Ekelund-Hebert 6E.

book Page i Thursday, August 1, 2013 11:03 AM

A History of Economic
Theory & Method
Sixth Edition
Ekelund-Hebert 6E.book Page ii Thursday, August 1, 2013 11:03 AM
Ekelund-Hebert 6E.book Page iii Thursday, August 1, 2013 11:03 AM

A History of Economic
Theory & Method
Sixth Edition

Robert B. Ekelund, Jr.

Auburn University

Robert F. Hébert
Auburn University

WAVELAND

PRESS, INC.
Long Grove, Illinois
Ekelund-Hebert FrontMatter.fm Page iv Wednesday, August 14, 2013 10:54 AM

For information about this book, contact:

Waveland Press, Inc.
4180 IL Route 83, Suite 101
Long Grove, IL 60047-9580
(847) 634-0081
[email protected]
www.waveland.com

Cover illustrations by Robert B. Ekelund, Jr.

Copyright © 2014, 2007, 1997 by Robert B. Ekelund, Jr., and Robert F. Hébert

10-digit ISBN 1-4786-0638-X

13-digit ISBN 978-1-4786-0638-3

All rights reserved. No part of this book may be reproduced, stored in a retrieval sys-
tem, or transmitted in any form or by any means without permission in writing from
the publisher.

Printed in the United States of America

7 6 5 4 3 2 1
Ekelund-Hebert 6E.book Page v Thursday, August 1, 2013 11:03 AM

Our mentors have shed their mortal coils . . .

but their legacy lives in us, and those we touch.
This book is dedicated to the memory of
William Breit, James P. Payne, Jr.,
Alfred Chalk, and Ludwig H. Mai.
Ekelund-Hebert 6E.book Page vi Thursday, August 1, 2013 11:03 AM

About the Authors

ROBERT B. EKELUND, JR., earned baccalaureate and masters degrees in economics, with
minors in ancient, medieval, and art history, at St. Mary’s University. He earned his doc-
torate degree in economics and political science from Louisiana State University in 1967.
He was professor of economics at Texas A&M University until 1979 when he joined the
faculty at Auburn University. At Auburn Ekelund was Professor and Eminent Scholar in
Economics, retiring at the rank of Eminent Scholar Emeritus in 2003. He was a Visiting
Scholar at the Hoover Institute at Stanford University and was the Vernon F. Taylor Dis-
tinguished Visiting Professor at Trinity University in 2003. In 2006–2007 he served as
Acting Director of the Jule Collins Smith Museum of Fine Arts at Auburn University. He
is the author or coauthor of 30 books including (with Robert D. Tollison and Rand
Ressler) Economics: Private Markets and Public Choice (7th ed. 2006); (with Tollison)
Mercantilism as a Rent-Seeking Society (1981), Politicized Economies (1997), and Eco-
nomic Origins of Roman Christianity (2011); (with David Saurman) Advertising and the
Market Process (1988); (with Richard W. Ault) Intermediate Microeconomics: Theory and
Applications (1995); (with Mark Thornton) Tariffs, Blockades and Inflation: The Eco-
nomics of the Civil War (2004); (with Catherine Walsh) The Persistence of Myth and
Tragedy in Twentieth-Century Mexican Art (2004); and (with E. O. Price III) The Eco-
nomics of Edwin Chadwick (2012). He is a contributor to Art Interrupted: Advancing
American Art and the Politics of Cultural Diplomacy (2012). He has published more than
200 articles, papers, and monographs on aspects of applied microeconomic theory, his-
tory of economic theory, economic history, the economics of regulation, cultural econom-
ics, and the economics of religion in such journals as the American Economic Review,
the Journal of Political Economy, the Quarterly Journal of Economics, History of Political
Economy, and Politics and Religion. Dr. Ekelund is an artist featured in a number of one-
person exhibits over the past several decades and an amateur classical pianist who regu-
larly enters the Van Cliburn Amateur Video contests.

ROBERT F. HÉBERT earned his PhD from Louisiana State University in 1970. He taught at
Clemson University for four years (1970–74) and at Auburn University for over 25 years
(1974–2000). At Auburn he served two terms as head of the economics department
(1980–87; 1991–93) and was the Benjamin and Roberta Russell Foundation Professor of
Entrepreneurial Studies for 13 years. In 1995 he was a Senior Fulbright Research
Scholar and Visiting Professor of Economics at the Université de Paris I (Sorbonne). He
also has been visiting professor at the Institut d’Administration des Entreprises de Caen
(I.A.E.), Basse Normandie, France, and at the University of Louisiana at Lafayette. He is
currently Russell Foundation Professor Emeritus, Auburn University. Dr. Hébert is past
president of the History of Economics Society and former trustee of the Southern Eco-
nomic Association. He served on the Board of Editors of the History of Political Economy
for many years. He has published widely in major journals, including Economica, Eco-
nomic Inquiry, European Journal of the History of Economic Thought, History of Political
Economy, Journal of Economic Behavior and Organization, Journal of Economic Per-
spectives, Journal of Political Economy, Southern Economic Journal, and Quarterly Jour-
nal of Economics, on topics involving the history of economic thought, historical aspects
of entrepreneurship, and the economics of religion. His books include A History of Entre-
preneurship (with A. N. Link, 2009); The Marketplace of Christianity (with R. B. Ekelund,
Jr., and R. D. Tollison, 2006); Secret Origins of Modern Microeconomics: Dupuit and the
Engineers (with R. B. Ekelund, Jr., 1999); and Sacred Trust: The Medieval Church as an
Economic Firm (with Ekelund, Tollison, G. M. Anderson, and A. B. Davidson, 1996).
Ekelund-Hebert 6E.book Page vii Thursday, August 1, 2013 11:03 AM

Contents

Preface xv

1 Economics and Its History 1

What Is the Value of Studying the History of Economics? 3
Aim, Scope, and Method 3
Suggestions on How to Use This Book 5
Other Useful Resources and Information 5

Part I
Preclassical Economics 7

2 Ancient and Medieval Economic Thought and Institutions 9

Contributions of the Ancient Greeks 9
Roman and Early Christian Contributions 21
Chinese Economics in the First Millennium 22
Medieval Arab-Islamic Economics 24
Medieval European Economic Thought 27
Theory Meets History: Economic Impact of
Christianity and the Medieval Church 35
Conclusion 38
References 39 ■ Notes for Further Reading 40

3 Mercantilism 46
Mercantilism as Doctrine: The Economics of Nationalism 47
Mercantilism as an Economic Process 53
Transition to Liberalism 65
Conclusion 66
References 67 ■ Notes for Further Reading 68

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viii ■ Contents

4 The Dawn of Capitalism 72

Sir William Petty 73
Nascent Liberalism in France:
Boisguilbert, Cantillon, and the Physiocrats 76
Richard Cantillon 77
The Spanish Enlightenment: Iberian Economics 89
Capitalism at the Junction of Ideas and History 93
The Decline of Catholicism and the Rise of Protestantism 94
Conclusion 98
References 99 ■ Notes for Further Reading 100

Part II
The Classical Period 105

5 Adam Smith: System Builder 107

The Nature of Smith’s Economic System 108
Microeconomic Foundations of The Wealth of Nations 114
Smith’s Macroeconomics:
Blueprint for Economic Development 127
Conclusion 130
References 131 ■ Notes for Further Reading 131

6 Classical Economics (I): Utility, Population, and Money 136

Jeremy Bentham and Utilitarianism 137
Thomas Robert Malthus and Population 140
Early Monetary Issues 144
Classical Economics and the Generators of Trade and Value 148
Conclusion 151
References 151 ■ Notes for Further Reading 152

7 Classical Economics (II): The Ricardian System and Its Critics 156
The Classical Doctrine of Land Rent 156
The Ricardian System 159
The Ricardo–Malthus Correspondence 164
Nassau Senior and the Emergence of “Scientific” Economics 169
The Supremacy of Ricardian Economics 174
The Elegant Dynamics of the Classical System 175
Conclusion 177
References 177 ■ Notes for Further Reading 178
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Contents ■ ix

8 Classical Economics (III): John Stuart Mill 183

Mill’s Intellectual Transition 184
The Structure of Mill’s Economic Inquiry 185
Mill’s Theoretical Advances 187
Mill’s Normative Economics 193
Mill and the Decline of Classical Economics 196
Entrepreneurism at the Classical Summit 202
Conclusion 203
References 204 ■ Notes for Further Reading 205

Part III
Responses to the Industrial Revolution—
Orthodox and Heterodox 209

9 Economic Policy in the Classical Period: 211

Technology, Labor, and Poverty
The “Real World” of Classical Economics 212
Income Distribution in England 213
Early Reforms: The Poor Laws and Factory Acts 216
Labor as a Utilitarian Policy Issue 220
The Big Question: Can the Poor Be Lifted out of Poverty? 220
Technology, Labor, and Poverty: Classical Perspectives 222
Conclusion 226
References 227 ■ Notes for Further Reading 228

10 J. S. Mill and Edwin Chadwick on Taxation and Public Economics 231

Social and Economic Policies of J. S. Mill 232
The Political Economy of Sir Edwin Chadwick 238
Conclusion 252
References 252 ■ Notes for Further Reading 253

11 Nineteenth-Century Heterodox Economic Thought 256

Romanticism 257
European Evolutionary Thought 259
The Utopian Socialists 267
German Historicism 273
Heterodoxy and Entrepreneurism 276
Conclusion 278
References 279 ■ Notes for Further Reading 279
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x ■ Contents

12 Karl Marx: Historical Determinism vs. Utopian Socialism 284

Overview of the Marxian System 285
Marx’s Early Writings on Capitalist Production 289
The Nature of Capitalism 292
Conclusion 301
References 302 ■ Notes for Further Reading 302

Part IV
The Neoclassical Era 307

13 Proto-Neoclassical Economics in France: Cournot and Dupuit 309

A. A. Cournot (1801–1877) 309
Jules Dupuit (1804–1866) 316
Engineers and Cross-Fertilization of Economic Ideas 329
Conclusion 330
References 331 ■ Notes for Further Reading 331

14 Microeconomics in Germany and Austria: 336

Menger, Wieser, and Böhm-Bawerk
German Proto-Neoclassicists 336
Carl Menger (1840–1921) 340
Friedrich von Wieser (1851–1926) 345
Eugen Böhm-Bawerk (1851–1914) 353
Entrepreneurism in German and Austrian Economics 359
Conclusion 362
References 362 ■ Notes for Further Reading 363

15 Microeconomics in England and America: 367

W. S. Jevons and J. B. Clark
W. S. Jevons 367
Jevons’s Theory of Value 370
Jevons as a Pure Theorist 377
Jevons and Statistical Science 379
Jevons and the International Spread of Economic Ideas 382
John Bates Clark and Marginalism in America 383
Assessing Clark’s Contribution 388
Clark on Entrepreneurship 388
Conclusion 390
References 390 ■ Notes for Further Reading 390
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Contents ■ xi

16 Alfred Marshall and the Neoclassical Synthesis 394

Marshall and His Method 397
Industry Supply and the Economics of Production 403
Demand and Consumer Surplus 409
Marshall on Optimum Pricing and Monopoly 413
Marshall on Elasticity, Factor Demand, and
Optimal Resource Allocation 420
Marshall on Capital and Entrepreneurship 424
Conclusion 427
References 428 ■ Notes for Further Reading 428

17 The Mantle of Léon Walras 433

Contrasts between Marshall’s and Walras’s Approaches 433
Léon Walras: Sketch of His Life and Work 437
Walras and Marshall on the Market Adjustment Mechanism 439
The Role of the Entrepreneur in Walrasian Economics 444
Pareto, General Equilibrium, and Welfare Economics 446
Walras’s Correspondence and Its Impact on Economics 448
Conclusion 449
References 450 ■ Notes for Further Reading 451

18 Hegemony of Neoclassical Economics 454

The Proto-Neoclassicists before 1870 454
Lessons to Be Learned 462
What Did Marshall Know and Where Did He Learn It? 463
Conclusion 468
References 468 ■ Notes for Further Reading 470

Part V
Twentieth-Century Paradigms 473

19 British Historicism, Thorstein Veblen, and 475

American Institutional Economics
Nineteenth-Century British Historicism 475
Thorstein Veblen and American Institutionalism 479
Second-Generation Veblenians 494
John Kenneth Galbraith: The Institutionalists’ Popularizer 496
Conclusion 500
References 501 ■ Notes for Further Reading 501
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xii ■ Contents

20 Competition Revised: Chamberlin and Robinson 507

Duopoly Analysis 507
Chamberlin’s Quest for a New Theory 510
Joan Robinson and Imperfect Competition 516
Knight, Chamberlin, Robinson, and Entrepreneurism 521
Conclusion 522
References 524 ■ Notes for Further Reading 524

21 John Maynard Keynes and the Development 528

of Modern Macroeconomics
Overview of Keynes and His Economics 528
J. M. Keynes, Dilettante and Economic Theorist 530
Theoretical Outline of the General Theory 532
Paradigm Shift or Paradigm Realignment? 544
Conclusion 545
References 546 ■ Notes for Further Reading 547

22 Contemporary Macroeconomics: 552

Monetarism and Rational Expectations
Monetary Theory Goes Neoclassical 553
Modern Monetarism: Theory and Policy 558
Conclusion 566
References 567 ■ Notes for Further Reading 567

