possible remedies. Theories
of the second best, imperfect competition, agency, mechanism design, and many others
offer an almost embarrassing choice of regulatory instruments to counter market failures.
Theories of political economy and public choice offer cautions against unqualified reliance on
these instruments.

In practice, every successful market economy is overseen by a panoply of regulatory

institutions, regulating conduct in goods, services, labor, asset, and financial markets. … In
fact, the freer are the markets, the greater is the burden on the regulatory institutions. …

It is important to recognize that regulatory institutions may need to extend beyond the
standard list covering anti-trust, financial supervision, securities regulation and a few others.
 99 ECS3705/1

This is true especially in developing countries where market failures may be more pervasive
and the requisite market regulations more extensive. … The experience of South Korea and
Taiwan in the 1960s and 1970s can be interpreted in that light. The extensive subsidization
and government-led coordination of private investment in these two economies played a
crucial role in setting the stage for self-sustaining growth (Rodrik 1995). …

C. Institutions for Macroeconomic Stabilization

Since Keynes, we have come to a better understanding of the reality that capitalist
economies are not necessarily self-stabilizing. Keynes and his followers worried about
shortfalls in aggregate demand and the resulting unemployment. More recent views of
macroeconomic instability stress the inherent instability of financial markets and its
transmission to the real economy. All advanced economies have come to acquire fiscal and
monetary institutions that perform stabilizing functions, having learned the hard way about
the consequences of not having them. Probably most important among these institutions is a
lender of last resort –typically the central bank – which guards against self-fulfilling banking
crises. …

D. Institutions for Social Insurance

A modern market economy is one where change is constant and idiosyncratic (i.e.,
individual-specific) risk to incomes and employment is pervasive. Modern economic growth
entails a transition from a static economy to a dynamic one where the tasks that workers
perform are in constant evolution and movement up and down in the income scale is
frequent. One of the liberating effects of a dynamic market economy is that it frees
individuals from their traditional entanglements – the kin group, the church, the village
hierarchy. The flip side is that it uproots them from traditional support systems and risk-
sharing institutions. …

The huge expansion of publicly provided social insurance programs during the 20th century
is one of the most remarkable features of the evolution of advanced market economies. …
Despite a considerable political backlash against the welfare state since the 1980s, neither
the U.S. nor Europe has significantly scaled back these programs. …

Social insurance legitimizes a market economy because it renders it compatible with social
stability and social cohesion. At the same time, the existing welfare states in Western
Europe and the United States engender a number of economic and social costs –mounting
fiscal outlays, an "entitlement" culture, long-term unemployment – which have become
increasingly apparent. …

E. Institutions of Conflict Management

Societies differ in their cleavages. Some are made up of an ethnically and linguistically
homogenous population marked by a relatively egalitarian distribution of resources
(Finland?). Others are characterized by deep cleavages along ethnic or income lines
(Nigeria?). These divisions hamper social cooperation and prevent the undertaking of
mutually beneficial projects. Social conflict is harmful both because it diverts resources form
economically productive activities and because it discourages such activities by the
uncertainty it generates. …

[Unresolved social conflicts] can be thought of as instances of coordination failure in which

social factions fail to coordinate on outcomes which would be of mutual benefit. Healthy
societies have a range of institutions that make such colossal coordination failures less
likely. The rule of law, a high-quality judiciary, representative political institutions, free
 100

elections, independent trade unions, social partnerships, institutionalized representation of

minority groups, and social insurance are examples of such institutions. What makes these
arrangements function as institutions of conflict management is that they entail a double
"commitment technology:" they warn the potential "winners" of social conflict that their gains
will be limited, and assure the "losers" that they will not be expropriated. They tend to
increase the incentives for social groups to cooperate by reducing the payoff to socially
uncooperative strategies.

III. How Are "Good" Institutions Acquired?

As I argued in the preceding section, a market economy relies on a wide array of non-market
institutions that perform regulatory, stabilizing, and legitimizing functions. Once these
institutions are accepted as part and parcel of a market-based economy, traditional
dichotomies between market and state or laissez-faire and intervention begin to make less
sense. These are not competing ways of organizing a society's economic affairs; they are
complementary elements that render the system sustainable. Every well-functioning market
economy is a mix of state and market, laissez faire and intervention.

A. Accepting Institutional Diversity

A second major implication of the discussion is that the institutional basis for a market
economy is not uniquely determined. Formally, there is no single mapping between the
market and the set of non-market institutions required to sustain it. This finds reflection in the
wide variety of regulatory, stabilizing, and legitimizing institutions that we observe in today's
advanced industrial societies. The American style of capitalism is very different from the
Japanese style of capitalism. Both differ from the European style. And even within Europe,
there are large differences between the institutional arrangements in, say, Sweden and
Germany.

It is a common journalistic error to suppose that one set of institutional arrangements must
dominate the others in terms of overall performance. …

The point about institutional diversity has in fact a more fundamental implication. ... There is
no reason to suppose that modern societies have already managed to exhaust all the useful
institutional variations that could underpin healthy and vibrant economies. Even if we accept
that market-based economies require certain types of institutions, as listed in the previous
section, such imperatives do not select from a closed list of institutional possibilities. … We
need to maintain a healthy skepticism towards the idea that a specific type of institution – a
particular mode of corporate governance, social security system, or labor market legislation,
for example – is the only type that is compatible with a well-functioning market economy.

B. Two Modes of Acquiring Institutions

How does a developing society acquire functional institutions –functional in the sense of
supporting a healthy, sustainable market-based system? An analogy with technology
transfer is helpful. Think of institution acquisition/building as the adoption of a new
technology that allows society to transforms its primary endowments (land, raw labor, natural
resources) into a larger bundle of outputs. Let us call this new technology a "market
economy," where we understand that the term encompasses all of the non-market
institutional complements discussed previously. Adoption of a market economy in this broad
sense moves society to a higher production possibilities frontier, and in that sense is
equivalent to technical progress in economist's parlance.

But what kind of a technology is a market economy? To over-simplify, consider two

possibilities. One possibility is that the new technology is a general purpose one, that it is
 101 ECS3705/1

codified, and that it is readily available on world markets. In this case, it can be adopted by
simply importing a blueprint from the more advanced economies. The transition to a market
economy, in this vision, consists of getting a manual with the title "how to build a market
economy" (a.k.a. the "Washington Consensus") and following the directions: remove price
distortions, privatize enterprises, harden budget constraints, enact legal codes, and so on.

A different possibility is that the requisite technology is highly specific to local conditions and
that it contains a high degree of tacitness. Specificity implies that the institutional repertoire
available in the advanced countries may be inappropriate to the needs of the society in
question – just as different relative factor prices in LDC agriculture require more appropriate
techniques than those that are available in the rich countries. Tacitness implies that much of
the knowledge that is required is in fact not written down, leaving the blueprints highly
incomplete. For both sets of reasons, imported blueprints are useless. Institutions need to be
developed locally, relying on hands-on experience, local knowledge, and experimentation.

The two scenarios are of course only caricatures. Neither the blueprint nor the local-
knowledge perspective captures the whole story on its own. Even under the best possible
circumstances, an imported blueprint requires domestic expertise for successful
implementation. Alternatively, when local conditions differ greatly, it would be unwise to deny
the possible relevance of institutional examples from elsewhere. But the dichotomy –whether
one emphasizes the blueprint or the local knowledge aspect of the process – clarifies some
key issues in institution building and sheds light on important debates about institutional
development. …

Although my sympathies in this debate are with the experimentalists, I can also see that
there are dangers with experimentalism. First, one needs to be clear between self-conscious
experimentalism, on the one hand, and delay and gradualism designed primarily to serve
privileged interests, on the other. The dithering, two steps forwards, one step backwards
style of reform that prevails in much of the former Soviet Union and in many Sub-Saharan
African countries is driven not so much by a desire to build better institutions as it is by
aversion to reform. This has to be distinguished from a programmatic effort to acquire and
process local knowledge to better serve local needs. …

Second, it is obviously costly – in terms of time and resources – to build institutions from
scratch when imported blueprints can serve just as well. Experimentalism can backfire if it
overlooks opportunities for institutional arbitrage. Much of the legislation establishing a SEC-
like watchdog agency for securities markets, for example, can be borrowed wholesale from
those countries that have already learned how to regulate these markets the hard way – by
their own trial and error. The same goes perhaps for an anti-trust agency, a financial
supervisory agency, a central bank, and many other governmental functions. One can
always learn from the institutional arrangements prevailing elsewhere even if they are
inappropriate or cannot be transplanted …

C. Participatory Politics as a Meta-Institution

The blueprint approach is largely top-down, relying on expertise on the part technocrats and
foreign advisors. The local-knowledge approach, by contrast, is bottom-up and relies on
mechanisms for eliciting and aggregating local information. In principle, these mechanisms
can be as diverse as the institutions that they help create. But I would argue that the most
reliable forms of such mechanisms are participatory political institutions. Indeed, it is helpful
to think of participatory political institutions as meta-institutions that elicit and aggregate local
knowledge and thereby help build better institutions.

It is certainly true that non-democratic forms of government have often succeeded admirably
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in the task of institution building using alternative devices. The previously mentioned
examples of South Korea (with its "embedded" bureaucratic autonomy) and China (with its
decentralization and experimentalism) come immediately to mind. But the broad, cross-
national evidence indicates that these are the exceptions rather than the rule. Nothing
prevents authoritarian regimes from using local knowledge; the trouble is that nothing
compels them to do so either.

The case of Mauritius illustrates nicely how participatory democracy helps build better
institutions that lay the foundation for sustainable economic growth. … Mauritius found its
own way to economic development because it created social and political institutions that
encouraged participation, negotiation, and compromise. That it did so despite inauspicious
beginnings and following a path that diverged from orthodoxy speaks volumes about the
importance of such institutions. The following section presents some cross-national evidence
suggesting that democracy tends in fact to be a reliable mechanism for generating such
desirable outcomes.