23 Austrian Economics 571

The Gestalt of Austrian Economics 572
Ludwig von Mises: The Theory of Money and Credit 575
F. A. Hayek and the Theory of Business Cycles 578
Joseph Schumpeter on Competition, Dynamics, and Growth 579
Competition and the Market Process 583
Advertising and Demand Discovery 585
The Socialist Calculation Debate 586
Conclusion 588
References 589 ■ Notes for Further Reading 589

24 The New Political Economy: Public Choice and Regulation 595

Public Choice 596
The New Political Economy of Regulation 606
Conclusion 614
References 614 ■ Notes for Further Reading 615
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Contents ■ xiii

Part VI
Back to the Future: The Twenty-First Century 619

25 Mathematical and Empirical Economics: A Method Revolution 621

History and Development of Mathematical Economics 622
Common Mathematical Tools Used in Economics 623
Cournot’s Heirs: Applications of
Mathematics to Economic Ideas 626
Empiricism in Economics: Testing Economic Theory 638
Conclusion 643
References 644 ■ Notes for Further Reading 645

26 Changing the Boundaries of Microeconomics: 648

Demand, Consumption, and “Rationality”
Modern Consumption Technology 649
Newer Theories of the Firm 655
Nontraditional Approaches:
Prospect Theory, Happiness Theory, and Neuroscience 661
Conclusion 667
References 667 ■ Notes for Further Reading 668

27 The Resurgence of Economics as a Social Science 671

Economics and Sociology 672
Economics and Art 675
Economics and Religion 678
Economics and Archeology 681
Economics and Politics 683
Conclusion 686
References 688 ■ Notes for Further Reading 688

28 Quo Vadis? Economics in the Twenty-First Century 693

Nobel Laureates and Economics 693
The Transmission of Ideas and the
New “Technology” of Economics 697
Ideas, Ideology, and History 700
Does Method Matter? 703
Is Schism in the Cards for Economics? 706
References 708

Name Index 709

Subject Index 713
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Ekelund-Hebert 6E.book Page xv Thursday, August 1, 2013 11:03 AM

Preface

With this edition, A History of Economic Theory and Method enters its fifth decade.
It therefore seems safe to conclude that it has found a solid level of acceptance in
the marketplace. It could not have done so unless it satisfied a demand that was
fueled by many people, faculty and students, who have used this book. We are grat-
ified that students and professors have found our work useful for over four decades,
and grateful to all those who have provided us with their evaluations of past edi-
tions and suggestions for improvement. As authors, we are somewhat surprised,
but clearly delighted, at the longevity of this work. A new edition offers an opportu-
nity once again to reflect on the nature and scope of the history of economic theory
and method.

■ DISTINCTIVE FEATURES OF THIS BOOK

This book offers an extensive survey of the wide range of economic ideas from
ancient times to the present. We cannot be encyclopedic in scope, but we do attempt
to substantially illustrate the broad panorama and remarkable continuity of eco-
nomic analysis through the ages. As in previous editions, we have attempted to
show the interaction between ideas and the course of historical institutions at key
points throughout the book.
The student who has mastered the substance of this book will understand how
past analytic contributions, both those that were successful and those that were not,
shaped contemporary economic theory. He or she will also gain insights into differ-
ent methods of problem solving that distinguished one pioneer or group of pioneers
from another. By these smaller payoffs the ultimate gain to the student who masters
this subject is a sense of perspective regarding economic analysis—an appreciation
for the strengths and weaknesses of the discipline, its successes and failures.
As in all previous editions, we strived for clarity and probity in our survey of
intellectual history. We believe that it is not enough merely to catalog history; we
must also try to extract its valuable lessons. Hence, we connect our survey of pio-
neer performances with a running assessment (ours, to be sure) of the importance
and subsequent impact of key ideas. We have also tried to impart the international
character and scope of major contributions to economic analysis. Other books in
this field all too often focus exclusively on the Anglo-Saxon tradition in economic
thought to the exclusion of many critical contributions from other countries and
cultures. Like most scholars, we are impaired by our limited understanding of dif-

xv
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xvi ■ Preface

ferent languages, yet we hope that we have made tentative amends in regard to ear-
lier neglect of the multinational roots of economics, and encourage others to join
the fray. These themes of clarity, probity, and cosmopolitanism that marked our ear-
lier editions continue throughout the present one.

■ THE SIXTH EDITION

This edition retains the structure and content of its immediate predecessor
while expanding coverage of economic policy and its theoretical underpinnings in
nineteenth-century Britain. The “evils” wrought by the Industrial Revolution—poor
sanitation, disease, plague, low wages, and a highly skewed income distribution to
name a few—provided the grist for socialist and “heterodox” reformers. Often
ignored is the fact that “radical” reform ideas provoked a response from “orthodox”
thinkers. This edition focuses on orthodox responses to hostile attacks by myriad
“reformers” who gained currency during the era. Chapters 9 and 10 provide a
detailed analysis of possible administrative solutions advanced by John Stuart Mill
and Edwin Chadwick, defenders of orthodox economic theory who advanced sound
and meaningful discussions of issues relating to social problems wrought (or exag-
gerated) by the Industrial Revolution. Their views on policies involving taxes, exter-
nalities, social cost, moral hazard, and human capital were important elements of
an expanding orthodoxy that repay consideration, even today.
In this edition we have streamlined coverage in some respects and expanded
coverage in others. The last three chapters, which bring us closest to the present,
reflect the most significant changes. Chapter 26 expands on the role of psychology
and “experiments” in broadening our understanding of demand and consumer
behavior. In particular, psychologists have suggested relaxing the rationality
assumption of standard economic theory in a way that must be considered for its
impact on economics. Chapter 27, a new chapter, shows how modern economic the-
ory is being drawn into closer alliance with other social sciences such as sociology,
history, religion, and anthropology, which includes culture and archeology. These
extensions are treated as complements rather than substitutes to standard eco-
nomic analysis. Chapter 28, the final chapter, discusses the sociology of economics,
including the achievements of Nobel laureates, the changing technology of dissemi-
nation of ideas, and the possible future directions of the science.
Another new feature of this edition is its attempt to trace the episodic develop-
ment of the critical role of entrepreneurism as represented by the major economic
thinkers of the past. We are compelled to mention several caveats about this effort.
The first is that a historical survey of entrepreneurship, as established by the “build-
ers” of economics, shows that the concept means different things to different peo-
ple. As of this writing, there is no one, universal conception of entrepreneurship
that dominates economics. Another caveat is that although entrepreneurship is a
value-free concept in a strict, theoretical sense, in practice it is inevitably shaped by
a society’s reigning institutional framework. Culture and institutions determine
whether entrepreneurial efforts result in the creation of wealth or its mere distribu-
tion (what economists today call rent seeking). Normatively speaking, there is
“good” entrepreneurship and “bad” entrepreneurship, i.e., productive and unpro-
ductive enterprising behavior. Historically, its close connection to economic devel-
opment means that entrepreneurism is almost always identified as salutary
behavior. But rent-seeking societies do not necessarily have fewer entrepreneurs
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Preface ■ xvii

than market-oriented societies. We strive throughout this Sixth Edition to make

these distinctions, identifying the key factor at play in whether entrepreneurship is
productive or unproductive.
In addition to these substantive changes, the end-of-chapter notes for further
reading have been revised and updated. As in the Fifth Edition, “Force of Ideas” seg-
ments seek to connect key ideas—which are sometimes addressed briefly in the
text—to current economic thought or practice. These segments are intended to
illustrate the remarkable continuity of ideas throughout the history of economics.
The “Method Squabbles” segments attempt to convey the competing techniques, or
analytical procedures, of different writers who made a lasting imprint on econom-
ics. These segments are intended to illustrate the pluralistic nature of economic
method. How economists “do” economics is not a matter that has been conclusively
settled, despite more than two centuries of economic inquiry.
A revised and updated instructor’s manual is available to faculty. We hope that
this manual proves highly useful, especially for instructors teaching the course for
the first time. Prepared by the authors, each chapter of the manual contains five
key elements:
• A summary of the text chapter, highlighting key issues or ideas
• A set of multiple-choice examination questions (and answers)
• A set of discussion questions (and answers)
• Suggestions for term paper topics
• Hints about how one’s lectures might be extended on more detailed subject matter

■ ACKNOWLEDGEMENTS
Having survived four decades, it is not surprising that this book has generated an
abundance of encouragement, advice, and criticism. It would be impossible to thank
all of those users, reviewers, and colleagues who contributed to its success. Indeed,
we hesitate to try for fear of offending someone by omission. But on this issue,
silence is not an option. On a particular level we must acknowledge, first and fore-
most, our mentors (now all deceased): William Breit ignited our interest in the history
of economic thought, and his persistent encouragement and pride in our accomplish-
ments have sustained us throughout our professional careers. James P. Payne, Jr.,
taught us the nature and responsibilities of an academic economist (and more than a
fair amount of price theory). Ludwig H. Mai and Alfred F. Chalk were seminal inspi-
rations, perhaps more than they ever knew. These four individuals defined scholar-
ship for us and taught by example. Our joint overall debt to them is incalculable and
we hold their memories and their teaching forever close to our hearts.
A number of other people provided help and encouragement in bringing past
and present editions to realization. We are grateful to all of them: Richard Ault
(Auburn University), Randy Beard (Auburn University), Don Boudreaux (George
Mason University), Elynor Davis (Georgia Southern University), George Ford
(Phoenix Center), David E. R. Gay (University of Arkansas), John Jackson (Auburn
University), Yvan Kelly (Flagler College), Roger Koppl (Fairleigh Dickinson Univer-
sity), John Merrill (Kansas State University), Frank Mixon (University of Southern
Mississippi), the late Margaret O’Donnell (University of Louisiana at Lafayette), E.
O. Price (Oklahoma State University), Rand Ressler (University of Louisiana at
Lafayette), the late Larry Sechrest (Sul Ross State University), Parth Shaw (Univer-
Ekelund-Hebert 6E.book Page xviii Thursday, August 1, 2013 11:03 AM

xviii ■ Preface

sity of Michigan, Dearborn), John Sophocleus (Auburn University), Sven Thom-

mesen (Auburn University), and Mark Thornton (Mises Institute). We owe a special
debt of gratitude to Bob Tollison (Clemson University) and David Laband (Georgia
State) for help on the Sixth Edition and to Audrey Davidson (University of Louis-
ville) for excellent advice that spanned a number of editions.
Our graduate students, many of whom are now professors and mentors them-
selves, provided able assistance throughout five editions of this book. They include
Frank Adams, Paula Gant, Thomas McQuade, Keith Reutter, Shawn Ritenour, John
Thompson, Marc Ulrich, and Mark Yanochik. A special thanks to Matthew McCaf-
frey and Briggs Armstrong for research, editing, and design assistance with the
Sixth Edition. Last, but far from least, we acknowledge the help of Waveland Press.
We owe a special debt to our editor at Waveland Press, Jeni Ogilvie, whose interest,
enthusiasm, and painstakingly careful attention to detail made this book far better
than it otherwise would have been. Graphic artist, Tom Curtin, who transformed the
sketches rendered by Robert B. Ekelund, Jr., into the cover of this Sixth Edition,
exceeded our expectations.
As we have constantly reminded our students, there is no substitute for reading
the “classics” in the original. We hope that our text, which for us has been a labor of
love, energizes students to go to those wonderful and rewarding original sources.
There are gems to be found in the past that, if polished now, will shine on the future.

Robert B. Ekelund, Jr.

Robert F. Hébert
Ekelund-Hebert 6E.book Page 1 Thursday, August 1, 2013 11:03 AM

Economics and Its History

Every aspiring economist, whether amateur or professional, must sooner or later

confront the fact that economics is a heterogeneous discipline with numerous tradi-
tions, each based on a cluster of theories. Each theory uses observations, ideas, and
assumptions about how the world works. Most theories produce models of human
behavior of varying degrees of complexity. Different theories often give rise to
opposing views on the nature of a problem, its significance, how best to formulate
the problem, what method(s) to apply, and what policy judgments to make. Igno-
rance of this fact, or failure to appreciate its consequences, constitutes a serious
deficiency in the training of any economist. This book is designed to provide aware-
ness and appreciation of the variety and complexity of the field of economics, from
its early and loose origins as household management in antiquity to its intricate and
complex analysis of human action in contemporary economics.
The ancient Greeks gave us the word economics, but restricted its meaning to
household management. Roman civilization infused economics with legalistic ele-
ments. Medieval society imbued it with ethical discourse. In the seventeenth century
economics was overtly treated as a subset of moral philosophy, although a mutant
strain developed called political arithmetic. In the eighteenth century a subtle bifur-
cation occurred, which on the one hand focused on the nature of enterprise econom-
ics, shorn mostly of it political integuments, and on the other hand focused on the
essential interplay of politics and economics. From this latter focus emerged the
“classical” form of economics known as political economy. As political economy
evolved toward a mature statement in the nineteenth century, various strains (some
virulent) of heterodoxy appeared. But owing to the further refinement and profes-
sionalization of economics in the twentieth century, political economy gave way to
the preferred, simple term, economics, a consensus label for a body of principles and
a method of analysis that can now be called “mainstream.” This book is about the
evolution of economics as it developed and consolidated into mainstream science.
As such, it is a history of economic analysis, not the history of economic analysis.
Economics, like physics or meteorology, is a science inasmuch as it comprises a
set of analytical principles that work with consistent regularity. Unlike the so-called
natural sciences, however, economics is a social science because it studies human
behavior rather than the disembodied workings of nature. Thus, it is appropriate to
describe the subject, by analogy, as a set of tools. Just as a carpenter uses tools to
build a house; or a printer uses tools to make a book; so an economist uses tools to
build models designed to enhance understanding of human behavior and its conse-
quences. Every social science makes the same claim, however. What distinguishes

1
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2 A History of Economic Theory and Method

economics from, yet is sometimes applicable to, its “sister” social sciences, such as
sociology or psychology, is that it studies human behavior within the context of
markets. A market is an institutional arrangement that fosters trade or exchange. A
market can be explicit as with the market for shoes or implicit, such as the market
for marriage or religion. Modern economics, therefore, is primarily the study of
how markets of both kinds work, in terms both of their internal logical mechanism,
and how external forces bring about behavioral adjustments. From economics we
gain insights into how value and prices are determined and how inputs relate to
each other in production, for example, as well as how market participants adjust to
changes in important parameters, such as tastes or income.
Exchange, or trade, is probably as old as mankind. So the existence of markets
preceded the study of how markets work by a long period of time. For eons people
exchanged goods and services as a matter of social necessity, or survival, without
much thought given to the abstract nature of individual decisions made or the conse-
quences for society at large. Only after markets had reached a mature stage of devel-
opment and became a general feature of many (mostly Western) societies did attention
become focused on abstractions regarding how they work and what consequences
they have. Thus, it becomes possible to pinpoint, at least approximately, the birth of a
science that treats these issues. But it is clear that there is a larger set of questions
involved, namely: Where did the market come from? Is it the only way to organize eco-
nomic activity? What are the viable alternatives and how might they work?
The history of economics is replete with writers who sometimes addressed how
markets work, and sometimes explored what the alternatives are. Occasionally, but
rarely, did a writer address both. Karl Marx was such a writer, which is perhaps why
he is regarded as more than an economist. Most of the writers who achieved lasting
fame as architects of the field of economics concentrated on how markets work,
however. So dominant was this focus that the resulting analysis has come to be rec-
ognized as mainstream, or orthodox. By contrast, attempts to explore the second set
of questions are typically regarded as heterodox, or outside the mainstream.
Although this book focuses primarily on mainstream economic analysis, it does not
ignore heterodox points of view (e.g., socialist, Marxist, radical, historical, institu-
tionalist, or psychological)—mainly because criticism almost always has an impact
on received ideas. Other writers may be disposed to treat the subject differently.
Surely the marketplace of ideas encourages and accommodates variety. Our justifi-
cation for the approach adopted in this book is twofold: (1) mainstream economics
represents a consensus of what contemporary economics is all about; (2) a histori-
cal perspective on mainstream economics is apt to be more serviceable to you, the
reader. In our historical survey of economics, therefore, economic heterodoxy
enters the picture as a direct challenge to the reigning orthodoxy or as a variation
on the basic theme of mainstream economics. Although this emphasis is a matter of
choice, it does not obviate the fact that economics—in its past as well as its present
(and more than likely its future)—is a vibrant form of intellectual discourse, not a
settled body of principles.
Economics continues to ferment with the continual march of time. Even among
mainstream economists, gnawing questions persist about the nature, scope, and
method of economic inquiry and the value and place of economics among compet-
ing social sciences and its applicability to some of the subjects ordinarily dealt with
by history, sociology, and politics. Disagreement persists about the proper boundar-
ies of the subject, the role of the individual versus the group, the method of analysis
to be employed, the desired level of abstraction, and the very usefulness of the sub-
Ekelund-Hebert 6E.book Page 3 Thursday, August 1, 2013 11:03 AM

Chapter 1 ■ Economics and Its History 3

ject. Hence, even though we emphasize continuity and consensus in the evolution of
economic theory, we urge students of the history of economics to keep an open
mind to alternative points of view and to seek gainful lessons, not only in the suc-
cesses of past, but in its errors as well.

■ WHAT IS THE VALUE OF STUDYING THE HISTORY OF ECONOMICS?

Historians are necessarily stationed at the border between the past and the
present. By its nature history is backward looking, whereas economics—conceived
as the study of human decision making—is forward looking. Is it reasonable, there-
fore, for historians of economics to concentrate on past triumphs and failures? Is
this concern a waste of time, an obsession with irrelevant minutiae, an exercise in
mere ancestor worship, or does it produce constructive results? To no one’s sur-
prise, the answer is: “It depends.” Merely looking backward for nostalgia’s sake is
of no particular benefit. However, studying the past for lessons that might be
learned, or fresh insights gained, can be of enormous benefit. Humans can judge
where they are only in terms of where they have been, and since history is the study
of humanity, we ignore history at the risk of not understanding ourselves. Because
this book is about intellectual history, if properly used, it can provide insights into
the ways of the mind: how our intellectual ancestors perceived economic problems,
grappled with solutions, advanced their ideas and how shortcomings were modified.
One of the things that can be gained from a study of the past is a better under-
standing of the creative process. All the great intellectual pioneers held a skeptical,
almost iconoclastic, attitude toward traditional ideas and maintained an open, almost
naive, credulity toward new concepts. Out of this combination came the crucial
capacity to see a familiar situation or problem in a new light. The creative process is
always a wrenching away of a concept from its traditional context or meaning.
Another benefit from a study of the past is an appreciation for the kind of ideas
that have staying power. What separates good ideas from bad ideas? Why do certain
ideas survive in economic theory long after their emergence on the intellectual
scene? Why do other ideas fizzle quickly? Traditional economics courses have little
time for such issues, yet they are entirely appropriate within the context of intellec-
tual history, and, it turns out, the answers have an enormous impact on the content
of economics at any particular point of time.
Yet another benefit is a keener understanding of contemporary economic the-
ory by exposure to the shortcomings of past theories and the obstacles overcome by
the principles that survive. Some students will find the abstract theory of economics
more palatable—indeed, more understandable—when it is presented in a historical
context. But in the final analysis the only justification needed for studying the his-
tory of economic thought may be that the subject is interesting. Herpetology is the
narrow study of reptiles, especially snakes. When asked by a brash young student
what good snakes are, a noted herpetologist deftly replied, “Snakes are damned
interesting, that’s what good snakes are.” This defense is equally apt to a study of
the history of economics.

■ AIM, SCOPE, AND METHOD

The title of this book is intended to convey a desire to impart, alongside the
march of ideas, something of the intellectual framework that incubates and illus-
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4 A History of Economic Theory and Method

trates each writer’s economics. Understanding the thought process of the great
minds in economics provides valuable insights and lessons for today’s economists.
Thus, we employ the term “method” in an unpretentious way to convey a concern
for the overall structure of thought within which theoretical contributions emerge,
much as bricks and mortar, to hold the structure together. We do not identify
“method” with methodology, which is the study of method. Some method, or modus
operandi, is essential to any systematic form of reasoning, but we don’t address how
and why economists came to use the methods they did, or how analytical methods
differ from one another. Methodology is closely related to the sociology of knowl-
edge, which seeks to trace the origin of patterns of thought. Our historical treatment
of economics leaves methodology and/or the sociology of knowledge to the special-
ists who work this field. Existing studies that confront these issues, such as the late
Mark Blaug’s The Methodology of Economics, or How Economists Explain, may be
used profitably with A History of Economic Theory and Method, but unlike Blaug,
we do not attempt to present a history of methodology. In practice, this separation
of the history of economics from the methodology of economics is difficult to main-
tain because, according to the standard classification of economic literature estab-
lished by the American Economic Association, periodical literature dealing with the
former is lumped with periodical literature dealing with the latter. But we accept the
personal mantra that writers of textbooks must be wary of trying to do too much, as
well as actually accomplishing too little.
Principally, this is a textbook in the history of economic analysis, and its content
is dictated, more or less, by the subjects that have been treated by past and present
historians of economics, among whom we count ourselves. Some contributors to the
field of economics have simply been successful, and must be included on this crite-
rion alone. The names of Adam Smith, David Ricardo, Alfred Marshall, and John
Maynard Keynes readily come to mind. In other cases, selective judgment must be
exercised about whom to include and exclude. Although our selection of individuals
and topics may seem idiosyncratic to some, we stand ready to abide by the wisdom
of the marketplace, which is the ultimate arbiter of the usefulness of this book.
Standard history is the story of events. Intellectual history is the story of ideas.
This book is an exercise in intellectual history. Its primary emphasis is the evolution
of economic abstractions per se, although social and methodological issues are fre-
quently discussed as integral parts of the intellectual landscape. We believe that
economic theories do indeed have a life of their own, and that a study of their devel-
opment is interesting and beneficial to an educated mind. Any book of limited scope
will necessarily leave many questions unanswered, and this book is no exception.
What role, if any, does the environment play in the development of economic the-
ory? Do great empirical concerns (e.g., food shortages, income distribution, popula-
tion demographics, or the magnitude of unemployment and inflation) temper the
nature and direction of analytical inquiry? If economic abstractions really do have a
life of their own, has insularity led theorists to shut out potential areas of interest
and benefit to economics? How do ideas join forces and spread within countries and
between countries? How are ideas related to the times in which they emerge? How
does philosophy (or other disciplines) relate to economic theory? These and many
other questions impinge on intellectual history. We do not have conclusive answers
to these questions, but we offer this book as a device to deepen appreciation and
understanding of the issues.
We have tried to free our historical survey from particular and/or idiosyncratic
points of view, even while admitting the probability that this is impossible in a field
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Chapter 1 ■ Economics and Its History 5

as vast and varied as economics. We merely seek to expose the historical record for
what it is, leaving others to take the measure of the advantages and disadvantages
of any single view.

■ SUGGESTIONS ON HOW TO USE THIS BOOK

The history of economic thought is a vast field having many resources at its dis-
posal. Insofar as historians of thought are inevitably involved in interpreting (and
often reinterpreting) past ideas, it is a field that allows wide sway for different points
of view. It is easy for the neophyte to be overwhelmed with historical material.
Therefore we tentatively offer some guidance. The chapters in this book follow a
chronological progression, more or less, beginning with the ancient Greeks and con-
cluding with the first decade of the twenty-first century. We have tried to make each
chapter reasonably self-contained, while emphasizing key issues (often debatable)
along the way. Certain boxes have been placed in each chapter: One set of boxes is
called “The Force of Ideas”; the other is labeled “Method Squabbles.” The former
underscores certain key ideas from the past that have had a particular impact on
contemporary thought and practice. The latter marks certain procedural disagree-
ments or alternative approaches to economics that have rubbed against each other
through the march of time. Each box is freestanding, but it treats a topic that is inti-
mately related to the subject of the chapter within which it appears. At the end of
each chapter the reader will find a “References” section that contains bibliographic
information for all citations made in the chapter. Finally, there is a “Notes for Further
Reading” section, a bibliographic assemblage that offers more detail, depth, or
sophistication on the key individuals, concepts, and issues treated in each chapter.
Because the river of economic thought runs deep and wide, instructors may
find it necessary to impose narrower limits on the scope of their course than this
book presents. Our book is composed in such a way as to allow individual instruc-
tors to select some chapters and omit others. In such instances, care must be taken
by the instructor to supply necessary transitions, but we have tried to present the
material in such a way as to minimize this effort.

■ OTHER USEFUL RESOURCES AND INFORMATION

In addition to the storehouse of secondary literature contained in the “Notes for
Further Reading,” there are many other useful resources for the novice and the
advanced student alike. For the past several decades, Edward Elgar Publishing has
been rendering a singular service to the field by turning out books on the history of
economics, including multi-volume collections of reprints of primary and secondary
literature in the history of economics. Perusal of a recent Elgar catalog will reward
the interested scholar no less than the casually interested beginner with a number
of desirable additions to one’s library.
There are at least four English-language journals now devoted exclusively to
the history of economic thought. They are, in order of longevity, The History of Polit-
ical Economy (published at Duke University), the Journal of the History of Economic
Thought (published under the auspices of the History of Economics Society), the
History of Economic Ideas (published in Rome by an international group of editors),
and the European Journal of the History of Economic Thought (published and dis-
tributed by Routledge). Global interest in the history of economic thought is also
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6 A History of Economic Theory and Method

evident in the formation of societies to promote the subject in different countries.

Some of these societies are informal (e.g., in the UK and Europe), without an official
body of officers or constitution, whereas others are formal organizations with all the
official trappings (e.g., in the U.S.). Australia and Japan as well as North America
and Europe have established societies to promote the history of economics. If you
are interested in the activities of these societies, or membership in any of them, ask
your instructor for appropriate information, or search the Internet for details.
In a short span of time the Internet has become a superb tool for identifying,
locating, and disseminating information. A Web search using the phrase “history of
economics” will repay the effort multifold. But be forewarned—selection is called
for. At this writing, the most popular Internet search engine, Google, boasted
538,000,000 entries under this rubric.
Ekelund-Hebert Part 1.fm Page 7 Thursday, August 1, 2013 11:32 AM

Part I
PRECLASSICAL ECONOMICS

Economic theory developed as a consequence of the attempt to construct a scien-

tific explanation of society and the economy. This attempt reached a watershed in
1776 when Adam Smith published An Inquiry into the Nature and Causes of the
Wealth of Nations. As monumental as Smith’s work was in economics, he neverthe-
less built on an intellectual tradition of Western thought that reached back as far as
ancient Greece. Among other things, Smith derived from his intellectual ancestors a
belief in natural law. Natural law held that society was governed by an (unseen)
order, or set of rules, and that the job of the philosopher/scholar/scientist was to dis-
cover those rules through reason. The ancient Greeks—in particular, Plato and Aris-
totle—formed the first wave of natural law philosophers. The second wave was
represented by the medieval fathers of the Church, who are usually referred to as
the Scholastics. The Enlightenment shaped the third wave, and it is at this juncture
that we find Smith and many of his contemporaries.
Writers like Plato, Aristotle, and St. Thomas Aquinas lived in economic circum-
stances different from modernity. In the ancient and medieval societies basic eco-
nomic decisions were taken by tradition and command rather than by individual
economic agents acting within a system of open markets. Consequently, the lasting
influence on Western social thought of the earliest writers lies not so much in their
insights into the operation of market forces, but rather in their preconceptions
regarding the nature of social laws. They had a “prescientific” vision that estab-
lished a foundation on which “scientific” economics was slowly but surely erected
through time.
Chapter 2 takes a brief foray into Asian and Arabic thought, but concentrates
mostly on tracing the highlights of the Western natural law tradition as it developed
from antiquity to the emergence of merchant capitalism, or mercantilism. Chapter 3
surveys the mercantile period, emphasizing economic history alongside the history
of economic thought. Chapter 4 brings us closer to Adam Smith’s pivotal influence
by examining the ideas of his immediate predecessors who were inching ever closer
to a systematization of economic thought. Throughout this section you should be
alert to the progression of ideas over time, and the connection—sometimes immedi-
ate, sometimes remote—of thinkers with their predecessors. You should also be
aware that as Western Europe moved from feudalism to capitalism the consequent
changes in economic organization helped to shape intellectual activity.