IV. Participatory Political Regimes Deliver Higher-Quality Growth

In policy circles, the discussion on the relationship between political regime type and
economic performance inevitably gravitates toward the experience of a handful of
economies in East and Southeast Asia, which (until recently at least) registered the world's
highest growth rates under authoritarian regimes. These countries constitute the chief exhibit
for the argument that economic development requires a strong hand from above. The deep
economic reforms needed to embark on self-sustaining growth, this line of thought goes,
cannot be undertaken in the messy push and pull of democratic politics. Chile under General
Pinochet is usually exhibit no. 2.

A systematic look at the evidence, however, yields a much more sanguine conclusion. While
East Asian countries have prospered under authoritarianism, many more have seen their
economies deteriorate – think of Zaire, Uganda, or Haiti. Recent empirical studies based on
samples of more than 100 countries suggest that there is little reason to believe democracy
is conducive to lower growth over long time spans. Neither is it the case that economic
reforms are typically associated with authoritarian regimes (Williamson 1994). Indeed, some
of the most successful reforms of the 1980s and 1990s were implemented under newly
elected democratic governments –think of the stabilizations in Bolivia (1985), Argentina
(1991), and Brazil (1994), for example. Among former socialist economies too, the most
successful transitions have occurred in the most democratic countries.

In fact, the record is even more favorable to participatory regimes than is usually
acknowledged. This section provides evidence in support of the following assertions:
1. Democracies yield long-run growth rates that are more predictable.
2. Democracies produce greater short-term stability.
3. Democracies handle adverse shocks much better.
4. Democracies deliver better distributional outcomes.

The first of these implies that economic life is less of a crapshoot under democracy. The
second suggests that, whatever the long-run growth level of an economy, there is less
instability in economic outcomes under democratic regimes than under autocracies. The
third finding indicates that political participation improves an economy's capacity to adjust to
changes in the external environment. The final point suggests that democracies produce
superior distributional outcomes.

Taken together, these results provide a clear message: participatory political regimes deliver
higher-quality growth. I would contend that they do so because they produce superior
institutions better suited to local conditions. …
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The bottom line is that living under an authoritarian regime is a riskier gamble than living
under a democracy.

Our interest in democratic institutions in this context derives from the idea that such
institutions provide ways of regulating and managing social conflicts through participatory
means and the rule of law, and hence dissipate the adverse consequences of external
shocks. …

These results are perhaps surprising in view of the common presumption that it takes strong,
autonomous governments to undertake the policy adjustments required in the face of
adversity. They are less surprising from the perspective articulated above: adjustment to
shocks requires managing social conflicts, and democratic institutions are useful institutions
of conflict management. …

More participatory regimes produce greater equality not only within the modern
(manufacturing) sector, but throughout the economy. And they do so … without cost to
economic growth and while producing greater stability and resilience overall.

V. Concluding Remarks

Institutional reform has become the buzzword of the day. Policy advisors and international
financial institutions (IFIs [the IMF, the World Bank and the like]) find it tempting to extend
their advice and conditionality to a broad range of institutional areas, including monetary and
fiscal institutions, corporate governance, financial and asset market supervision, labor-
market practices, business-government relations, corruption, transparency, and social safety
nets. While such efforts have got the basic diagnosis right – the development of a market-
based economy requires a heavy dose of institution building – they suffer from two
weaknesses.

First, it is not clear whether the IFIs can overcome their bias towards a particular, "neo-
liberal" social-economic model – a model that is approximated, if not fully replicated, in the
real world by the United States. … This model is not only untested, it forecloses some
development strategies that have worked in the past, and others that could work in the
future. … [A]n approach that presumes the superiority of a particular model of a capitalist
economy is quite restrictive in terms of the range of institutional variation that market
economies can (and do) admit.

Second, even if the IFIs could shed their preference in favor of the neo-liberal model, there
would remain an organizational bias towards providing similar, even if not identical, advice to
client governments. It would be difficult for institutions like the World Bank and the IMF to
adopt a "let a hundred flowers bloom" strategy, as it would appear that some countries are
being treated more or less favorably. The result is likely to be at best unfriendly to
institutional experimentation on the part of client governments.

To be sure, some institutional convergence can be useful and proper. No one can be
seriously against the introduction of proper accounting standards or against improved
prudential supervision of financial intermediaries. The more serious concern with regard to
IFI conditionality is that such standards will act as the wedge with which a broader set of
institutional preferences – in favor of open capital accounts, deregulated labor markets,
arms-length finance, American-style corporate governance, and hostile to industrial policies
– will be imparted on the recipient countries.
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My focus on the importance of local knowledge, and on participatory democracy as a meta-

institution for eliciting and aggregating it, suggests that conditionality is perhaps better
targeted at basic political freedoms. I have shown in this paper that democracies perform
better on a number of dimensions: they produce less randomness and volatility, they are
better at managing shocks, and they yield distributional outcomes that are more desirable.
One interpretation of these results, and the one that I have emphasized throughout, is that
democracy helps build better institutions. While I am a great believer in institutional diversity,
I see no argument that would make it appropriate for some governments to deny their
citizens basic political rights such as freedom of speech, the right to vote and stand for
political office, or freedom of association. If there is one area where institutional conditionality
is both appropriate and of great economic value, it seems to me that this is it.

References left out

Question: After having studied historical and institutionalist economics, can you identify which
institutions in South African culture (black and white) aid growth and employment, and which
institutions in that culture impede them?

OVERVIEW OF THE GERMAN HISTORICAL SCHOOL

• chapter 11: only the section “Overview of the German historical school” (pp. 193-197)

This is a short section, which is important mainly because the German historical school is a
precursor to American institutionalism. Here you will find just about all the themes of the
American institutionalists: the evolutionary approach, the emphasis on the positive role of
government and the inductive/historical approach. The irony is, of course, that the German
historicists were predominantly right-leaning and conservative while the American
institutionalists were, and are, predominantly left-leaning and progressive. It just goes to show
how careful one needs to be with labels. Note that Germany (more particularly Prussia) was a
monarchy at the time, and that the historicists were often against its democratisation. Germany
only became a fully-fledged democracy after World War I during the highly unstable time of the
Weimar Republic, which lasted only a few years and gave way to Hitler’s Third Reich in 1933.

The main theme in the controversy between classical/neoclassical economics and the historical
school concerns the nature and usefulness of theory. The historicists argue that
classical/neoclassical theory is not very useful, because it is unrealistic, static and ahistorical. It
is unrealistic because it replaces real flesh-and-blood people with an abstract concept of
“economic man” who is a mathematical profit/utility maximiser; it is static because this
“economic man” has a set of choice options and preferences which do not change within a
given period; and it is ahistorical because the theory does not show how these options and
preferences are shaped by the social circumstances of the day, that is by institutions.
Institutions are organisational structures or behavioural patterns which have acquired a certain
degree of persistence. Because they are persistent, they become part of the social environment
which can systematically shape behaviour.

The historical school was basically anti-theoretical, because its supporters believed that
institutions continually change too. As a result there are no universal economic laws applicable
to all times. Instead of formulating abstract logical theory, economists should rather study
history so as to try to discern evolutionary patterns, which could teach us valuable lessons for
the present and the future.

The criticism of the historical school seems to have a great deal of merit: classical and
neoclassical/marginalist theory is often unrealistically abstract, static and ahistorical. But it does
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not follow that we should, therefore, entirely give up on theory, as the historical school was
inclined to do. Classical and neoclassical/marginalist theory is not the only type of theory there
is. While institutions change, they possess a degree of persistence too – as already indicated.
Their ability to shape behaviour can, therefore, be used to explain economic regularity, which is
the aim of theory. And while real people are not strict maximisers of economic benefit, they may
still be significant pursuers of economic benefit in the marketplace. This softer, more realistic
kind of “economic man” (homo economicus) may be sufficient to explain behaviour patterns.

OVERVIEW OF THE INSTITUTIONALIST SCHOOL, VEBLEN AND GALBRAITH

• all of chapter 19, excluding “19-1 Past as prologue” (pp. 376-377), “Wesley Clair Mitchell”
(pp. 384-388).

The institutionalist school has both a theoretical side and a political economy side to it. On the
theoretical side, it criticises neoclassical/marginalist economics along very much the same lines
as the historical school. The “holistic, broad perspective”, “focus on institutions”, “Darwinian
evolutionary approach” and “rejection of pleasure-pain psychology” (2007:370-372) are all
criticisms of neoclassical/marginalist theory and method. The holistic perspective and rejection
of the pleasure-pain psychology emphasise that market behaviour cannot be solely explained in
terms of the profit/utility maximising behaviour of “economic man”. Other motives play a role as
well, so that the explanation of market phenomena should be multidisciplinary. The focus on
institutions draws attention to the fact that behaviour is often shaped by state laws,
organisational structures, habits and culturally determined customs, which show a certain
persistence over time. Hence institutions cause human behaviour to display a certain regularity,
a certain predictability. While human behaviour is never completely predictable, it does display
some broad patterns. The evolutionary approach highlights how institutions are, nonetheless,
also subject to evolutionary change, and that there is a certain logic and predictability to how
they change.

On the political economy side, it criticises corporate industrial capitalism. The two adjectives
“corporate” and “industrial” should be distinguished. Industrial capitalism (Veblen called it
“machine industry”, 2007:383) has existed from the start of the Industrial Revolution, dating from
1790 in Britain and a bit later in other European countries. It is not necessarily linked to the
corporate form of enterprise - for example in the early 1800s most industrial companies were
not yet corporations but still non-corporate proprietorships or partnerships. Nonetheless, some
industrial companies, like public utilities, railway companies and banks, had already acquired
corporate status; they had become “chartered companies” as the term was then. But this was
the exception. Business firms did not yet have the right to incorporate themselves and
incorporation was still a special privilege granted by the state rather than a right. The negative
side-effects typical of the industrial mode of production, like increased inequality of income,
were important issues for institutionalists as well.