7
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Ancient and Medieval Economic

Thought and Institutions

For most of human history, economics did not have a separate identity apart from
social thought in general. As late as the eighteenth century Adam Smith viewed eco-
nomics as a subset of jurisprudence. This makes the search for first principles of
economic reasoning more difficult, not because the intellectual cupboard of antiq-
uity was bare, but because the subject boundaries between the social sciences were
blurred beyond recognition. Economics attained its distinctive identity when it
came to be identified with a self-regulating market process, and the discovery of the
market as a self-regulating process was an eighteenth-century phenomenon. How-
ever, the seeds of economic analysis were sown long before, in ancient Greece, the
cradle of Western civilization.

■ CONTRIBUTIONS OF THE ANCIENT GREEKS

We start with the ancient Greeks because they gave us the best recorded history
on which to base our intellectual safari. Although enterprise flourished in ancient
Babylonia, Assyria, and neighboring lands, only scant surviving sources exist that
would allow us to identify a theory of economic activity. This is no less true for
Egypt, which, except for its military excursions, was more commercially self-con-
tained than other parts of the Near East. At any rate, Edward Bleiberg (“The Econ-
omy of Ancient Egypt,” pp. 1382–1383) maintains that the normal Egyptian state of
affairs was a redistributive economy.
The Greeks also give us a convenient starting point because in the Western
world our patterns of thought, the framework within which our ideas emerge and
circulate, the forms of language in which we express ideas, and the rules that gov-
ern them, are all products of antiquity. Thus, as Theodor Gomperz wrote, “Even
those who have no acquaintance with the doctrines and writings of the great mas-
ters of antiquity, and who have not even heard the names of Plato and Aristotle, are,
nevertheless, under the spell of their authority” (Greek Thinkers, p. 528). The very
word “economics” takes its name from Xenophon’s instructional treatise on effi-
cient management and leadership, the Oeconomicus.
What the ancient Greeks contributed to economics was a rational approach to
social science in general. Their economy may be described as “premarket,” not in
the sense that trade was absent, but rather in the sense that products were neither

9
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10 Part I ■ Preclassical Economics

uniform, nor traded on organized exchanges, nor analyzed for their own sake.
Greek thinkers were interested primarily in economic and organizational efficiency.
Their view of the world was anthropocentric, not mechanistic. In other words, man
was the center of all things. The ancient Greeks placed great stock in the self-regu-
lating capacities of individuals who sought to maximize human happiness by mak-
ing rational decisions, but they did not discover the key principle of modern
economics: the self-regulating marketplace.
Ancient Greek culture admitted two contrasting ideas of individualism. On the
one hand, an authoritarian ruler was empowered to make administrative decisions
on behalf of the interests of society. This led to the development of rational calcula-
tion based on the abstract definition of an individual as the basic social unit. On the
other hand, each family was patriarchal and success-driven, which led to the devel-
opment of the individual male citizen as a fundamental decision maker. These two
contrasting forms of individualism, “macro” and “micro” as it were, contributed to
the formal emphasis in Greek society on private household management (oikonom-
ics) and to the development of a hedonic calculus of rational self-interest.
Because the Greeks concentrated on elements of human control, they devel-
oped the art of administration rather than the science of economics. Their economy,
after all, was basic and simple. It consisted of primary agriculture and limited pal-
ace trade. The production of goods was supervised on large, landed estates and in
the halls of military chieftains. Warfare dominated political and economic life from
500 BC to 300 BC. As the focal point of religious and military activities, the state had
few nonmilitary expenditures. Nevertheless, in the course of elaborating the nature
of administration, the ancient Greeks developed analytic structures that have signif-
icance for economic theory. In particular, the following components of modern eco-
nomics originated in Greek thought: efficiency, resource allocation, the notion of
subjective value, the hedonic calculus, and the concept of diminishing marginal util-
ity. The major writers of this period who contributed to economic analysis were
Xenophon, Plato, Protagoras, and Aristotle.

Xenophon on Organization, Value, and the Division of Labor

Philip Wicksteed, a noted British economist of the nineteenth century, wrote that
economics “may be taken to include the study of the general principles of administra-
tion of resources, whether of an individual, a household, a business, or a State;
including the examination of the ways in which waste arises in all such administra-
tion” (Common Sense, p. 17). He might have had in mind the Greek philosopher,
Xenophon (c. 427–355 BC), whose writings are paeans to the science of administra-
tion. A decorated soldier and a student of Socrates, Xenophon couched his ideas in
terms of the individual decision maker, whether he was a military commander, public
administrator, or head of a household. He emphasized efficient, as opposed to ineffi-
cient, courses of action. In Oeconomicus he explored the proper organization and
administration of private and public affairs, and in Ways and Means he prescribed
the course of Athens’ economic revitalization in the middle of the fourth century BC.
For this Greek philosopher who regarded the material environment as fixed, the chief
element of good administration was human capacity, honed into good leadership.
A good manager strives to increase the size of the economic surplus of what-
ever unit he supervises, whether it is family, city, or state. Xenophon maintained
that this is accomplished through organization, skill, and division of labor. The divi-
sion of labor became the linchpin of economic growth in the writings of Adam
Smith, as we shall see in chapter 5, but its important economic implications were
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 11

recognized in antiquity. Xenophon attributed an increase in both the quantity and

the quality of goods to this organizing principle. Moreover, by exploring the rela-
tionship between population concentration and the development of specialized
skills and products he supplied the basis of Adam Smith’s famous dictum that spe-
cialization and division of labor are limited by the extent of the market.
Xenophon’s emphasis on the nature and importance of leadership, though not
formulated in the strict context of competitive markets, nevertheless provided a
prototype for an important element of economics that gained traction in the eigh-
teenth-century: the function and pivotal importance of the entrepreneur in a market
economy (see chapter 4). Entrepreneurship and its role in economic theory, as we
shall see throughout this volume, is a theme that has faded in and out of economic
theory through time.
Modern economists would say that the deficiency in Xenophon’s leader—that
exceptional individual who organizes human activity—is that he confronts the pow-
ers of nature seemingly unaware of the forces of a competitive economy. Although
the leader is motivated by self-interest, Xenophon decries acquisitive behavior as
“unnatural.” The “natural” economic process, he claims, consists of intelligent man
using perception and reason to extract from nature what is necessary to avoid dis-
comfort and fulfill human wants. The Greeks formalized the active and rational pur-
suit of pleasure and avoidance of pain in their doctrine of hedonism, an idea that
resurfaced many centuries later in the subjective theory of value that separated neo-
classical economics from classical economics (see chapters 12–17).
Even though his thinking is not set in an explicit market context, it is easy to
see how Xenophon’s concept of subjective value presages modern economic
thought. In one of his works, Hiero, Xenophon remarks that “the greater the num-
ber of superfluous dishes set before a man, the sooner a feeling of repletion comes
over him; and so, as regards the duration of his pleasure, too, the man who has
many courses put before him is worse off than the moderate liver” (Scripta Minora,
p. 9). The clear implication here is that extra satisfaction derived from consumption
falls as the quantity consumed increases, an idea that eventually entered formal
economic analysis as the principle of diminishing marginal utility. Xenophon also
grappled with the distinction between a purely individual subjective concept of
value and a more objective general concept of wealth, or property. His conclusion
was that wealth is a relative concept. Thus, in his discussion of estate management
he observed that “the same things are wealth and not wealth, according as one
understands or does not understand how to use them. A flute for example, is wealth
to one who is competent to play it, but to an incompetent person it is no better than
useless stones . . . unless he sells it . . .” in which case, “it becomes wealth” (Oeco-
nomicus, 1.10–13). Thus, in the end, “wealth is that from which a man can derive
profit,” but if it causes him harm, it is not wealth. “Even land is not wealth if it
makes us starve instead of supporting us” (Oeconomicus, 1.8).
The idea that value comes not from a good itself but from the pleasure it pro-
duces lies at the center of utility/value theory in contemporary economics. Xeno-
phon embellished the idea of subjective utility in the dialogue between Aristippus
and Socrates, where Aristippus asks, “Do you mean that the same things are both
beautiful and ugly?” Socrates replies, “Of course—and both good and bad. For what
is good for hunger is often bad for fever, and what is good for fever is bad for hun-
ger; what is beautiful for running is often ugly for wrestling, and what is beautiful
for wrestling ugly for running. For all things are good and beautiful in relation to
those purposes for which they are well adapted, bad and ugly in relation to those for
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12 Part I ■ Preclassical Economics

which they are ill adapted” (Xenophon, Memorabilia, III.8.6–7). This resort to sub-
jective evaluation in the measurement of good versus bad was an important premise
of Greek thought from the time of the early Sophists through Aristotle.

Plato and the Administrative Tradition

Whereas Xenophon focused on the practical nature of leadership and policy,
Plato (c. 427–347 BC) analyzed the entire political and economic structure of the
state. Both writers shared the view that human activity is the primary variable of
political economy and statecraft, but Plato searched for the optimum polity/econ-
omy by investigating and refining the moral imperative of justice. For Plato the opti-
mum state is a rigid, static, ideal construct from which any deviation whatsoever is
considered to be regressive.
Extending the concept of division of labor raised by Xenophon, Plato molds the
argument into an explanation of the origin of cities, which is an outgrowth of exchange.
The origin of the city . . . is to be found in the fact that we do not severally suffice
for our own needs, but each of us lacks many things. We, being in need of many
things, gather many into one place of abode as associates and helpers, and to this
dwelling we give the name city or state. . . . And between one man and another
there is an interchange of giving . . . and taking, because each supposes this to be
better for himself. (Republic, vol. 1, p. 149)

A city can be viewed from many different angles, of course, but in his explana-
tion, Plato starts us on the road to a theory of exchange. Specialization creates
mutual interdependence, and mutual interdependence establishes reciprocal
exchange. Although Plato did not go so far as to establish an actual theory of
exchange, he did confront the nature of economic distribution—which is inevitable
in any inquiry about justice.
Plato’s first principle in his discourse on justice is that specialization and divi-
sion of labor establish efficiency and productivity. How then, are the fruits of effi-
ciency and productivity to be distributed? Plato answered that goods and services
are distributed through a marketplace, with money as a token of exchange. But in
typically Greek fashion, he did not consider the marketplace capable of self-regula-
tion. He maintained that the marketplace, like the state, requires administrative
control. The elements of control that Plato sponsored were fiat money, which must
be managed to eliminate profit and usury, and certain “rules” of justice (i.e., custom
and tradition), which would have the effect of establishing distributive shares
according to strict mathematical principles.
In keeping with the ancient Greek administrative tradition, Plato based his ideal
state on wise and efficient leadership. Xenophon had recognized that profit seekers
make good managers as long as their excesses are curbed by appropriate adminis-
trative controls. Plato advanced this thinking further by devising the necessary con-
trols. Convinced that all forms of profit (including interest—the profit on money)
were threats to the status quo, he went to great lengths to insulate his leaders from
corruption. He proposed that communism be imposed on the rulers so that they not
be tempted by possessions or diverted from the task of wise governance. He sought
to make philosophers out of soldiers, in order to shape a ruling class of “guardians,”
who would combine the strength and discipline of the warrior with the wisdom and
understanding of the scholar. Aware of the benefits of specialization and division of
labor, Plato championed a kind of “class specialization” whereby an elite group of
capable and high-minded rulers would be trained to direct the political economy.
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 13

Plato on Democracy and “Public Choice”

The establishment of Plato’s ideal polity depends on elitism rather than on any
participative social process. Plato could only envision the ideal state as a conse-
quence of authority. To safeguard stratified social interests, the governing elite were
to be conditioned by censorship and communism of the family and property. In the
final analysis, justice was the product of superior intellectual authority, tempered by
administrative constraints. This view stands in stark contrast to those of Adam
Smith and the classical economists we will meet in part II, who believed that a cen-
tral value of liberty could only be achieved through individual participation and
freedom of action constrained by competitive forces.
Despite his advocacy of this ideal, however, Plato may have sensed the implau-
sibility of long-term equilibrium in a utopian society. He analyzed how states
“declined” from the ideal, offering implicit and explicit criticisms of various founda-
tions of the state known in his time. The following chart summarizes the regressive
decline from the just society envisioned by Plato.

State Form Central Value Ruled By

Aristocracy Justice Elite

Timocracy Honor Military Elite

Oligarchy (early) Wealth Rich

Money-Making
Oligarchy (late) (conspicuous consumption) New Rich

Democracy Equality Random Poor

Tyranny Fear Dictator

Plato maintained that states decline due to an excess of their central value. In
his mind, lust, greed, and wanton acquisitiveness were major culprits that could
undermine an established polity. From a contemporary perspective it is noteworthy
that while Plato listed tyranny as the worst of all states, he cited democracy as a
close second. Across the ages, Plato speaks to us derisively about a treasured form
of Western government and its potential dangers. But remember that Plato’s ideas
were limited to his own experience. The ancient world witnessed many varieties of
democracy, but none that mirrored the parliamentary or congressional forms of rep-
resentative democracy that we know today.
In his analysis of comparative forms of government Plato addressed two impor-
tant issues concerning democracy: (1) Why was it such an attractive state? and (2)
Why was it basically unstable, leading in the extreme to dictatorship? In the first
instance he maintained that democracy’s appeal comes on the one hand from the
individual liberty that permits each citizen to speak and act as she likes, and on the
other from the diversity of individual characters that it permits. According to Plato
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14 Part I ■ Preclassical Economics

democracy comprises a “bazaar of constitutions and characters,” which allows indi-

viduals to choose their form of government “cafeteria-style,” as it were. In the sec-
ond instance, despite the political and economic charms of democracy as it was
known, Plato considered it unstable. The logical outgrowth of democracy, he
argued, is anarchy, because it treats people as equal, whether they are equal or not.
Plato believed the excessive desire for liberty and equality that democracy promotes
eventually leads to its destruction. Offices are obtained by lot (or worse, by “sale”).
Furthermore, democracy tends to abuse those who obey authorities—as servile and
contemptible—and reserves its approval, in private and public life, for rulers who
behave like subjects and subjects who behave like rulers. In such a society the prin-
ciple of liberty is bound to go to extremes. Tyranny, for Plato, was the logical conse-
quence of democracy (Republic, vol. 2, pp. 305–307).
A democratic society is ripe for tyranny when a leader discovers that not every-
one can be satisfied all of the time. Because the majority rules in a democracy, lead-
ers rely on polls of public opinion and so base their judgments on sentiment,
prejudice, and self-interest, rather than justice. Elected rulers gain political advan-
tage by taking from the rich and giving to the poor. Thus, democracy encourages
redistributive battles that intensify when a tyrant (in Plato’s symbolic language, “the
wolf”) is raised up to “protect” the poor from their enemies. Once the tyrant has
“disposed of his foreign enemies by treaty or destruction, and has no more to fear
from them, he will in the first place continue to stir up war in order that the people
may continue to need a leader” (Republic, vol. 2, pp. 323–325). Moreover, high taxa-
tion in times of war keeps the masses busy earning their daily bread—and away
from ideas of freedom or rebellion—so that a tyrant must always be provoking war.
It follows that in Plato’s political landscape the descent to tyranny from democ-
racy is a natural evolution. Thus, it is no surprise that Plato placed his bet on
authority rather than democracy to establish the ideal state. Ironically, however, the
experience of Western civilization in the millennia since antiquity shows that where
absolute authority exists it is more likely to impose despotism than harmony. As a
result, democracy is upheld today as a Western ideal. To be sure, modern democra-
cies have tried to erect bulwarks against their devolution into tyranny, with prac-
tices such as federalism and the separation of executive, judicial, and legislative
powers. Nevertheless, representative democracies in the world today continue to
grapple with many of the problems Plato warned against—which makes his impor-
tant lessons worth remembering.

Protagoras and the Hedonic Calculus

Whereas Plato was an absolutist, Protagoras (c. 480–411 BC) was a relativist. He
held that there was no objective truth, only subjective opinion. This subjectivism is
exemplified in his famous maxim: “Man is the measure of all things.” In other
words, although truth cannot be discovered, utility can. According to Protagoras it
is up to the citizens of a state to decide what constitutes social welfare and how to
achieve it. As against the absolute authority of Plato, Protagoras extolled the demo-
cratic process. He put his faith in common sense rather than science, and trusted
the practical social experience of mankind as opposed to the doctrines of moral and
political theorists. Not surprisingly, Plato was one of his main critics.
Protagoras’s subjectivism is based on the interaction between human percep-
tion and physical phenomena. Formulated at a time when vision was believed to be
produced by light emanating from the eye (rather than entering it), it suggests an
active rather than a passive view of individualism. Plato challenged Protagoras’s
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 15

philosophy in his dialogue with Theaetetus. Recalling Protagoras’s dictum that

“each one of us is the measure of the things that are and those that are not,” Plato
responded, “but each person differs immeasurably from every other in just this, that
to one person some things appear and are, and to another person other things”
(Theaetetus, p. 95). Hence, Plato did not see how relativism could be accepted as the
basis for a proper polity. He rejected Protagoras’s belief that means are more impor-
tant than ends, stating that social stability is achieved by individual participation in
the wise choice of ends. (By analogy, economics maintains that market stability is
established by the active involvement of market participants.) Like the rest of the
ancient Greek philosophers, Protagoras was interested in the effects of leadership
and administration, but he insisted that the proper role of the administrator/leader
was to offer advice, not to rule absolutely. Administration, in other words, would
make its contribution through the informed choice of means to achieve given ends.
S. Todd Lowry makes certain claims on behalf of Protagoras. He asserts, sim-
ply: “What Protagoras claimed to teach sounds very much like political economy”
(“Greek Heritage,” p. 11). More specifically, Lowry claims that Protagoras’s man-
measure doctrine is the parent idea of both the labor theory of value and the idea of
subjective individualism. He also asserts that Protagoras anticipated two of the
most basic elements of modern economic theory: (1) the way the market maximizes
utility through its function of allocating resources, and (2) the use of hedonic mea-
surement in the evaluation of choice (Archaeology, p. 159). These claims are diffi-
cult to substantiate fully in view of the fact that Protagorean thought survives only
in secondary sources. Nevertheless, the Sophists, of whom Protagoras was one of
the earliest and greatest, definitely planted the seeds of certain ideas that were to
flower in the nineteenth century.

Aristotle and Two-Party Exchange

Aristotle (c. 384–322 BC) was interested in the analytic potential of comparing
utility measurements. In his Topics and Rhetoric he presented a systematic exami-
nation of the elements of choice appropriate to public decision making. Most impor-
tant for modern economic theory, Aristotle discussed value in terms of incremental
comparisons. However, his systematic comparisons of value based on subjective
marginal utility developed in a way completely unrelated to contemporary price the-
ory. It is most likely that Aristotle’s analysis of exchange was an attempt to deter-
mine the criteria for fairness on which the Athenian legal system was founded. In
any event, equity considerations dominated economic considerations in his analysis
of exchange.
It is important to note that Aristotle set out to analyze isolated exchange as
opposed to market exchange. The difference is vital to understanding both the proce-
dure and conclusions of the Aristotelian model. Economists define isolated exchange
as two parties exchanging goods in conjunction with their own subjective prefer-
ences, without reference to any alternative market opportunities. Market exchange,
on the other hand, takes place when individual traders arrive at their decisions from
their awareness of continuous, pervasive trading among large numbers of partici-
pants in an organized and informed market. In market exchange, the publicly known
price is the end result of an impartial working out of the interests of many buyers and
sellers. In isolated exchange, by contrast, there is no going market price established
by large-numbers feedback. Absent the interplay of large numbers of market partici-
pants, the fairness of each transaction can only be determined by a disinterested
third party, such as judge or arbitrator. Moreover, the judgment must be rendered on
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16 Part I ■ Preclassical Economics

a case-by-case basis. Isolated exchange was a commonplace of Aristotle’s experi-

ence, and it remains fairly common today in preindustrial economies, where primi-
tive or idiosyncratic production techniques lead to highly differentiated products.
The Nature of the Polity. Although he was Plato’s prize pupil, Aristotle rejected
his master’s notion of the ideal state. Instead he favored a mixed economy that
allowed greater play for economic incentives. Unlike Plato, who defended private
property only for the nonrulers, Aristotle defended private property for all classes—
on the grounds that it promotes economic efficiency, engenders social peace, and
encourages the development of moral character.
In Aristotle’s day the Athenian polity functioned mainly as a distributive econ-
omy. Wealth and privilege were distributed by custom, tradition, and government
directives. Among the things distributed were: honors of all sorts, free public meals,
public entertainment, rations of grain, profits from the silver mines at Laurium, and
payments to many citizens for jury duty and for attendance at public assemblies.
These “entitlements” became the prerogative of every Greek citizen, and Aristotle
viewed them as protection against an unfettered democracy. His central civic con-
cern, therefore, was distributive justice.
The Nature of Trade. Aristotle’s analysis of two-party exchange arose from
his focus on distributive justice. He viewed exchange as a bilateral process that
made both parties better off. Exchange is induced when two parties to a potential
trade each have a surplus that they are willing to give up in return for one another’s
goods. Thus, exchange is built on the notion of reciprocity. His analysis proceeds on
a judicial rather than a commercial footing. Consider the following passage in
which Aristotle analyzes exchange by barter:
Now proportionate return is secured by cross-conjunction. Let A be a builder, B a
shoemaker, C a house, D a shoe. The builder, then, must get from the shoemaker
the latter’s work, and must himself give him in return his own. If, then, first there
is proportionate equality of goods, and then reciprocal action takes place, the
result we mention will be effected. If not, the bargain is not equal, and does not
hold; for there is nothing to prevent the work of the one being better than that of
the other; they must therefore be equated. . . . This is why all things that are
exchanged must be somehow comparable. It is for this end that money has been
introduced, and it becomes in a sense an intermediate; for it measures all things,
and therefore, the excess and the defect—how many shoes are equal to a house or
to a given amount of food. The number of shoes exchanged for a house must there-
fore correspond to the ratio of builder to shoemaker. For if this be not so, there will
be no exchange and no intercourse. And this proportion will not be effected unless
the goods are somehow equal. All goods must therefore be measured by some one
thing, as we said before. Now this unit is in truth demand, which holds all things
together . . . ; but money has become by convention a sort of representative of
demand; and this is why it has the name “money”—because it exists not by nature
but by law and it is in our power to change it and make it useless. There will, then,
be reciprocity when the terms have been equated so that as farmer is to shoe-
maker, the amount of the shoemaker’s work is to that of the farmer’s work for
which it exchanges. (Nichomachean Ethics, 1133a5–30)

This passage plus other elaborations by Aristotle became the subject of intense
and repeated examination by the Scholastic writers of the Middle Ages (see this
chapter, below), who were also concerned primarily with distributive justice. Notice
that Aristotle’s notion of demand is basically empirical; it is something “which holds
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 17

all things together” and its popular measure is “money.” It is not clear what meaning
we should attribute to the phrase, “holds all things together,” but one clear implica-
tion is that demand constitutes an essential element of trade. Obviously, supply is
the other, and the interaction of the two, in Aristotle’s mind, constitutes reciprocity.
Aristotle’s analysis of two-party exchange does not move us very close to an anal-
ysis of market price because its rudimentary notions of demand and supply are limited
to single market participants, and the “comparability” standard on which “equilib-
rium” rests, remains obscure. In the final sentence from the passage above it would
appear that “equilibrium” trade depends on a rough equality between the work (effort)
of the buyer and seller. Here, in embryonic form, we find the root of the idea that later
came to be known as the labor theory of value in classical economics (see part II).
Later writers tried to give Aristotle’s analysis geometric form. In his fourteenth-
century commentary on Aristotle’s works Nicole Oresme presented the diagram re-
produced here as figure 2-1. Unfortunately, this geometric “model” does not clarify
the fundamental economic issues. De-
spite its apparent resemblance to mod-
Carpenter Shoemaker
ern supply and demand curves, the
cross-diagonals of figure 2-1 are not A B
functional relationships in a mathemati-
cal sense. Furthermore, there is no rec-
ognition of price, although there is the
suggestion of a kind of equilibrium that
equates subjective utilities.1 Moreover,
the figure reveals nothing about the dis-
tribution of benefit between the two
traders or of the justice of the exchange
within the limits of voluntary choice. C D
Persistent confusions about the
Aristotelian exchange model should not House Shoes
be allowed to obscure the fact that it
became an important foundation for the
prolonged discussions of value that sub-
Figure 2-1 If the carpenter and the
sequently emerged in the Middle Ages shoemaker trade at the intersection of
(discussed below). If nothing else, Aris- the diagonals, then proportional com-
totle’s exchange model established pensation is achieved.
important preconditions for trade, and
these premises became part and parcel of early economic analysis. For example,
Aristotle clearly established the following propositions:
1. Trade arises only when surpluses exist.
2. There must be differing subjective estimates among traders of the worth of each
surplus.
3. Traders must establish a rapport that recognizes the potential mutual advantage
from exchange.
4. If a dispute arises in isolated exchange regarding the specific allocation of bene-
fits, the proper shares will have to be determined by an administrative authority,
taking into account the rules of common justice and the welfare of the state.