The dominance of capitalism by the corporate form of enterprise dates from after the 1870s,
when firms acquired the right to freely incorporate themselves (see study unit 1 and the
references given in footnote 1). Institutionalists like Veblen sharply criticised the corporation in
particular (“absentee ownership”, “separation of ownership from control”), arguing that it
intensifies industrialisation, leads to monopoly and creates a decisive bargaining advantage of
producers over consumers and of employers over employees. Notice how “the age of monopoly
may be said to have begun in the 1870s” (2007:369), which is roughly the time the corporate
form of enterprise started to dominate capitalism too. By increasing the power and size of the
firm, corporate capitalism thus intensified the potential conflict of interest between the classes in
society, which is why institutionalists emphasised “clashes of interest” (2007:372). The
corporate form of business also bolstered the profit motive, because it causes the corporate firm
to be ruled by a dispersed mass of anonymous shareholders for whom profit has become the
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lowest common denominator of all their motives. The profit motive is also bolstered by the fact
that corporate management is under continual threat of being dethroned by corporate take-over,
which it can avoid only by relentlessly pursuing profit to the absolute limit.

Moreover, by intensifying industrialisation, corporate capitalism also intensified both the

negative and the positive spin-offs of industrialisation: greater inequality and greater wealth
creation. Corporate industrial capitalism had become so productive as to lead to excessive
luxury and waste, themes emphasised by Veblen as well. Instead of doing away with free
incorporation, institutionalist authors preferred to rely on “liberal democratic reform” (2007:372)
to contain the excesses of corporate capitalism. Such reform boils down to throwing more
pragmatic socialism, worker participationism, interventionalism and welfare statism in the liberal-
capitalist mix. Institutionalists are generally not Marxian socialists; Veblen did not endorse
Marxian labour value theory nor did he advocate an all-out nationalisation of all firms (dogmatic
state socialism). But institutionalists were (and are) strongly critical of corporate industrial
capitalism.

The section on Thorstein Veblen should be easily accessible as well as entertaining to read. It
is difficult not to like Veblen in spite of all his weaknesses and eccentricities.

Veblen appears to overstate his case at times. There’s certainly plenty of “conspicuous
consumption” in South Africa and the Western world in general, but not necessarily mainly by a
“leisure class”. Most wealthy South Africans maintain their “conspicuous consumption” at the
cost of a great deal of stress and hard work - in fact often too much stress and hard work. A
strictly non-working leisure class would seem small, both in South Africa and elsewhere in the
world. In addition, while the consumer is certainly not sovereign and has a great deal less
economic muscle and power than the big corporate producers, the consumer is most certainly
not entirely powerless. The big corporates still cannot force people to buy their products,
however big their advertising budgets - consider how many products flop and how many
advertising campaigns fail.

Veblen’s views on the “instinct for workmanship” are interesting (2007: 380-381). It seems
certainly true that people do not consistently experience their work as “irksome”, that is, as
having a negative utility – as assumed by neoclassical economics. Provided they are not
overworked, people do generally “want to work and to do it well”. Not for nothing do the
unemployed generally experience huge frustration about their idleness. Moreover, we do find
satisfaction in providing for our descendents, and somehow allowing them to build a better life
than we had. To be sure, large-scale machine production dominated by the corporate form of
business is hugely more productive than small-scale handicraft production ever was. We are all
much better off than we were a century and a half ago (provided we do have work). But
something has also been lost in the process: pride in work, a slower pace of life, care for people
beyond their economic value, personal identification with what is produced, and the like. The
power of the profit motive has somehow squashed other, equally important values.

Veblen’s emphasis on the role of credit in modern capitalism (2007:381-383) is interesting and
merits some attention. Bank credit is, in essence, lending by a commercial bank which gives
rise to money creation. The reason why commercial banks create money when providing credit
is that they do not need to finance their lending with deposited cash. Instead, they can simply
issue the borrower with additional deposits by way of a bookkeeping entry. Credit, according to
Veblen, tends to favour big business over small business because the former have a larger and
safer balance sheet which contains better collateral than the latter. Because they can obtain
credit more easily, big business can invest in the latest technologies more quickly, which gives
them the edge over smaller business with less ready access to finance.

Veblen also argued that credit merely raises prices without stimulating real production. While
credit creation can indeed be inflationary, this is not necessarily the case. It depends on factors
such as what we nowadays refer to as the “output gap”: when there is a significant output gap,
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credit creation will tend to stimulate real output but leave prices roughly unchanged, and when
the economy operates close to capacity, credit creation will tend to push up prices but leave
output largely unchanged. It seems obvious that, broadly speaking, the modern credit-money
system has facilitated a much accelerated real growth by boosting both real production and the
public’s ability to buy that production. It has boosted real production by allowing firms to
increase their investments beyond society’s savings - their own savings as well as the savings
of households. Firms can augment their finance by borrowing from banks which banks can
finance with money creation rather than with the savings of depositors. Similarly consumers can
augment their spending beyond their current income plus savings by borrowing from banks
which amounts to money creation. As the textbook (p. 382) correctly observes in criticism of
Veblen:
Veblen’s strictures on credit would be valid only if the supplies of the factors of production
and final products were perfectly fixed and, therefore, could not be readily expanded.

The paragraph beginning with “Veblen’s views on credit led him directly into …” (p. 382) until the
end of the section with the title “Credit and Business Cycles” (p. 383) may be somewhat
obscure to some students. You can ignore these paragraphs if you find them inaccessible.
Instead, consider the following broad explanation of the business cycle which covers the same
type of issues.

There is a fair degree of consensus among modern economists that the business cycle is
indeed closely related to the credit-money system8. In that regard, Veblen has broadly been
vindicated. The best known contemporary economist who espouses this view is Charles
Kindleberger who took his ideas on this issue from Hyman Minsky9. The following steps in the
typical credit cycle are usually identified:
1. Future optimism soars.
2. Producers and consumers take up more bank credit to finance their increased investment
and consumption spending.
3. The money stock increases.
4. Incomes and spending increase.
5. Asset prices (mainly real estate and financial assets) increase.
6. Balance sheets of firms and consumers improve, which appear to raise their
creditworthiness.
7. Optimism soars even further, which feeds back into 2 and the upward spiral starts all over
again.

But as the money stock keeps on increasing, the level of bank indebtedness of the public keeps
on increasing too. At some stage, the public’s bank indebtedness will rise to such a level that it
makes the public more nervous. If some bad news story then comes up, the public will start to
worry about its ability to meet its debt servicing obligations (payment of interest and repayment
of principal). The same cycle will then start to operate in reverse:
1. Future pessimism sets in.
2. Producers and consumers start to repay rather than take up bank credit.
3. The money stock shrinks (or grows less).
4. Incomes and spending fall (or grow less).
5. Asset prices fall (or rise less).
6. Balance sheets of firms and consumers deteriorate, which lowers their creditworthiness.
7. Pessimism soars even further, which feeds back into 2 and the downward spiral starts all
over again.
Usually, the government will at some stage step in to counter the fall in spending by raising its

8
The credit-money system is a system where most money in circulation consists of bank deposits
created when banks grant credit to nonbanks.
9
See Charles P. Kindleberger and Robert Aliber (2005). Manias, Panics and Crashes: a History of
Financial Crises. 5th Edition. Hoboken (NJ): John Wiley & Sons.
 108

own spending and financing its raised spending with credit from the banking system, until such
time as optimism recovers and the public is prepared to take up more bank credit again. The
government will then slowly reduce its bank indebtedness again to create scope to counteract
the next cyclical downturn. Such is the classic Keynesian remedy (see next study unit). If you
wish to pursue these issues, you should do a course in monetary economics or money, banking
and financial markets, either at undergraduate or at honours level.

Finally, Veblen’s discussion of “the soviet of technicians” should be accessible enough and
requires no clarifying remarks. The idea that a revolt of technicians and engineers can save
corporate capitalism from itself is interesting but also seems somewhat naive.

Then we move to Galbraith who is the best known of the more recent institutionalists.

His themes are very similar to Veblen’s. He also criticises neoclassical theory and corporate
industrial capitalism. Galbraith’s criticisms of neoclassical theory (“Conventional wisdom”, pp.
388-389) are entertaining for their sharp wit. You should have little difficulty following them.

Galbraith’s criticisms of corporate industrial capitalism are contained in the sections “The
Dependence Effect” and “Galbraith’s Theory of the Firm” (pp. 389-392).

In the former section, he criticises the neoclassical idea of consumer sovereignty, which is that
consumers, through their buying decisions, determine what corporations produce (“dollar
democracy”). Galbraith turns this around, arguing that big business through advertising creates
the wants in consumers. Take note of the policy implications of this view.

In the latter section, Galbraith argues that big corporations (the “planning sector”) are not
necessarily motivated by profit alone. A basic characteristic of the corporate form of business is
that ownership is divorced from control. Because ownership (shareholders) does not actually
own the assets of the corporate firm, it has little control over how the firm is run. That control is
exercised only indirectly, through its ability to appoint management. Management, by acting as
the agent for the corporation as a legal entity in its own right, does have control over the firm’s
assets thereby enjoying a large degree of autonomy from owners/shareholders. Galbraith’s
point is that, while shareholders may be predominantly motivated by profit, the motivation of
management (the technostructure) is more complex and multi-faceted. He distinguishes the
protective purpose (the survival of the technostructure) and their affirmative purpose (the growth
in the firm’s size and thus in the power and prestige of the technostructure), which partially
overlap with profit maximisation but also partially conflict with it.

You can fill in the detail by studying the relevant sections yourself.

As some of the policy implications of Galbraith’s views, the textbook mentions the futility of anti-
trust legislation (the stuff of the Competition Commission in our country), the need for more
government control over wages and management salaries, and the need for centralised
planning of production (pp. 391-392). In other words, Galbraith once again relies on government
interference to counter the negative side-effects of corporate capitalism rather than repealing
the right of private individuals to incorporate their business concerns.

Read the textbook’s (2007:392) criticisms of Galbraith carefully.