1
In fact, the diagram is reminiscent of one used by W. S. Jevons, one of the founders of marginal-util-
ity analysis, in 1871 (see chap. 14). Jevons acknowledged Aristotle’s influence on his own thought.
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18 Part I ■ Preclassical Economics

Aristotle also left an imprint on the theory of value in other ways. For example,
he approached the subject in terms of incremental comparisons. Thus, he observed
that “a thing is more desirable if, when added to a lesser good, it makes the whole a
greater good. Likewise, you should judge by means of subtraction: for the thing
upon whose subtraction the remainder is a lesser good may be taken to be a greater
good, whichever it be whose subtraction makes the remainder a lesser good” (Top-
ics, 118b 15). He also took account of scarcity and use value, alluding to the famous
water–diamonds paradox elaborated by Adam Smith (see chapter 5). “What is rare
is a greater good than what is plentiful,” he maintained, “thus, gold is a better thing
than iron, though less useful: it is harder to get, and therefore better worth getting”
(Topics, 1364 20–25). “What is often useful surpasses what is seldom useful,” Aristo-
tle said, and quoted Pindar to the effect that “the best of things is water.” His ordinal
ranking of human wants in the Politics also presaged the theory of the great Aus-
trian economist, Carl Menger (see chapter 14).

Aristotle on Money and Interest

Aristotle’s theory of money rationalized both the origin of money and its func-
tions. The passage about reciprocity quoted above from the Ethics underscores his
perception of money as a standard of value and a medium of exchange. He also rec-
ognized money as a store of value by observing that “if we do not need a thing now
we shall have it if ever we do need it—money is as it were our surety; for it must be
possible for us to get what we want by bringing the money” (Nichomachean Ethics,
1133b 10). Some scholars even argue that the modern idea of money as a contrac-
tual standard of deferred payment is implicit in Aristotle’s analysis of usury.
Of course Aristotle wrote before the creation of paper money and banking, but
he nevertheless spelled out the properties required of money in the fourth century,
BC, when gold was the common currency. Although gold has been replaced by fiat
currency in modern times, the properties of money designated by Aristotle are nev-
ertheless just as meaningful now as they were then. The five properties specified by
Aristotle are:
1. Durability. Gold makes good money because it won’t evaporate, mildew, rust,
crumble, break or rot. Gold is chemically inert, which makes for a lasting
medium of exchange.
2. Divisibility. Whether bullion, dust, or coin, one ounce of gold is exactly 1/100 of
one hundred ounces. Hence it is divisible without depreciation of its value. By
contrast, when a diamond is split, its full value may be destroyed.
3. Convenience. Gold allows the owner to carry his money with him. Real estate stays
where it is and equivalent value of many other metals may be too heavy to carry.
4. Uniformity. Only one grade exists for 24-carat gold, so there is no danger of
owning 24-carat gold varying in quality. Pure gold is the same in every time and
place because it is a natural element, unlike gemstones, artwork, land, corn, or
other commodities.
5. Intrinsic value. Gold finds many uses other than money. Of all the metals, it is the
most malleable, most ductile, and the least reactive. Next to silver (another popular
form of money in ancient times), it is the most conductive of heat and electricity.2

2
While these five characteristics, taken together, make gold uniquely suited as a medium of
exchange and a store of value, it is important to note that arguments that gold’s value is “mystical”
are silly—it is simply one of the 92 natural elements.
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 19

Aristotle’s concern with justice and the administrative nature of the economy
led him to a discussion of money as an object of acquisitive behavior, and particu-
larly to an examination of interest as an “unnatural” return. Modern economic
thought regards acquisitive behavior as a healthy manifestation of self-interest,
which can be demonstrated to have beneficial effects through the restraints placed
on it by competition. To the Greek mind, however, which did not grasp the self-reg-
ulating character of the marketplace, unrestrained acquisitive behavior was a threat
to social and economic stability. Aristotle believed that coined money permitted the
development of “unnecessary” exchange, which was to be discouraged in the
“good” state. In the context of ancient Greece, unnecessary exchange is exchange
without a natural limit. Unlike the necessary exchange of households, which was
restrained by the limited wants of the family and by diminishing marginal utility,
unnecessary exchange (i.e., retail trade) occurs merely for the purpose of accumu-
lating wealth for its own sake. In other words, although Aristotle recognized the use
of exchange to satisfy (natural) individual and collective wants, he did not approve
of the use of exchange as a mere device for accumulating wealth. Since such accu-
mulation was without natural limit, its relentless pursuit runs the risk of impover-
ishing the many in order to profit the few—a violation of distributive justice.
To Aristotle, the natural use of money was to spend it. He regarded hoarding, or
accumulation for its own sake, as unnatural and, therefore, condemned it. Insofar
as there can be no lending without previous accumulation, lending, too, was sus-
pect. It is this kind of thinking that underlies Aristotle’s condemnation of interest as
“unnatural.” He equated interest with usury and condemned both because in his
view it is not “natural” that money (considered as a medium of exchange) should
reproduce itself solely by passing from hand to hand. Unfortunately, he never grap-
pled with the question of why interest is paid in the first place. In other words, Aris-
totle did not develop a theory of interest, even though he had a primitive theory of
money to which he linked interest.
Looking backward through the millennia, it is clear that what the Greeks con-
tributed to Western thought was a rational approach to social science. Their ideas
established a continuum that stretched from the microeconomic values of the basic
production/consumption unit of the household to the macroeconomic values of hap-
piness and self-sufficiency of the collective citizenry. What they did not grasp is the
concept of the marketplace as a self-regulating mechanism. Thus, their framework
of analysis was anthropocentric and administrative. (For more on the Greek legacy
to economic thought, see the box, Method Squabbles 1: What Can Economists [or
Anyone] Know?)

Method Squabbles 1: What Can Economists (or Anyone) Know?

In economics, as in any field of knowledge, one of the most fundamental questions that any-
one can ask is whether and under what circumstances we can know anything. Alternative views
about knowledge and change have shaped the way economists have analyzed the world.
This issue bedeviled the early Greek philosophers, who originated the mother of all
method controversies. The critical issue is the basis of knowledge itself. Method controversies
about the nature of change began to gather steam in the earliest days of Greek philosophy.*
One group of pre-Socratics, led by the philosopher Heraclitus, based their arguments about
change on a perpetual and ever-fluctuating view of the world. We might call this the dynamic

(continued)
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20 Part I ■ Preclassical Economics

method of analyzing change. The opposing view was that of another Greek philosopher, Zeno
the Eleatic. He adopted a static view, which held that all change is mere surface appearance
generated by unreal and unreliable sense experience. In this static view the world is unchang-
ing and predictable.
Although daily events appeared to contradict Zeno’s conception, philosophers such as
Plato and Aristotle adopted the static view, and it became the dominant philosophical pre-
conception for more than two thousand years. Zeno and his followers searched for the “per-
manent attributes” of nature that lay behind the surface world of sense experience. This world
permitted change, but that change was “predictable” as in, say, regular cycles of business
activity. This kind of world (in which A causes B; B causes C; therefore A causes C) was ulti-
mately dubbed “static” and was said to be “deterministic.” Perhaps more than anyone else, the
French astronomer and mathematician, Pierre Laplace, captured the essence of determinism
with his famous remark that if he knew the state of every particle in the universe at any given
moment, he would be able to predict the future course of events throughout eternity. This
static view of the world dominated Western thought and became an integral part of some sci-
ences, including economics.
The opposing view—one of perpetual change—resurfaced in the nineteenth century in
the work of Charles Darwin, whose Origin of the Species (1859) emphasized the dynamism of
biological evolution. As a result, biology and other life sciences have come to be dominated
by a more dynamic view of “how the world works,” thereby providing a counterpoint to the
more orthodox and accepted static view of other sciences.
Economics, as will become evident throughout this book, has not escaped this fundamental
philosophical controversy about knowledge and what we can know. Formal or empirical eco-
nomic models or theories, especially those within the main tradition of “neoclassical” econom-
ics that prevails today, are highly deterministic. In the standard economic “model” conditions
surrounding some “event” are specified and the model then predicts the outcome. For exam-
ple, if the demand for computer chips rises, given theorized or empirically specified supply
conditions, the price and quantity of computer chips will rise. This kind of predictive theorizing
is simply an extension of determinism and a belief in “natural laws” subscribed to by a wide
variety of eighteenth century “Enlightenment” philosophers. As we will see in chapter 5, Adam
Smith—the founder of economics—was one of these philosophers. His emphasis on the “invis-
ible hand” as an immutable universal law of nature is a latter-day reflection of Zeno’s view.
The static view had and continues to have an enormous impact on the method by which
economists study their field. But Heraclitan dynamics has had an important influence, too.
Shortly after the promulgation of Darwinian principles, the American economist Thorstein
Veblen criticized orthodox economics as “old-fashioned” because it did not utilize dynamic
and evolutionary methods (manifest by Darwinian biology). About this time another famous
economist, Joseph Schumpeter, introduced a new evolutionary theory of economic develop-
ment that relied heavily on dynamic theories of change. Veblen and Schumpeter did not con-
vince their contemporaries to replace the static method with the dynamic one, but the study
of economics periodically undergoes new “revolutions” aiming to analyze institutional
change from a dynamic perspective.
Which view of change will ultimately dominate: Zeno’s static view or Heraclitus’s dynam-
ics? One hindrance to dynamic discussions or theories of change is that if all factors relating to
the economy or particular events are in constant flux, the future is not predictable. And econ-
omists, perhaps along with all scientists, want to be able to predict, at least within limits. Both
of these views, as will be shown throughout this book, have support in the discipline of eco-
nomics. The opposing views of two ancient Greek philosophers will continue to fuel debates
over method in economics. Look for them as you read through this book.
*Some of this discussion follows Alfred Chalk, “Schumpeter’s Views on Philosophy and Economics.”
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 21

■ ROMAN AND EARLY CHRISTIAN CONTRIBUTIONS

Economic details are available for only about two centuries of Roman history,
circa 150 BC to AD 50. Little genuine analytical work emerged during this period,
however, because the focus was mainly military and political. By the time Rome
reached the pinnacle of its power, important commercial interests had developed and
spread throughout the empire. And by the end of the Roman Republic there were
enough economic problems—problems of trade, finance, war, colonization, and slav-
ery, to name a few—to employ a legion of economists and government advisers. But
for all its power and ensuing troubles, Rome shared the oligarchic ethic of ancient
Greece. The major ways to accumulate wealth were by conquest, piracy, slave cap-
ture and trade, money lending, tax farming, and kindred predatory activities.
In other words, the social structure of ancient Rome was not congenial to
purely entrepreneurial activities or to extensive reflection on the behavior of mar-
kets. From the bottom up, Roman society consisted of slaves, peasants, artisans,
and traders, capped by a civil and military aristocracy. Although the aristocracy nur-
tured a considerable interest in Greek philosophy and art, it did so more as an avo-
cation than a vocation, with the predictable result that little serious analytical
advance in economics occurred.
The one great achievement of Roman society was the law. From a social stand-
point, it was the crowning glory of one of the greatest empires in the history of the
world. Roman law was divided into a civil law that applied only to relations between
citizens (jus civile) and a kind of common law—though not in the English sense—
that ruled commercial and other relations between noncitizens or between citizens
and noncitizens (jus gentium). This last body of law became a repository of eco-
nomic principles that later provided a starting point for economic analysis, espe-
cially in the Middle Ages. The Roman law of property and contract, for example,
subsequently became the mainstay of legal systems in the Western world. The con-
cept of natural law, which can be traced back to Aristotle, found its way into Roman
law, where it was used as a touchstone for determining the validity of human legis-
lation. Finally, the modern doctrine of the corporation can be traced back to Roman
law.3 In general, Roman law provided a frame on which the economics of a later day
was slowly but surely mounted. The focal point of later discussions of market price,
for example, is found in the Justinian Code:
The prices of things function not according to the whim or utility of individuals,
but according to the common estimate. A man who has a son whom he would ran-
som for a very large sum is not richer by that amount. Nor does he who possesses
another man’s son possess the sum for which he could sell him to his father; nor is
that amount to be expected when he sells him. In the present circumstances he is
evaluated as a man and not as somebody’s son. . . . Time and place, however, bring
about some variations in price. [Olive] oil will not be evaluated the same in Rome
as in Spain, nor, since here as well prices are not constituted by momentary influ-
ences, nor by occasional scarcity, will it be evaluated the same in times of pro-
longed sterility as in times of abundant harvest. (Corpus Iuris Civilis, in Dempsey,
p. 473)

It is worth noting that from the time of the fall of Rome to the end of the eighteenth
century, most of the writers on economics were by profession either businessmen or
3
An excellent, brief historical treatment of the modern corporation is contained in Robert Hessen’s
In Defense of the Corporation. Curiously, Hessen does not trace the concept back as far as Roman
law, stopping instead at the Middle Ages.
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22 Part I ■ Preclassical Economics

lawyers. If they were lawyers, moreover, they were either clergymen trained in
canon law or jurists trained in civil law.
The rise of Christianity overlapped the decline of the Roman Empire and
offered a different kind of civilizing influence. Rome’s efforts at civilizing its annex-
ations pretty much began and ended with the establishment of law and order. The
only message it offered to those outside its jurisdictional limits was military surren-
der. Perhaps for this reason its social and political order was inherently unstable.
Christianity offered a different message, one that proved to be an inspiration and a
rallying point for millions of people, but one not especially fruitful for the advance
of economic analysis until after a period of consolidation.
Early Christian thought treated the kingdom of God as being near at hand, and
so it emphasized “other worldly” treasures. Production and material welfare would
be superfluous in the kingdom of God. Indeed, earthly treasures were regarded as
an impediment to the attainment of this heavenly kingdom. As the passage of time
made the comings of this kingdom seem more distant, wealth came to be looked on
as a gift of God, furnished to promote human welfare. Christian thought therefore
came to center on the “right” use of material gifts, an idea that persisted in medieval
economic thought. Thus, St. Basil (c. 330–379) wrote:
The good man . . . neither turns his heart to wealth when he has it, nor seeks after
it if he has it not. He treats what is given him not for his selfish enjoyment, but for
wise administration. (Works of St. Basil, in Gray, p. 52)

This kind of writing is more prescriptive than analytical. The same could be
said of the early writings of Saints John Chrysostom (c. 347–407), Jerome (c. 347–
419), Ambrose (c. 339–397), and, to a lesser extent, Augustine (c. 354–430). Augus-
tine went further than the others in that he pointed the way to a subjective theory of
value, where wants are individually determined. See if you can detect the subtle
influence of Aristotle and/or Protagoras in this passage from The City of God:
There is . . . a different value set upon each thing proportionate to its use . . . very
frequently a horse is held more dear than a slave, or a jewel more precious than a
maid servant. Since every man has the power of forming his own mind as he
wishes, there is very little agreement between the choice of a man who through
necessity stands in real need of an object and of one who hankers after a thing
merely for pleasure. (in Dempsey, p. 475)

By and large, however, the early Christian writers treated economic topics with
indifference, if not hostility. They were primarily interested in the morality of indi-
vidual behavior. The how and why of economic mechanisms seemed to be of no
interest to the Church’s leaders or its writers.

■ CHINESE ECONOMICS IN THE FIRST MILLENNIUM

China is one of the world’s oldest civilizations, but its intellectual history
remains inaccessible to many Westerners because of its long-time geographic, cul-
tural, and linguistic isolation. Chang (“History of Chinese Economic Thought”)
maintains that Chinese economic thinking originated mainly during the Eastern
Chou Dynasty (771–249 BC), a period that partially overlaps with the age of Greek
antiquity. The Chou Dynasty was marked by steady decline in the authority of the
monarchy and the aristocracy on the one hand and the emergence of the kingdom’s
fiefs as independent states on the other. Economically the productivity of land
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 23

increased; monetization and specialization grew; merchants, cities, and market-

places emerged; and the contrast between rich and poor became sharper. Three
groups of writers, the Confucianists, the Legalists, and the Moists, dealt with eco-
nomic issues during this golden age of Chinese philosophy.

Confucius and His Followers

Like his contemporaries in ancient Greece, Confucius (551–479 BC), was preoc-
cupied with moral issues. He promulgated an ethical system of order that regulates
all natural and social phenomena, including the movement of heavenly bodies, the
variation of seasons, the rise and fall of governments, and all interpersonal rela-
tions. Aside from the sweeping nature of this system, one finds certain parallels
with Greek antiquity. In the Confucian society, interpersonal obligations are recip-
rocal. The ascendancy of rulers is not based on heredity but on virtue and ability.
The state is legitimized by a set of ethical norms and rules that are codified by leg-
endary sages and is governed by men who derive authority through moral influence
rather than law, coercion, or divine spirits. In Confucius’s hierarchical society, each
person has a unique role, and social harmony results only if every person under-
stands and carries out his role. The ideal Confucian society is not driven by per-
sonal gain but is propelled by people’s desire to serve the common good. These
ideas, as simple and direct as they are, set the scope of Chinese economic thinking
for centuries to follow. Chief among Confucius’s precepts were:
1. Taxes should derive from people’s productive abilities and should be limited to
one-tenth of the produce of the land.
2. Government spending, which includes palace expenditures, should be adjusted
to government revenues, not the other way around.
3. Living standards should conform to each person’s social status, without extremes
of lavishness or parsimony.
4. The foremost obligation of the ruler is the well-being of the people.
5. Government should maintain a general posture of noninterference, yet provide
assistance to production and sustain equitable distribution of income when nec-
essary.
Ambiguities in this program (for example, item 5) became increasingly trouble-
some after Confucius’s death and led to squabbles among his followers about the
essence of human nature and about the proper role of government in the economy.
One of Confucius’s disciples, Mencius (c. 372–287 BC), believed that individuals are
inherently good and that government should promote the public welfare by a policy
of noninterference; another, Hsun-tzu (c. 300–237 BC), held that people are domi-
nated by evil impulses, and he advocated a more authoritarian government.

The Legalists
Han-fei-tzu (280–233 BC), one of Hsun-tzu’s disciples, believed—following his
teacher—that people are motivated primarily by self-interest. Han-fei-tzu believed
that social order and economic progress would only result from the strict, central-
ized control of rewards and punishments. Aware that a Confucian society would
function well only if individuals were guided by moral principles and kings were
wise rulers, Han-fei-tzu argued that in reality societies are headed only by average
rulers and that avarice is the rule rather than the exception. Another legalist, the
innovative administrator Kuan Chung (c. 730–645 BC), rejected Confucian methods
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24 Part I ■ Preclassical Economics

of decentralization, moral suasion, and personal virtue in favor of centralized state

power and legal mechanisms of control. His followers, working vigorously to stamp
out the remnants of the old aristocracy from Chinese society, wrote on such topics
as monetary and fiscal policies, government monopoly, price stabilization, popula-
tion, agriculture, and commerce.

The Moists
A third school of economic thinkers was led by Mo Ti (c. 479–438 BC), who stud-
ied under disciples of Confucius but later rejected their teachings. Disillusioned by
Confucianists who rejected their learned principles in favor of personal gain, Mo Ti
saw the Confucianists’ failure to deal with existing chaos and misery as flaws in
their thinking. Like Confucianists, Moists sought to promote economic harmony
and welfare under existing monarchical regimes, but they differed on matters of
implementation. Mo Ti believed in a kind of universal brotherly love as an antidote
to mankind’s natural inclinations toward selfishness and injustice. He was opposed
to class distinctions, luxury, and ostentation. He favored social mobility, peace,
order, national wealth, and a large population. His concept of division of labor,
focusing on the advantages of specialization, was quite advanced for his time. Mo Ti
was also strongly confident of government effectiveness if directed by a disciplined
hierarchy and a strong sovereign. He organized his disciples according to strict mil-
itary and authoritarian principles, which encouraged a religious zeal and authori-
tarian spirit unmatched in ancient China.
This kind of diversity of thought did more to highlight contentious issues than
to produce a unified field of economic analysis. Like their Greek counterparts in the
ancient Western world, Chinese philosophers cast economic inquiry in the frame of
morality and ethics. Their analyses were influenced by the institutional makeup of
the societies of their time, in which the marketplace was never conceived as a mech-
anism that was capable of regulating itself by allowing the free play of individual
self-interest. Quite naturally, therefore, economics was regarded as a branch of
moral philosophy—a tendency that continued in the East as well as the West well
into the eighteenth century.

■ MEDIEVAL ARAB-ISLAMIC ECONOMICS

Whereas the contribution of ancient Greek philosophers to economic analysis
is sometimes debated, the influence of Arab-Islamic thought has been persistently
neglected. Historians acknowledge, however, that the death of the last Roman
emperor in 476 ushered in a long period of secular decline in the West and a con-
comitant rise in the power and influence of the East. For five centuries, from AD 700
to 1200, Islam led the world in power, organization, and extent of government; in
social refinements and standards of living; and in literature, scholarship, science,
medicine, and philosophy. Moreover, it was Muslim science that preserved and
developed Greek mathematics, physics, chemistry, astronomy, and medicine during
this half millennium, while the West was sinking into what historians commonly call
the Dark Ages. By 730 the Muslim empire reached from Spain and southern France
to the borders of China and India; it was an empire of spectacular strength and
grace. In this expanded capacity, the Arab world provided a bridge across which
Greek and Hindu wisdom and culture traveled to the West. Perhaps the most signif-
icant, single innovation that the medieval Arab scholars contributed to the West was
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 25

their system of writing numbers. Arabic numerals displaced the clumsy Roman
numerals of the previous empire. In addition, one of the more eccentric Arab math-
ematicians, Alhazen, founded the modern theory of optics around the year 1000.
But for our purposes, the most important contribution of Arab culture was its rein-
troduction of Aristotle to the West.
A substantial body of economic knowledge is attributable to no less than thirty
Arabic scholars of the medieval period, who, like the clerics of medieval Christen-
dom discussed in the next section, focused on the possibility of reconciling reason
with faith. They viewed economics not as an end in itself but as a means to an end.
The end was salvation; hence economic activities were seen as part of the earthly
struggle to earn heaven. It can be said that Muslim society believed in homo Islam-
icus, not homo oeconomicus. Thus, Muslim philosophy showed little concern for the
validity of certain economic formulations. Instead, it emphasized how economic
ideas were treated in relation to ethical and political principles. In Islam there is no
tradition of positive law derived from human reason. The law is derived from
Shari’a, an expression of divine will, from which jurists and theologians develop
ethical, social, and economic principles. This makes comparison between Muslim
economics and Western economics highly problematic. Nevertheless, a brief review
of Muslim medieval economic thought serves to underscore a strain of continuity
between the philosophical inquiry of the ancient Greeks and that of medieval Euro-
pean scholars. Space constraints do not permit a comprehensive survey of the
entire medieval Arabic intellectual tradition. Instead, we shall concentrate on the
main link in a chain of Islamic thought that stretched from the eleventh to the four-
teenth centuries.
Abu Hamid al-Ghazali (1058–1111) is a mirror of this tradition. He developed
what might be called a social welfare function based on consideration of utilities
(masalih) and disutilities (mafasid). Although salvation is the ultimate goal of human
action, the pursuit of economic activities is a necessary part of achieving that goal
because human beings would perish without them (Ihya, 2:32, in Ghazanfar and
Islahi, p. 384). Economic efficiency is therefore seen merely as an aspect of fulfilling
one’s religious imperatives (Ihya, 2:249, 3:236; Mizan, 377—in Ghazanfar and Islahi,
p. 384). Following Aristotle, Ghazali stressed a “middle path,” or “golden mean,” and
the “correctness” of intentions in all actions. When intentions are consistent with
divine will, he asserted, then economic activities become a kind of worship—part of
one’s calling (Ihya, 2:83—in Ghazanfar and Islahi, p. 384).4 He recognized three
sources of wealth: individual earnings, profit from exchange, and acquisition by
bequest or discovery. The European Scholastics (see next section) accepted many of
his views and made them part of their medieval philosophy because he made sci-
ence, philosophy, and reason subservient to religion and theology.
Ghazali made specific contributions to four major areas of economic thought:
(1) voluntary exchange and markets; (2) the nature of production; (3) money and
interest; and (4) public finance. For Ghazali, markets—the mechanism within which
voluntary exchange takes place—evolve as part of the natural order of things. Trade
adds value to goods by making them available at a convenient time and place. Peo-
ple are acquisitive by nature, and they will seek to maximize their individual situa-
tions. Although he did not regard wealth accumulation as the noblest of activities,
he recognized it as essential to the proper functioning of a progressive economy.
4
S. M. Ghazanfar and A. A. Islahi (“Economic Thought of an Arab Scholastic,” p. 386) suggest that
Ghazali laid the foundation for what later became known as the “spirit of capitalism.” See, for
example, Max Weber, Protestant Ethic.
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26 Part I ■ Preclassical Economics

The mutuality of exchange necessitates specialization and division of labor with

respect to resources and regions, which leads, among other things, to the creation
of profit-motivated middlemen. Although Ghazali did not grasp the modern tech-
nique of demand and supply analysis, his discussion of prices and profits fits easily
into the modern framework. He had an intuitive understanding of the concept of
price elasticity, and a primitive notion of equilibrium price.5 Like all medieval writ-
ers, Ghazali based his discussion of markets on an ethical-moral code of conduct
that roundly condemned secrecy, deception, manipulation, and profiteering.
Ghazali classified production activities in terms of their social importance,
emphasizing fundamental Islamic principles of duty and responsibility. Apart from
its moral roots, his hierarchy of production is reminiscent of Adam Smith’s ranking
many centuries later. For Ghazali, output resolves itself into primary production
(agriculture), secondary production (manufacturing), and tertiary production (ser-
vices). He regarded the first category as the most important—even to the extent of
requiring the state to be a mediating force in order to prevent agriculture’s decline.
But he made it clear that proper social harmony requires the active pursuit and pro-
motion of all three levels of production. Within any given level of production,
Ghazali was conscious of the linkages that exist in the production chain. Thus, he
speaks of how the farmer produces grain, the miller turns it into flour, and the baker
converts the flour into bread. These linkages require specialization and division of
labor as well as cooperation and coordination. In driving home his point, Ghazali
described how needles are made by passing through multiple transformative
stages—thus anticipating the famous pin factory example espoused by Adam Smith
more than half a millennium later (see chapter 5).
Ghazali recognized that money evolved in order to overcome the deficiencies of
barter: in particular, the lack of mutual coincidence of wants between traders. He
seemed to be aware of the distinction between use value and exchange value, but he
took the curious position that gold and silver money have no intrinsic value. In other
words, he argued that gold and silver have no value other than exchange value.
Although this is not a defensible argument today, it may have served to buttress
Ghazali’s arguments against hoarding for its own sake. Like Aristotle, Ghazali argued
that usury is wrong because charging interest on the borrowing and lending of money
deflects money from its key function, which is to facilitate exchange. We shall see in
the next section that this fiction was perpetuated by the European Scholastics as well.
Ghazali was not shy about giving advice on the proper role and function of the
state, which he considered a necessary institution to ensure the proper operation of
the economy and the fulfillment of divinely ordained social obligations. His position
in this respect echoes down through the ages of Islam: “The state and religion are
inseparable pillars of an orderly society. Religion is the foundation, and the ruler,
representing the state, is its promulgator and protector; if either pillar is weak, soci-
ety will crumble” (Ihya, 1:17; Mizan, 297; Counsel, 59—in Ghazanfar and Islahi, p.
395). Although the inseparability of religion and state was later rejected in some
Western traditions, other aspects of Ghazali’s system were readily embraced: for
example, his belief that the state must establish peace, justice, security, and stability
in order to promote economic prosperity. His discussion of public finance, though
insightful in some respects, was constrained by the religious, ethical, and cultural
5
Throughout his economic writings, Ghazali talks of a “prevailing price, as determined by market
practices.” This concept was referred to as “just price” by some of his Arab contemporaries and
was later adopted by European medieval philosophers. Still later it culminated in the notion of
“equilibrium price,” as discussed in the next section.
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 27

precepts of Islam. He seemed aware of the benefits-received and ability-to-pay prin-

ciples of taxation (he advocated the latter as a matter of equity). He approved of
government borrowing only if it is possible to secure repayment from future reve-
nues. And he considered public goods to be a legitimate use of public funds, citing
specifically the need to provide for a country’s defense, education of its people,
health care, law enforcement, and the construction of roads and bridges.
Ghazali had a number of students, who in turn influenced other students, so that
a continuous line of economic inquiry (always as a subsidiary branch of morals) was
established in the eleventh, twelfth, and thirteenth centuries. This intellectual tradi-
tion culminated in the fourteenth century with the work of Ibn Khaldun (1332–1404).
It was Khaldun who first formulated the labor theory of value that subsequently pre-
occupied the classical economists of the eighteenth and nineteenth centuries. Writ-
ing against the backdrop of the dramatic rise of the Ottoman Empire, which served
to spread medieval Muslim thought ever wider, Khaldun anticipated Adam Smith on
a number of important facets of what was to become political economy.6 But he was
preceded in this endeavor by the medieval scholars of Christian Europe.