ECONOMICS IN ACTION: LOOKING BACK

The main weakness of institutional economics is that it has not yet been able to come up with a
credible alternative to neoclassical theory. There is no body of institutionalist theory rigorous
and realistic enough to challenge the neoclassical supremacy, although all the necessary tools
seem available. The power of institutions in explaining economic phenomena is plain. For
instance, cultures are different and these differences can powerfully influence economic
outcomes.
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STUDY UNIT 7
The Keynesian and Chicago schools, and some concluding thoughts

Study the following prescribed material in the textbook:

• all of chapter 21, excluding “21-1 Past as prologue” (pp. 442-443)

• chapter 22: only the sections “The Phillips curve” (pp. 460-461), “The post-
Keynesians” (pp. 464-466) and “The new Keynesians” (pp. 466-469)

• all of chapter 24, excluding “24-1 Past as prologue” (pp. 505-506), “Consumption
Function (pp. 497-498) and “Gary S. Becker” (pp. 508-516)

• all of chapter 25

STUDY OUTCOMES

When studying this unit, you should aim at gaining knowledge and understanding of the
following:

For the Keynesian school:

• Keynes’s rejection of Say’s law, and how that causes him to engage in
macroeconomic analysis, to focus on demand rather than supply, and to emphasise
instability in the macro-economy.
• The main reason why, according to Keynes, total demand was erratic and the macro-
economy unstable.
• “Wages are a source of demand as well as a cost of production”.
• Why, according to Keynes, reductions in the wage rate may be ineffective in
stimulating employment, and possible criticisms of that view.
• How Keynes sought to stimulate and stabilise the macro-economy, and possible
negative side-effects of these measures.
• The main elements of Keynes’s analysis: the consumption function and the marginal
propensity to consume; the savings function and the marginal propensity to save; the
investment function and the marginal efficiency of capital (mec); the unstable
expectations (animal spirits) underlying the mec; the liquidity preference theory of the
interest rate; the multiplier; and monetary and fiscal policy. (This list is just to refresh
your memory. You should already know all these elements from you second-year
macroeconomics. If not, revisit the relevant sections as well as your second-year text.)
• Possible criticisms of Keynes’s view about the economy’s long-term trend towards
stagnation.

• The major tenets of the post-Keynesian school, with particular emphasis on mark-up
pricing, endogenous money, macroeconomic instability (already a Keynesian theme)
and the need for incomes policy to combat inflation.
• The importance of endogenous money and the relevance of cost-push factors in the
inflationary process – as emphasised by the post-Keynesians.
• The major tenets of the New Keynesian school, and their emphasis on the downward
 110

rigidity of relative prices and wages as the cause for unemployment.

• The questionable view, underlying New Keynesian economics, that price and wage
flexibility would have ensured full employment and full capacity utilisation.
• Possible reasons why prices and wage may be inflexible downwards: menu cost,
formal and implicit contrasts, efficiency wages and insider-outsider theory.

For the Chicago school:

• The emphasis of the Chicago school on neoclassical economics’ basic method

(economic man, microeconomic orientation, mathematical analysis) and political
philosophy (limited government).
• The view of the Chicago school that monopoly power abuse is fleeting and self-
correcting.
• The view of the Chicago school that monetary policy, by controlling the money stock,
could ensure that Say’s law holds, and that total demand would be neither insufficient
nor oversufficient.
• Friedman’s view that “inflation is always and everywhere a monetary phenomenon”,
and possible weaknesses of that view.
• Friedman’s modern quantity theory of money, and the role of the “monetary rule”.
• The Phillips curve.
• The meaning of Friedman’s adaptive expectations.
• Friedman’s short-run Phillips curve: the effectiveness of expansionary fiscal/monetary
policy to raise employment above its natural level in the short run.
• Friedman’s long-run vertical Phillips curve: the ineffectiveness of expansionary
fiscal/monetary policy to raise employment above its natural level in the long run.
• The meaning of Lucas’s rational expectations.
• Lucas’s long-run vertical aggregate supply curve: the ineffectiveness of anticipated
demand stimulation to boost employment and output, in both the short run and the
long run.
• Lucas’s short-run aggregate supply curve: the effectiveness of unanticipated demand
stimulation to boost employment and output in the short run – but still not in the long
run.
• How Lucas’s model presupposes Say’s law.

ECONOMICS IN ACTION

This study unit is mainly about macroeconomic stability and its contribution towards growth and
employment. The schools of thought discussed (the Keynesian and Chicago schools) differ
mainly on what is necessary to achieve macroeconomic stability: the attainment and
maintenance of Say’s law.

As an introduction to this study unit, consider the following excerpt from the New Growth Path
as introduced in 2010 by the South African government. We have included fairly large sections
which do not directly deal with macroeconomic issues, because they provide important
background knowledge of the South African economy. You should still find them interesting.

THE NEW GROWTH PATH: THE FRAMEWORK (excerpt)

1. INTRODUCTION

… There is growing consensus that creating decent work, reducing inequality and defeating
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poverty can only happen through a new growth path founded on a restructuring of the South
African economy to improve its performance in terms of labour absorption as well as the
composition and rate of growth. To achieve that step change in growth and transformation of
economic conditions requires hard choices and a shared determination as South Africans to see
it through. The Government is committed to forging such a consensus and leading the way by:
1 Identifying areas where employment creation is possible on a large scale as a result of
substantial changes in conditions in South Africa and globally.
2 Developing a policy package to facilitate employment creation in these areas, above all
through:
a. A comprehensive drive to enhance both social equity and competitiveness;
b. Systemic changes to mobilise domestic investment around activities that can create
sustainable employment; and
c. Strong social dialogue to focus all stakeholders on encouraging growth in employment-
creating activities. …

Achieving the New Growth Path requires that we address key tradeoffs. Amongst other
decisions, government must prioritise its own efforts and resources more rigorously to support
employment creation and equity; business must take on the challenge of investing in new areas;
and business and labour together must work with government to address inefficiencies and
constraints across the economy and partner to create new decent work opportunities. Some key
tradeoffs include:
. Between present consumption and future growth, since that requires higher investment
and saving in the present;
. Between the needs of different industries for infrastructure, skills and other interventions;
. Between policies that promise high benefits but also entail substantial risks, and policies
that are less transformative and dynamic but are also less likely to have unintended
consequences;
. Between a competitive currency that supports growth in production, employment and
exports and a stronger rand that makes imports of capital and consumer goods cheaper;
and
. Between the present costs and future benefits of a green economy.

2. THE CONTEXT

This section first reviews the extent of joblessness and inequality, which makes employment
creation our top priority. It then outlines changes in global and national conditions that generate
new challenges but also immense opportunities for overcoming the legacy of inequality and
exclusion that still shapes our economy.

2.1 THE CORE CHALLENGE: MASS JOBLESSNESS, POVERTY AND INEQUALITY

For most of the ‘00s, South Africa enjoyed relatively strong economic growth. As a result,
despite the volatility of the 1990s, overall economic expansion between 1994 and 2008
approached 4%, more or less the same as other upper-middle income countries. In contrast,
from the late 1970s to the early 1990s, South Africa’s economic growth lagged its peers,
running at just over 1% a year. Despite improved growth, the economy remained one of the
most inequitable in the world. In the mid-‘00s, some 40% of the national income went to the
richest 10% of households. Deep inequalities were associated with extraordinarily high levels of
joblessness.

In the late ‘00s, less than half of all working-age South Africans had income earning
employment, compared to an international norm of almost two thirds. Inequalities and
joblessness were also associated with the legacy of apartheid geography. In the mid-‘00s,
around a third of the population lived in the former Bantustans. Fewer than one in three adults
there was employed. Over half of all households in the former Bantustans depended mostly on
 112

remittances or grants, compared to under a quarter in the rest of the country. The position was
worst for young people, largely because too few jobs were created to absorb the large numbers
of new entrants to the labour market. In the first quarter of 2010, the unemployment rate for
young people aged 16 to 30 was 40%, compared to 16% for those aged 30 to 65. Amongst the
employed, many workers had poorly paid, insecure and dead-end jobs. In the third quarter of
2008, half of all employed people earned less than R2500 a month and over a third earned
under R1000 a month, according to Statistics South Africa. The informal sector, agriculture and
domestic work contributed a third of all employment, but two thirds of working people earning
under R1000 a month. Moreover, one in five employed African women was a domestic worker.
The share of wages in the national income dropped from 50% in 1994 to just over 45% in 2009,
while the share of profits climbed from 40% to 45%. In short, the economy has not created
sufficient employment opportunities for many of our people over the past three decades.
Creating more and better jobs must lie at the heart of any strategy to fight poverty, reduce
inequalities and address rural underdevelopment.

2.2 THE CHANGING GLOBAL AND NATIONAL CONTEXT

At the global level, the New Growth Path responds to the severe economic downturn from late
2008 as well as accelerating technological change. Nationally, it results from the insufficient job
growth of the ‘00s and the need to accelerate employment creation, income growth and a
decline in poverty.

The global economic crisis means that South Africa must re-think historical patterns of trade and
investment. In the past two years, slow growth in our traditional partners in the global North has
been offset by the rapid recovery of growth in China, India and Brazil. Africa’s importance has
also grown in recent years, as a source of resources and a potential market with one billion
consumers as well as one of the fastest-growing regions in the world. Shared development
across our region is a pre-condition for sustainable prosperity in South Africa.

Global economic turmoil has also opened up new policy space for developing economies to go
beyond conventional policy prescriptions. Our strategic objective must be to forge a consensus
on the new opportunities within South Africa, across the continent and globally, and how these
can be seized to achieve socially desirable and sustainable outcomes. The government has a
critically important role to play in accelerating social and economic development including
through effective regulation of markets. The world economy faces far-reaching changes as a
result of efforts to reduce global warming. While efforts to control emissions will impose heavy
costs – especially on relatively carbon-intensive economies like South Africa – they also lay the
basis for major new industries. More broadly, accelerating technological change promises to
transform the world economy in the coming years, with new job opportunities in areas such as
biotechnology and nano-technology.

The New Growth Path also responds to domestic developments. The transition to democracy
emerged when the economy was already undergoing considerable structural change.
Reintegration with the world economy as well as changes in mining and agriculture saw
extensive job shedding. In the late 1970s, around two thirds of all working-age South Africans
were employed – just on the international norm. By the early 1990s, in contrast, fewer than half
had employment. Despite substantial improvements in employment creation from 1994, in 2010
South Africa still ranked amongst the ten countries with the lowest level of employment in the
world. The upswing from the early ‘00s to 2008 built on South Africa’s traditional strengths, as
booming international commodity prices combined with high global liquidity to foster significant
short-term inflows of capital. One consequence was that this enabled the country to spend more
than it earned; another was that it increased the nominal value of the rand. It also resulted in
what has been described as consumption-led growth that was not underpinned by a strong
production base, with rapid growth in retail, the financial sector and telecommunications and
comparatively slow expansion in manufacturing, agriculture and mining.
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While the ‘00s saw relatively rapid employment creation, many jobs were poorly paid and
insecure. Most new jobs emerged in retail, security and other low-level business services, and
housing construction. Finance and telecommunications did not create much employment,
despite their rapid growth, and mining and agriculture shed workers. Security guards alone
accounted for one in 14 new jobs created between 2002 and 2008, with 150 000 new security
guards employed in this period. The strong rand permitted reductions in the interest rate,
contributing to rapid credit creation, as well as cheaper imports, but it also contributed to lower
profitability and competitiveness in manufacturing, agriculture and other tradable-goods sectors.
It generated a consumption boom that was largely restricted to South Africans in the upper
income group. Deep inequalities in incomes and wealth meant that working people saw only
limited improvements, as the richest 10% of households captured around 40% of the national
income and around three quarters of new credit creation. According to the Organisation for
Economic Co-operation and Development (OECD), wages for lower paid workers fell in the
‘00s.

The global economic downturn ended this pattern of growth abruptly with a 3% fall in the GDP
from the third quarter of 2008 to mid-2009. Job losses were still more severe, as employment
dropped by a million jobs from the end of 2008 to the middle of 2010. As a result, the
employment ratio fell back from a high of 45% in 2008 to 41% in 2010 – virtually the same level
as in 2002, before the economic boom started. In addition to high unemployment, the growth
phase in the ‘00s pointed to fundamental bottlenecks and imbalances in the economy,
especially:
. Dependence on the minerals value chain, including smelting and refining, whichused huge
amounts of electricity, leading to high emissions intensity.
. Weaknesses in the state’s use of commodity-based revenue for economic diversification
and skills development.
. A persistent balance-of-trade deficit funded with short-term capital inflows (essentially
foreign investment in equities and in 2009/10 increasingly in interest-bearing assets),
attracted largely by interest rates that were high by international standards. In effect, the
country borrowed abroad to sustain government spending, investment and household
consumption which remained heavily biased toward the well off. Both investment and
domestic savings remained below the levels required for sustained growth.
. Bottlenecks and backlogs in logistics, energy infrastructure and skills, which raised costs
across the economy. A particular concern arose from energy shortages that resulted in
part from weak investment in new generation capacity as well as high demand spurred by
low prices for much of the ‘00s.
. Continued economic concentration in key sectors, permitting rent-seeking at the expense
of consumers and industrial development.

The New Growth Path responds to emerging opportunities and risks while building on policies
advanced since the achievement of democracy 16 years ago. …

3 THE NEW GROWTH PATH

The New Growth Path starts by identifying where employment creation is possible, both within
economic sectors as conventionally defined and in cross-cutting activities. It then analyses the
policies and institutional developments required to take advantage of these opportunities. In
essence, the aim is to target our limited capital and capacity at activities that maximise the
creation of decent work opportunities. To that end, we must use both macro and micro
economic policies to create a favourable overall environment and to support more labour-
absorbing activities. The main indicators of success will be jobs (the number and quality of jobs
created), growth (the rate, labour intensity and composition of economic growth), equity (lower
income inequality and poverty) and environmental outcomes.
 114

To achieve profound changes in the structure of savings, investment and production, the
government must steadily and consistently pursue key policies and programmes over at least a
decade. Moreover, the state must coordinate its efforts around core priorities rather than
dispersing them across numerous efforts, however worthwhile, that do not contribute to a
sustained expansion in economic opportunities for our people. These are the core
characteristics of a developmental state. …

Long-term structural change also requires phasing to establish the preconditions for success
over time. In the case of employment, for instance, the steps that the state can take vary over
time:
1. In the very short run, the state can accelerate employment creation primarily through
direct employment schemes, targeted subsidies and/or a more expansionary
macroeconomic package.
2. Over the short to medium term, it can support labour-absorbing activities, especially in the
agricultural value chain, light manufacturing and services, to generate large-scale
employment. Government can provide effective inducements to private investment in
targeted sectors principally by prioritising labour-absorbing activities for the provision of
appropriate and cost-effective infrastructure, regulatory interventions that effectively
address market and state failures, measures to improve skills systems, and in some cases
subsidies to production and innovation.
3. In the longer run, as full employment is achieved, the state must increasingly support
knowledge- and capital-intensive sectors in order to remain competitive. This inherent
phasing means that in the medium term the state must focus on facilitating growth in
sectors able to create employment on a large scale. But it should not neglect more
advanced industries that are crucial for sustained long-run growth. Government must
encourage stronger investment by the private and public sectors to grow employment-
creating activities rapidly while maintaining and incrementally improving South Africa’s
core strengths in sectors such as capital equipment for construction and mining,
metallurgy, heavy chemicals, pharmaceuticals, software, green technologies and
biotechnology. These industries build on our strong resource base and our advanced
skills and capacity in some economic sectors. South Africa needs to re-industrialise off the
back of the opportunities identified in the growth path. But this is more than simply
identifying sectors and product niches. It also requires markets. In this context, South
African businesses need to do more to find opportunities in the fast-growing economies of
China, India and Brazil. This requires more active pursuit of exports to, and investment
from, these emerging centres of economic power.

This strategy comes with challenges, for example in the composition of the trade relationship. …
The growth path emphasises supply-side needs. A critical requirement, however, is
simultaneously to improve demand. In all successful economies, the domestic and regional
market has been a critical factor in long-term growth. This points to the importance of production
aimed at meeting basic needs within the national economy. In South Africa, however, the
domestic market is relatively narrow due to the relatively small population, low employment
levels and deep inequalities.

The growth path therefore proposes strategies:

. To deepen the domestic and regional market by growing employment, increasing incomes
and undertaking other measures to improve equity and income distribution, and
. To widen the market for South African goods and services through a stronger focus on
exports to the region and other rapidly growing economies. The measures in the New
Growth Path, taken together, constitute a key means to address the income inequalities in
our society. They place decent work (more and better jobs) at the centre of the fight
against inequality but also include measures such as skills enhancement, small enterprise
development, wage and productivity gain-sharing policies, addressing the excessive pay
gap between top and bottom, progressive taxation and support for the social wage,
 115 ECS3705/1

meaning public services targeted primarily at low-income households. …

3.1 JOBS DRIVERS

If we can grow employment by five million jobs by 2020 (around three million more than the
anticipated growth if we extrapolated from 2002 to 2009), over half of all working-age South
Africans would have paid employment and narrow unemployment would drop by 10 percentage
points from 25% currently to around 15%. Achieving this goal will be the key target that informs
the annual employment and growth targets that will be set. We can reach this target if we focus
consistently on areas that have the potential for creating employment on a large scale – what
we term “jobs drivers” - and securing strong and sustainable growth in the next decade. Most of
the projected new jobs will come from the private sector. …

Two key variables will affect the target of five million new jobs: the rate of economic growth and
the employment intensity of that growth – that is, the rate of growth in employment relative to
the rate of growth in GDP. In effect, we need both to maximize growth and to ensure that it
generates more employment, mostly in the private sector, in order to reach our target. The
employment intensity of growth must be kept between 0,5 and 0,8, while the rate of growth in
GDP should rise to between 4% and 7% a year. The following box explains this relationship.
Supporting the jobs drivers through appropriate measures is important to encourage more
employment-intensive growth. …

The rate of growth required to achieve the target of five million jobs over the next ten years
depends on the employment intensity of growth – that is, the relationship between the growth in
employment and the growth in the GDP. The actual employment intensity of growth in South
Africa is the subject of debate both because of difficulties with the data, especially before 2001,
and because of annual fluctuations. …

The jobs drivers we have identified are:

1. Substantial public investment in infrastructure both to create employment directly, in
construction, operation and maintenance as well as the production of inputs, and indirectly
by improving efficiency across the economy.
2. Targeting more labour-absorbing activities across the main economic sectors – the
agricultural and mining value chains, manufacturing and services.
3. Taking advantage of new opportunities in the knowledge and green economies.
4. Leveraging social capital in the social economy and the public services.
5. Fostering rural development and regional integration.
…

3.2 A DEVELOPMENT POLICY PACKAGE FOR GROWTH, DECENT WORK AND EQUITY

The work done for the New Growth Path indicates that our goal of growing employment by five
million new jobs over the coming decade is achievable. It cannot, however, be achieved with
only a single policy instrument. It needs a package of interventions that addresses a range of
challenges in the economy and that balances competing policy concerns while mitigating
unintended consequences. …

We outline below the details of a developmental package consisting of macroeconomic

strategies, microeconomic measures and stakeholder commitments that can lead our society to
a new growth trajectory and achieve a higher, sustainable expansion in decent work
opportunities and in output based on our common efforts.

The macroeconomic section of the package entails a careful balancing of more active monetary
policy interventions to achieve growth and jobs targets, inter alia through a more competitive
exchange rate and a lower cost of capital, with a more restrained fiscal stance and repriorisation
 116

of public spending to ensure sustainability over time. The microeconomic section in the package
involves targeted measures to control inflationary pressures and support competitiveness and
increased equity, which in turn makes the macroeconomic strategy sustainable and viable. It
includes reforms in policies on skills, competition, industry, small business, the labour market,
rural development, African integration and trade policy. …

3.2.1 The macroeconomic package

In terms of the macroeconomic stance, for the foreseeable future government will be guided by
a looser monetary policy and a more restrictive fiscal policy backed by microeconomic
measures to contain inflationary pressures and enhance competitiveness. The package entails
the following:
1. The monetary policy stance will continue to target low and stable inflation but will do more
to support a more competitive exchange rate and reduced investment costs through lower
real interest rates. This will be accompanied by measures proposed below to contain
inflationary pressures and build competitiveness.
2. Additional and larger purchases of foreign currency flowing into South Africa, as a result of
foreign direct investment and portfolio inflows, in order to counter appreciation of the rand
as required. An African development fund will be established to invest in African
infrastructure, as outlined below. A further set of tools to address the competitiveness of
the exchange rate is being explored, including measures to address the negative effects
of short-term capital inflows. These tools will take into account global agreements to deal
with imbalances.
3. Greater restraint in fiscal policy to slow inflation despite easier monetary policy. A counter-
cyclical fiscal stance through the business cycle will manage demand in support of a more
competitive currency while achieving critical public spending goals. The MTEF foresees
real growth in expenditure of just over 2% a year for the next few years.
4. Mobilisation of resources to finance growth path priorities, particularly jobs, skills and
infrastructure. The new fiscal policy will require vigorous prioritisation and improved value
for money, with reductions in less important areas while protecting priority public services.
Spending proposals need to be subjected to a clear and rigorous prioritisation process,
corruption and waste eliminated, and remuneration growth moderated to avoid squeezing
crucial developmental programmes.
…
Source: http://www.moneyweb.co.za/mw/action/media/downloadFile?media_fileid=9594
16 March 2012.

Question: What, in your estimation, is the role of macroeconomic stability in the achievement of
a high growth and high employment levels? What do you learn from the Keynesian and Chicago
schools about what is necessary to achieve macroeconomic stability? What more besides
macroeconomic stability is needed to realise greater employment growth for South Africa?

OVERVIEW OF THE KEYNESIAN SCHOOL AND KEYNES

• all of chapter 21, excluding “21-1 Past as prologue” (pp. 442-443)

Modern mainstream economics consists of neoclassical microeconomics and Keynesian

macroeconomics. You studied the historical roots of microeconomics in study unit 5. Now you
will study the historical roots of macroeconomics, which are mainly found in one book written by
one author. The author is John Maynard Keynes and the book is The general theory of
employment, interest and money, commonly shortened to the General theory.

The General theory was published in 1936 during the height of the Great Depression of the
1930s, when around 25% of the labour force of the Western world was unemployed. Such an
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unemployment rate may seem mild to South Africans, who have been accustomed to
unemployment rates of 30% and beyond. But in the most advanced Western countries where
unemployment rates normally fluctuated between 4% to 6%, this was an unheard-off disaster.
While it is controversial whether Keynes’s ideas are applicable only to exceptional situations of
crisis, it is undoubtedly so that the Great Depression stimulated these ideas. Once again there
is a theoretical side and a political economy side to Keynes's ideas as contained in his General
theory.

As for the theoretical side, Keynesian theory is characterised by a “macroeconomic emphasis”,

a “demand orientation”, an emphasis on “instability in the economy” and “wage and price
rigidity” (2007:428-429). Let’s briefly explore these characteristics. The macroeconomic
emphasis means that Keynes theorised in terms of relationships between aggregate amounts
(total income, total consumption, total investment, the general interest rate, the general price
level), whereby these relationships were not always derived from the benefit-maximising
behaviour of an individual consumer or producer. This applies in particular to Keynes’s
consumption function, which he explains by way of a “fundamental psychological law”,
according to which most people on average do not spend all their income. However, Keynes’s
investment function does seem to be microeconomic in that it is still grounded in the profit-
maximising behaviour of an individual representative firm. Something similar can, perhaps, be
said about Keynes’s employment and liquidity preference function. The moral of this story is that
Keynes’s macroeconomics was still to a significant degree influenced by Marshallian
microeconomics.

The demand orientation of Keynesian theory is simply the result of Keynes’s rejection of Say’s
law. Refer back to our discussion of Say’s law in study unit 3. When Say’s law does not
necessarily hold and “supply does not always create its own demand”, the sale of produced
goods can be constrained by insufficient demand, which then acts as a drag on sales and
eventually on production as well. In other words, the failure of Say’s law makes demand the
bottleneck, which then comes to determine income and production.

More particularly, Keynes emphasised that “wages are a source of demand for goods as well as
a cost of production” (2007:430). The classical remedy for unemployment was, of course, to
allow wages to fall, which would decrease the cost of labour and so stimulate employment.
Keynes disagreed, among other things because a drop in wages would curtail demand for
goods which would limit the profitable expansion of employment. Note, however, that the
reduction of wages, ceteris paribus, causes the incomes of workers to fall but the incomes of
business firms (profits) to rise. Whether total demand falls will then depend on the extent to
which businesses would re-spend their increased incomes following the reduction in wages,
which will be discussed below.

In the context of falling wages the textbook (2007:430-431) also remarks how, according to
Keynes, a decrease in nominal wages is inadvisable because it may lead to deflation, which
tends to worsen economic depression. Let us see why this is the case. First, deflation raises the
“real burden of debt”, as money has to be repaid in money units (rands or dollars) of increasing
real value. Since firms are normally debtors, their profitability would consequently fall. Second,
deflation directly reduces profits, simply because producing and selling take time and the
incurring of costs therefore always precedes the recoupment of costs from sales. When prices
continually fall, it is likely that the fall in output prices will lag behind the fall in input prices, which
lowers profit margins. All this further depresses economic activity and employment creation, as
indeed happened during the Great Depression. Finally, bear in mind that Keynes’s opposition to
reducing wages as a way of remedying unemployment presupposes a closed economy. In order
to improve the competitiveness of a country’s exports on the international market it may,
however, be beneficial if its production cost, including labour cost, were to fall. This may be
particularly important for an open economy like South Africa’s.
 118

Keynes’s emphasis on the instability of the economy is similarly related to his rejection of Say's
law, because that instability is caused by the instability of total demand, in particular investment
spending by businesses (2007:429). Since investment is unstable, it regularly falls below the
level necessary to compensate for the reduction in spending due to household saving (the so-
called “savings gap”, which follows from Keynes’s consumption function). When investment is
insufficient in this regard, production and employment will eventually fall. The destabilising effect
of investment spending on total spending is also related to the industrial form of capitalism.
Because the benefit of investment lies, by nature, fairly far into the future, these benefits are
particularly uncertain. As a result, the level of investment spending is highly sensitive to
entrepreneurs’ and investors’ volatile moods and confidence levels, to which Keynes referred,
somewhat disparagingly, as “animal spirits”. The more industrialised an economy is and thus
the greater the proportion of total spending which goes toward investment and intermediary
goods, the more unstable total demand will be.

It is also in the nature of the modern credit-money system that it makes spending levels more
unstable relative to the traditional commodity-money system. As noted before, a credit-money
system is a system where money consists mainly of demand deposits created when banks
grant credit to their clients. In such a system, the total money supply is highly flexible and
adapts itself easily to demanders’ spending plans, especially when these demanders have
direct access to bank credit as do most large businesses and investors. By contrast, a
traditional commodity-money system is a system where money predominantly consists of
precious metals or notes and deposits fully convertible into precious metals. Such a system
makes the money supply much less flexible in the short run, with the result that a limited
availability of funds becomes a more important determinant of the level of total spending.
Because a modern credit-money system thus renders a limited availability of funds less
important and unstable future expectations more important, as determinants of investment
decisions on the part of investor-entrepreneurs, it adds to the instability of investment spending.
If you want to know more about these things, do one of our third-year or honours courses in
monetary economics or money, banking and financial markets.

Lastly, the Keynesian assumption of wage and price rigidity is similarly related to institutional
factors such as the industrial mode of production and the corporate form of the business firm.
As we saw in chapter 20 of the textbook, these institutions make for a large and powerful
corporate business firm, which therefore has the market power to control prices. The greater
power of the modern trade union movement has similarly caused the wage rate to be rigid as
well, seldom if ever allowing it to drop.

It thus transpires from all the major tenets of Keynes’s economics that he implicitly criticised
corporate-industrial credit-money capitalism. Even the inherent instability and speculativeness
of stock markets, which Keynes regarded as not “one of the most outstanding triumphs of
laissez-faire capitalism” (2007:432), he attributed to the corporate form of private business firm:
With the separation of ownership from management [i.e. the corporate firm] which prevails
today and with the development of organised investment markets, a new factor of great
importance has entered in, which sometimes facilitates investment but sometimes adds
greatly to the instability of the system.10

Recall how the institutionalists, Veblen in particular, also directed their attack at corporate-
industrial capitalism and the modern credit-money system. The only difference between
Keynes and Veblen in this regard is that Keynes focused his attack more narrowly on the
inherent instability of corporate capitalism and chose to employ neoclassical theory for his
purposes, while Veblen criticised corporate capitalism more broadly and was, of course, more
consistently opposed to the neoclassical method. This brings us to the political economy side of
Keynes’s ideas.

10
JM Keynes (1936) The general theory of employment, interest and money. London: Macmillan, pp.150-
151.
 119 ECS3705/1

Keynes did not advocate cutting back on industrialisation or doing away with the corporate
business form and the credit-money system. Instead, he preferred to correct the negative side-
effects of modern corporate capitalism by way of government policy. Keynes believed that
public works programmes, a degree of wage and price control as well as careful monetary and
fiscal policy making could stabilise total demand at a level somewhere round where full
employment is obtained. In that way, Say’s law could be made to hold. It has to be admitted that
the Keynesian medicine has been amazingly successful in many Western countries. Largely
inspired by Keynesian-style policies, Western industrialised nations have enjoyed unparalleled
economic prosperity over the last fifty-odd years since the end of World War II, with the
exception of a few periods of relatively minor recession, such as during the 1970s and the early
part of the 1980s. In the light of this, Keynes is often regarded as capitalism’s saviour.

Still, not all Keynesian policies are necessarily “mild, safe and sane” (2007:430) and they can
have serious negative side-effects. For example, stimulation of the economy by way of demand
can lead to inflation, which can destabilise the economy by creating extra uncertainty among
other things. Uncertainty, as you should know by now, is the enemy of industrial capitalism. The
extensive involvement of government in the economy through public works can, furthermore,
lead to inefficiency and waste of resources, which is partly why many nations have since opted
for the privatisation of state assets. Moreover, even if Keynesian demand management is
scrupulously applied and there is little government inefficiency, serious problems with corporate-
industrial capitalism remain. While it has in the main generated sufficient levels of employment
in developed nations, it has been singularly unsuccessful at generating anything like sufficient
employment in most developing nations, including South Africa. The trend towards the
concentration of power in the hands of a few big corporations proceeds unabated, both in South
Africa and the world at large. Financial markets (stock exchanges and foreign exchange
markets in particular) remain highly volatile and unstable, which is especially disruptive for
vulnerable developing economies like South Africa's. Furthermore the natural environment
continues to be damaged by an immoderate drive towards wealth creation. Keynesian-style
policies, even with optimal planning and implementation, can provide no solution to such
negative side-effects. Keynes could not completely save capitalism.

Keynes can furthermore be criticized for implicitly regarding the satisfaction of Say’s law
(effective demand sufficiency) as a sufficient condition for the achievement of full employment
by contending that Say’s law amounts to “the proposition that there is no obstacle to full
employment” (Keynes 1936: 26). The implication is that unemployment is solely the result of
insufficient aggregate demand. The caricature thus created is not harmless as it provides the
theoretical rationale for the kind of macroeconomic populism which indiscriminately applies
expansionary monetary and fiscal policy to all instances of unemployment. Especially for
developing economies with typically large structural unemployment levels (caused by supply-
side constraints on growth), such a policy stance may spell serious macroeconomic
destabilisation, as practice has unfortunately borne out all too often.

The textbook (2007:433-441) ably sums up the particularities of Keynes's theoretical system,
with which you should already be familiar from your second-year studies in macroeconomics.
There is, therefore, no need to add extra explanation, which should not be taken to mean that
this theoretical system is in any way less important. It is important and needs to be studied
carefully.
 120

THE POST-KEYNESIANS AND NEW KEYNESIANS

• chapter 22 only the sections “The post-Keynesians” (pp. 464-466) and “The new
Keynesians” (pp. 466-469)

We purposefully left out the textbook’s discussion of the IS-LM framework (“The Hicks-Hansen
synthesis”, at the start of chapter 22), with which you should already be familiar. The
formalisation of Keynes’s economics by way of the IS-LM model is often called the “neoclassical
synthesis”, because it is believed to be an eclectic mix between Keynes’s ideas and
neoclassical, mathematically oriented analysis. Essentially, the school of thought called post-
Keynesian believes that the essence of Keynes’s message got lost when too much of his ideas
were forced into the neoclassical mould. But because Keynes himself made extensive use of
neoclassical analysis, it seems the problem is a matter of degree rather than principle. The
general problem with Keynes’s theoretical system is that its various elements (his theory of
consumption and investment spending, his theory of employment, his theory of interest rates
and prices, his theory of money, etc) are difficult to combine into a single integrated whole,
without doing violence to at least some of them. Moreover, there are things about Keynes's
system, like his emphasis on uncertain profit expectations, which are difficult to model at all.

The post-Keynesian school wishes to wrestle Keynes’s theory free from its neoclassical
entanglements, so that its essential message can come out more clearly, especially concerning
the inherent instability of capitalism and the inability of the price system automatically to
maintain full employment. At times, the message is remoulded in Ricardian terms, whereby a
cost-of-production theory of value is endorsed, like Sraffa’s theory (2007:464—465). At other
times, this message is remoulded in more institutionalist terms, whereby the modern capitalist
institutions of the corporate form of enterprise and credit money are blamed for the inherent
instability of total spending, the inherent instability of the banking system, and the high levels of
inequality of income.

Two important aspects of the post-Keynesian perspective are furthermore worth mentioning,
because they can easily be recognised as valid, even if one chooses to remain sceptical about
the broader intent of post-Keynesian economics.

Firstly, the post-Keynesians can be credited for being the first to emphasise the predominantly
endogenous nature of the money supply (2007:465). Conventional theory had assumed that
money is exogenously determined, meaning that it is fully controlled by the central bank and
treated as given by private agents. But it seems obvious that in a credit-money system, most
money is created in the process of banks granting credit to their clients. If so, the demand for
credit by the private sector is the most important driver of the money supply. The primary way in
which the central bank can influence the money supply is then by influencing private credit
demand, which it achieves by manipulating the cost of bank credit through the interest rate. And
this is exactly what happens in practice. The actions of private sector agents thus play an
important role in determining the money supply, which is therefore not exogenous in the sense
of being fully controlled by the central bank without the involvement of private sector actions.
These themes are developed further in our third-year and honours courses in Monetary
Economics or Money, Banking and Financial Markets.

Secondly, post-Keynesians rightly emphasise that inflation is not purely and solely caused by
excess demand for goods, even if they may be wrong in advocating an incomes policy to
combat inflation (2007:466). Inflation can most certainly also be caused by cost or profit push
factors, such as when the rand cost of imported inputs rises when the exchange rate falls, as is
happening at the time of writing. The problem with cost push inflation is that the government
cannot directly combat it by way of Keynesian demand management. But demand management
(a restrictive monetary policy) can still indirectly combat cost push inflation. By restricting total
demand for goods, the bargaining power of demanders vis-à-vis suppliers is enhanced.
Suppliers are thus encouraged to absorb inflationary cost increases rather than pass them on to
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demanders in the form of higher prices. In that way, restrictive demand management can slowly
squeeze inflation out of the system, even if an excess of demand did not originally cause the
inflation. This is essentially what the South African Reserve Bank is presently trying to achieve
as well, although you will realise that such an anti-inflationary policy goes at the expense of
lower profit margins for business (which may slow down production and employment creation),
if labour does not simultaneously limit its wage demands.

Experience all over the world has shown that an incomes policy to control inflation, if it means
that prices and wages are artificially frozen, does not work and has serious detrimental side-
effects. It leads to the development of black markets, reduces supply if the fixed price does not
allow sufficient cost recovery (all the shops go empty, as happened in Zimbabwe), it stifles
competition and it cannot do anything about the prices of imported goods. Moreover, its inflation
dampening effect tends to be short-lived, nullified by accelerated inflation once the price
controls are lifted again. However, if an incomes policy means some kind of social contrast
among labour, business and government, it can potentially be highly effective. Business, labour
and government could sit around a table and work out a compromise on allowable
price/wage/tax increases, so as equitably to share the necessary sacrifices to squeeze out
inflation, which is precisely how many European countries got rid of their inflation in the 1980s.
But such a strategy would require a degree of willingness to sacrifice sectional interest for the
sake of the interest of the country as a whole, which may not be present in South Africa. The
antagonism and mutual distrust between business, labour and government is probably too
strong in South Africa for such a cooperation to materialise.

So much for the post-Keynesians and now for the new Keynesians (we hope you are not yet
thoroughly confused by the profusion of labels), who are an altogether different breed. While the
post-Keynesians operate more on the fringes of mainstream economics, the new Keynesians
operate right in the middle of it, in that they employ the mathematical-neoclassical style of
theorising. New Keynesians latch on to one of the characteristics of Keynes's analysis, namely
the assumption of downwardly inflexible prices and wages. They then impose inflexible relative
wages and prices on a standard neoclassical Walrasian general equilibrium model, so as to
make it generate unemployment. Unemployment is thus attributed mainly to inflexibility and
other such market failures, whereby it is implicitly suggested that there would have been full
employment had relative prices/wages been perfectly flexible and had other market
imperfections been absent, which in a developing world context like South Africa’s, where a
large percentage of the unemployment is structural, is somewhat debatable. You will notice that
menu costs, formal and implicit contracts, efficiency wages and insider-outsider theory are all
explanations for downward relative price/wage inflexibility.

OVERVIEW OF THE CHICAGO SCHOOL

• Chapter 24 only the section “Overview of the Chicago school” (pp. 493-497)

Basically the Chicago school of thought is a reaction to Keynesianism, its theoretical and
political economy underpinnings. This reaction should be seen against the backdrop of the
economic situation of the 1970s when some of the negative side-effects of Keynesian policy
became especially pronounced: high inflation combined with high unemployment (stagflation),
excessive union power and high government inefficiency. The Chicago school goes back to
some of the basic theoretical and political economy suppositions of classical and neoclassical
economics. As for theory, they employ the Walrasian variety of neoclassical theory (just as the
new Keynesians, except that the new Keynesians impose inflexible relative prices on the
Walrasian system), which the new classical economists in particular have taken to new heights
of mathematical sophistication. In spite of this sophistication, the basic and simple classical
suppositions of the model remain intact: belief in the validity of Say’s law (aggregate demand is
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always more or less sufficient to buy up total aggregate production) and belief that markets are
sufficiently competitive for prices to be relied on to clear markets. The abuse of
monopoly/oligopoly power by firms is not a problem; new firms will spontaneously come up to
challenge existing monopolies/oligopolies, which will thus dissipate of themselves. This leaves
Chicago school economists with only the following causes for the existence of unemployment
and instability in modern capitalism: inappropriate government policies, temporary disruption
due to technological innovation and a reduced propensity to work (people are unemployed
because they want to be). Now these factors, especially the first two, may certainly contribute
towards unemployment, but it is unlikely that they can sufficiently explain unemployment in most
countries, especially not in South Africa. South Africa's macroeconomic policies are extremely
responsible and restrained (close to “textbook-perfect”), temporary disruption due to
technological innovation cannot be great and people definitely want to work here. Yet we sit with
an unemployment rate of around 30%!

As for the political economy side of their system, Chicago school theorists believe in minimal
government, leaving the economy as free as possible almost to the point of pure laissez-faire.
While Keynesians may in the past have relied too heavily on demand stimulation leading to
inflation, while they may have overemphasised public projects to stimulate employment leading
to inefficiency and waste of public resources, and while they may have over-regulated the
economy leading to inflexibility, it would seem to be equally misguided to go back to an almost
perfect laissez-faire system (which has never existed anyway). There is a role for Keynesian
demand stimulation provided it is carefully applied, there is a role for selective public projects
provided they are carefully managed, and there is a role for regulation provided it does not
become too stifling. Implicit in Chicago school theory and policy seems to be a view of the
economy, in which most markets are highly competitive because populated by a multitude of
small businesses of the proprietorship and partnership type, in which the banking system is
inherently stable and there is never too much or too little money creation, and in which the
ownership of land and capital is well spread out over the whole population. But it is not so. In the
modern capitalist economy, markets are dominated by huge corporations many of whom have
strong monopolistic/oligopolistic powers; the credit-money system is inherently unstable needing
careful central-bank oversight and control; financial markets are highly volatile and globalised;
and the ownership of capital and land is highly concentrated in the hands of a few, in the light of
which some Chicago-school policies seem naive indeed. But this is only the opinion of your
lecturer. Feel free to disagree.

The textbook (2007:495-496) note the interesting point that the minimalist government doctrine
of the Chicago school cuts both ways: it is not only against government regulation of private
business, but also against government protection of private business, which can be extensive
indeed. It is not uncommon for United States (US) or European Union (EU) governments to
prop up and subsidise ailing industries with billions of dollars or euros. In both the United States
and the European Union agriculture is also extensively subsidised and protected by the
government, not so much for strategic reasons but simply because the farmers are a very
powerful political lobby. The Chicago school would be opposed to such protection, which may
be a good thing. In this context, it is worth mentioning that a significant proportion of any
country’s economy depends on state spending. For example, many construction and
engineering companies depend on state spending on infrastructure, such as roads, railways,
and dams. Also the whole complex of armaments and related industries, which makes up a
sizeable proportion of the US and EU economies, depends on defence spending by their own
as well as foreign governments. Although such spending is evidently not a subsidy, it does
highlight that powerful private-sector interests are often bound up in the size and direction of
government spending, which explains why so much questionable lobbying (if not corrupting) is
going on in the world’s capitals.
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FRIEDMAN AND LUCAS

• all of chapter 24, excluding “24-1 Past as prologue” (pp. 505-506), “Consumption
Function (pp. 497-498) and “Gary S. Becker” (pp. 508-516).

As for the particulars of Milton Friedman’s economics (2007:497-504), the textbook should be
clear enough and needs little extra clarification. You can ignore the section “The demand for
money” (textbook, 498-499).

Friedman proposes that the demand for passive money holding is relatively stable (though not
static), which implies that the income velocity is stable (though not static). Moreover, Friedman's
restatement of the quantity theory of money proposes that the money supply can be
exogenously determined by the central bank; compare our remarks on endogenous money
above. The upshot of these two propositions is that total spending can be controlled by way of
the central bank’s control over the money supply. In other words, Say’s law can be made to hold
and inflation can be avoided, if the central bank keeps the growth in the money supply roughly
equivalent to the growth in the real economy (see “the monetary rule”; 2007:503). We now
know, however, that the demand for money is not very stable (and, in fact, has recently become
increasingly unstable) and that the money supply cannot be perfectly controlled by the central
bank, unless it accepts highly volatile interest rates which would be seriously destabilising. All in
all, Friedman’s monetary rule would be wonderful if it could work; but it is just not practicable.
With that, his critique of Keynesianism and his belief in the inherent macroeconomic stability of
the economy is undermined.

Friedman’s claim that inflation is “always and everywhere a monetary phenomenon” is true in
the sense that inflation cannot occur without the money stock increasing. If real income is not to
fall drastically, the higher general price level and the resultant higher nominal volume of trade
needs to be financed by more money. But that does not mean that inflation is purely a demand-
pull phenomenon which can be controlled by controlling the money stock. As we noted above in
our discussion of the post-Keynesians, inflation is also a cost-push phenomenon.

To understand the textbook’s (2007:501-503) discussion of the long-run vertical Phillips curve,
first study the normal Phillips curve (2007:460-461). Friedman’s theory about the long-run
vertical Phillips curve is also important because it drew attention to the role of expectations in
economic theory. Friedman argued that workers’ labour-supply decisions are determined by
expected rather than actual real wages. Under these circumstances, when policy makers cause
inflation by stimulating demand and that inflation remains unanticipated by the workers,
expected real wage remains the same, but actual real wage drops. Under these circumstances,
employers will be inclined to offer more jobs and produce more goods. But as soon as workers
realise that their real wage has fallen, they will start anticipating the higher prices and demand
higher nominal wages to restore their original real wage, which will bring production and
employment back to its original level. The moral of the story is that unemployment can only be
forced below its “natural” level, when policy makers cause unexpected inflation by expansionary
monetary or fiscal policies, which would trick workers into believing that their real wage is higher
than what it really is. But this trickery will obviously only be temporary. As soon as workers wise
up to the situation, real wage rises again and employment again falls to its long-term “natural”
level. A vertical long-run supply curve of goods thus emerges. We may call this adaptive
expectations.

Robert Lucas (The new classical school; 2007:504-508) took this idea a step further. He argued
that economic agents have rational expectations, meaning that expansionary monetary or fiscal
policy cannot even temporarily stimulate production and employment, because the inflationary
effects of these policies would have been anticipated by the workers, who would accordingly
adapt their nominal wage demands as soon as the policies were noticed. Only if the
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expansionary policy is unanticipated can it temporarily stimulate the economy, but this would
mean that the monetary or fiscal authorities would have to be erratic and unforeseeable in their
policy application, which would be destabilising anyway. Hence the rational expectationists
concluded that monetary or fiscal policy cannot stimulate the economy; its effects are only
inflationary.

Although Lucas and the new classical school seem right in pointing out that the anticipation of a
policy action can influence its effectiveness, the total ineffectiveness of policy seems to depend
on other assumptions as well. Most importantly, it depends on the assumption that the economy
always finds itself at its “natural rate” of employment and production. The natural rate of
employment and production (2007:501-503) is the level of employment and production where all
markets clear, and where the only remaining unemployment (that is, the natural rate of
unemployment) is frictional. Because demand and supply are presumed to be equal in all
markets, a stimulation of the total demand would have to be inflationary. However, if we assume
that Say’s law does not always hold and that demand can fall short of supply, a stimulation of
demand can have real expansionary effects in the medium to longer term, without prices
necessarily having to rise.

Nonetheless, rational expectations has become an important concept in modern

macroeconomic theorising. Just as agents in neoclassical models are supposed to maximise
their utility in their spending and production decisions, they are also supposed to maximise their
utility in their information-gathering efforts so as to form rational expectations. Rational
expectations theory, however, not only assumes that agents gather all relevant information but
also that they develop a correct understanding of the workings of the economy in the process.
As a result, the gathered information gets translated into averagely correct expectations of the
event concerned. In this context, it is popularly said that the rational expectations approach
presupposes that agents possess “the correct model of the economy”. While the approach does
not exclude the possibility that expectations are wrong, expectational errors are assumed to be
normally distributed around a mean value, which is the correct expectation. Moreover, as
already mentioned, the rational expectations approach postulates that the “correct model of the
economy” is a neoclassical Walrasian model in which Say’s law always holds, employment and
real income are a function of real wage/price only and markets always clear. As a result,
workers need to correctly forecast only the future price level, in order to be certain about the real
value of their currently negotiated money wage. Unless the parameters of the labour demand
and supply functions change, real wage will thus always be at the market-clearing level. That is
why employment is fixed at what is called the natural rate of unemployment.

ECONOMIC IN ACTION: LOOKING BACK

Several lessons can be learnt from the discussion in this study unit. To start with,
macroeconomic stability (stable and sufficient growth in aggregate effective demand – the
maintenance of Say’s law) is not enough to guarantee full employment, for several reasons. The
first is that growth can be constrained by both insufficient demand and insufficient supply. The
latter can be result of a lack of profit opportunities for entrepreneurs or a lack of productive
inputs required to exploit these opportunities, which requires addressing issues like inadequate
real and financial infrastructure, inadequate skills levels, and socio-political-legal uncertainty.
The second is that the degree to which growth in output translates into growth in employment
depends on the capital intensity of the sector in question. Increasing capital intensity in a sector
may neutralise the employment-creating effects of growth in that sector. The third is that
macroeconomic stability focuses mainly on local aggregate demand. But if foreign demand for
our goods is to be stimulated, we also need to look at stimulating foreign demand which is a
matter of raising the competitiveness of local manufacturing in both local and foreign markets.
The latter requires a conscious strategy involving all stakeholders: government, private business
and the unions. However, while it may be important to concentrate on export-led (and import-
replacement) growth, significant employment gains can also be made from growth in activities in
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the local non-tradables sector, in particular services and construction, the latter mainly through
large infrastructural works and tourism (although tourism can also be regarded as an export
tradable). Concentrating on local growth has the added advantage of being less dependent on
the vagaries of the world economy, which at the time of writing seems to enter a particularly
unstable phase. See the New Growth Path for more detail.

CONCLUDING THOUGHTS

• All of chapter 25

This chapter speaks for itself, so just a few additional thoughts from your lecturer.

The textbook’s remark (2007:522) that “new ideas seldom lead to the total abandonment of the
existing heritage” is important. What its authors are actually saying is that schools of thought,
whether they be classical, Marxian, socialist, neoclassical or institutionalist, all contain valid
ideas. Economics ideas, if wrong, are seldom totally wrong. It’s more likely they are some sort of
half truth. As a result, one should never totally discard the ideas of defunct and outdated
schools of thought, as one may thus miss out on some of the half truths that are validly
highlighted.

The textbook (2007:522) notes a certain danger of mathematical economic theory, namely that
“the tools at hand often dictate which jobs are undertaken”. In other words, the dominance of
mathematical theory leads economists to tackle only those economic phenomena that easily
lend themselves to mathematical modelling. But that is only half the problem. The way in which
these phenomena are explained is also dictated by the mathematical tools. As such, the danger
exists that economic reality is adapted to suit the tools, rather than that the tools are adapted to
suit reality. There is the old joke about the economist who rebuked the data when they refused
to confirm his model.

We hope you enjoyed this course.