■ MEDIEVAL EUROPEAN ECONOMIC THOUGHT

After the Spanish city of Toledo was recaptured from the Moors in 1085, Euro-
pean scholars flocked to that site in order to translate the ancient classics. The
ancient texts were turned from Greek (which Europe had forgotten) through Arabic
and Hebrew into Latin. In this last mode their philosophical gems were mined for
the next four hundred years by the scholars of the medieval Church—that group of
priests and philosophers who are known as the Scholastics. Like their Muslim coun-
terparts, this group of writers wrote within the context of a dominant religious
creed, which in this case was Christianity.

Economics in a Feudal Society

The dominant form of economic organization in the Middle Ages was feudal-
ism. In a feudal system of production and distribution the ownership of land is nei-
ther absolute nor divorced of duties, as it had been in ancient Rome and was to
become again in modern times. Instead, the king was the repository of all legal
property rights. He assigned land in large parcels to his favored chiefs and noble-
men, who could, in turn, assign the land to various subtenants. “Ownership” at the
production level meant the mere right to use (usufruct), although this right tended
to become hereditary. Usufruct remained, however, subject to the performance of
certain military, personal, and economic duties.
Feudal property established the seat of political power in the medieval era. A
strong, central authority requires social, economic, and political integration to an
extent found lacking in the Middle Ages. Consequently each feudal lord was vested
with numerous governmental functions, which he exercised in his particular fief-
dom. Economic production took place on the manor, or agricultural estate. Output
was produced on a small scale, using relatively primitive agricultural techniques.
Labor services were provided by serfs who were attached to the land rather than to

6
Besides the labor theory of value, among the key pillars of classical economics anticipated by
Khaldun are: capital accumulation and its relationship to economic progress; the dynamics of
demand, supply, prices and profits; the disentanglement of money and wealth; economic freedom
and the (limited) role of government.
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28 Part I ■ Preclassical Economics

the person who “owned” it. There was no wage system on the manor. The goal of
the manor was self-sufficiency; trading activities between regions and/or countries
were severely limited. In sum, the economic and social framework of the manor was
analogous in many respects to that of the polis, or Greek city-state. The principle of
organization in both was status, not contract.
Two major factors that set the Middle Ages apart from Greek antiquity were its
doctrinal unity, which was provided by the Roman Catholic Church, and the perva-
siveness of the market mechanism, which was manifest mostly in the cities. Medi-
eval society somewhat grudgingly nurtured a nascent form of capitalism, as
economic markets (both in products and in factors of production) became more and
more entrenched in the fabric of daily life. It was against this backdrop that Scho-
lastic economics developed.

Scholastic Economic Analysis

The social hierarchy of medieval civilization was almost Platonic in its struc-
ture. One belonged to either the peasantry (who worked), the military (who fought),
or the clergy (who prayed). The last group alone emphasized the importance of
knowledge, and so it was, almost by default, that the clergy became the repository
and the guardians of that knowledge, exercising a virtual monopoly of learning.
Consequently, medieval economics was almost the exclusive product of the clergy,
particularly a group of learned writers that we now refer to as Scholastics.7 It was
they who joined together the several strands of thought that constitute medieval
economics: ideas gleaned from Aristotle and the Bible, from Roman law and Church
law, and from Chinese and Muslim influences.
Scholastic economics is not held in high regard today. It is commonly perceived
as a tissue of misplaced fallacies about market price, interest, and property.
Although most Scholastic ideas have been expunged from the corpus of economic
knowledge, they have some significance in the painfully drawn-out evolution of
modern value theory. This last phenomenon deserves a close examination.8
The Scholastic Method. The method of Scholasticism was as follows: The
writer posed a question, then followed it with a lengthy and detailed exposition of
the view that was to be either refuted or reinterpreted. Attention was always paid to
the weight of authority. Eventually, an answer was given, contrary views scruti-
nized, and documentation brought forth. The whole process was deductive in
nature, depending not so much on the rules of logic or of human experience as on
faith and the weight of authority. While this method may seem decidedly unscien-
tific to a modern mind, it was the accepted procedure of the medieval period. There
were many masters of this method, but five in particular stand out in the tradition of
Aristotelian value theory. The five are Albertus Magnus (c. 1206–1280), Thomas
Aquinas (c. 1225–1274), Henry of Friemar (c. 1245–1340), Jean Buridan (c. 1295–
1358), and Gerald Odonis (c. 1290–1349).
As keepers of the moral code of medieval society, the main interest of the clergy
was justice, not exchange. One form of justice is exchange justice (or commutative
justice), which is exactly the issue broached by Aristotle in Book V, Chap. 5, of the
Nichomachean Ethics. It was there that Aristotle developed his reciprocity model
(see above), and it was from this point that Scholastic economics took its departure.
The text of Aristotle’s exchange analysis may have been garbled from the outset,
7
As used in this context, the term simply means “professors” or “teachers.”
8
The following section follows very closely the excellent study of Odd Langholm, Price and Value.
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 29

but it seems certain that subsequent translations into Arabic, Hebrew, and Latin did
little to remove any ambiguities. Perhaps it is not surprising, therefore, that the
Scholastics spent four centuries trying to disentangle and clarify its meaning. In the
process Scholastic analysis infused Aristotle’s primitive notion of value with the
idea of equilibrium. It also set the train of economic reasoning down two divergent
tracks that were not to come together again for over half a millennium, namely cost-
determined value on the one hand, and demand-determined value on the other.
Labor and Expenses: The Analysis of Albertus Magnus. Albertus Magnus,
Dominican provincial, Bishop of Regensburg, and doctor of the Church, was the
first great Latin Aristotelian. His place in the history of economics is assured by two
things: his tutelage of Thomas Aquinas, who subsequently had an enormous impact
on Western thought, and his commentaries on the Nichomachean Ethics, where he
traduced ancient Greek ideas through the prism of medieval society, providing the
point of departure for all subsequent thought on exchange and value. What Albert
did was to plant in Western thought the persistent notion that value-in-exchange
must comply with cost-of-production. In so doing, he set in motion a long train of
thought that did not reach its fruition until the nineteenth century, notably in the
work of Karl Marx (see chapter 12).
Earlier commentators on Aristotle’s exchange model did not advance much
beyond the question of the measurement of value. Recall that Aristotle said that
money was the measure of demand. The Scholastics most commonly referred to the
measure of value in terms of money (nummisma) and wants (indigentia). But
Albert, arguing that there is a natural order and an economic order in which things
are valued differently, maintained that in the economic order goods are measured in
relation to labor (opus). He asserted that “labor and expenses,” were elements of
cost and that cost was a proper measure of value. Mere recognition of the role of
cost in the measurement of value is not as important as Albert’s use of the insight,
however. He related costs of production to the “cross-conjunction” in Aristotle’s
model (see figure 2-1), noting that if the market price does not cover costs of pro-
duction, production will eventually cease. This was an important analytical leap for
two reasons: It suggested that price could be treated as an equilibrium value, and it
established an economic variable (i.e., costs) as the regulator of value. Certainly
Albert was a long way from presenting an integrated and systematic explanation for
the determination of market price, but his analysis was nevertheless an important
advance for the thirteenth century. The fact that he brought labor into the Aristote-
lian framework was a lasting contribution. In subsequent chapters of this book we
shall see how much mileage later economic writers got from the same notion.
Human Wants, Thomas Aquinas, and “Just Price.” Albert’s brilliant pupil,
Thomas Aquinas, did not really have any conflict with his teacher, but he tried to
improve on Albert’s labor theory, which he attempted by stressing human wants.
Thomas reached back to St. Augustine for this point, noting that men will not always
rank things according to the natural order. Stressing the natural order, Augustine
had toyed with subjectivism by noting that men will often value a jewel more than a
servant girl (see above). But he did not really distinguish between wants and plea-
sure. If Aquinas had followed Augustine’s lead it might have accelerated the early
development of demand theory. Instead, Aquinas chose to inject moral instruction
into his economics, a practice that tends to discount pleasure. Consequently, Aqui-
nas’s demand theory never got beyond the simple notion of the human usefulness of
goods as compared with their place in the natural order of creation.
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30 Part I ■ Preclassical Economics

Aquinas’s formal contribution to Aristotelian value theory was two-pronged:

one element conditioned the other. First, he reaffirmed the double measure of goods
(value in use versus value in exchange) that Aristotle had established; second, he
introduced wants into the price formula. This last contribution is especially impor-
tant because it marked the earliest root of an analytical demand theory of value.
Aquinas argued that price varies with wants. Thus, indigentia became a regulator of
value. This contribution, however, was strictly formal. Aquinas did not explain his
terms; he simply made the connection between wants and price. Nevertheless, that
connection stood as an invitation to subsequent Aristotelians to work out a more
complete theory of value, which they eventually did. In the Scholastic analysis that
followed Aquinas, the concept of indigentia was gradually enlarged to include util-
ity, effective demand, and even unmitigated desire.
It should be noted that Aquinas’s mentor, Albert, did not overlook wants in his
discussion of value, nor did Aquinas neglect costs. Rather it is the case that each in
turn helped to develop more fully one particular side of the argument. Taken
together, the discussion is fairly balanced, although there was still a long way to go
toward an integrated, analytical understanding of the market mechanism.
Indeed, an opinion shared by many modern historians of economics is that
Aquinas viewed market forces as antagonistic to justice. It is difficult to reconcile
the medieval notion of “just price” with the modern notion of “market price,” since
the former is generally defended on normative grounds whereas the latter is held to
be an objective result of impersonal forces. Certainly Aquinas’s language was open-
ended on many points, furthering the popular notion that his analysis was wrong-
headed. For example, bowing to Aristotle, Aquinas wrote:
If the price exceeds the quantity of the value of the article, or the article exceeds
the price, the equality of justice will be destroyed. And therefore, to sell a thing
dearer or to buy it cheaper than it is worth is, in itself, unjust and illicit. . . . The
just price of things, however, is not determined to a precise point but consists of a
certain estimate. . . . The price of an article is changed according to difference in
location, time, or risk to which one is exposed in carrying it from one place to
another or in causing it to be carried. Neither purchase nor sale according to this
principle is unjust. (in Dempsey, p. 481)

David Friedman (“In Defense”) has advanced a tolerant view of Aquinas by

arguing that the concept of just price was a substitute for the unregulated, competi-
tive, market price at a time in history when markets had not yet reached the stage of
development that would guarantee socially efficient results. Modern competitive
markets produce socially “efficient” prices only when large numbers of buyers and
sellers, each possessing reliable information, interact. These conditions were not
widespread in the Middle Ages. Medieval trade involved few buyers and sellers, in
some cases approaching the technical condition of bilateral monopoly (one seller,
one buyer). In these conditions, the relationship between “market” price and aver-
age costs of production was tenuous, at best, and it was relatively easy for one party
to “exploit” another. Friedman argues, therefore, that the “just price” was, in
essence, a kind of arbitrated price, involving the establishment of equity-based
guidelines designed to preserve distributive justice in exchange and to resolve the
kind of conflict endemic to limited-participation markets that could not “protect”
consumers by the law of large numbers (i.e., vigorous competition).
From an analytical standpoint, “just price” is a vague and imprecise idea,
unsuited to an operational theory that befits a science. But to paraphrase Alfred
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 31

Marshall (see chapter 15) economics, like nature, does not make sudden, gigantic
leaps forward. During the Middle Ages, if anything, economics seems to have
crawled rather than leaped forward, but it nevertheless headed in the right direction.
Aggregation and Scarcity: The Influence of Henry of Friemar. Aquinas had
developed the concept of indigentia in a way that related primarily to the individual.
But the modern notion of market demand is an aggregate notion that comprises the
wants of all those buyers who participate in the market. The next step toward estab-
lishing indigentia as an aggregate measure was taken by the Augustinian friar,
Henry of Friemar.
The Scholastics’ concept of indigentia differs from the technical, contemporary
notion of market demand. It is not quantity demanded as a function of price; its
meaning is much less precise, including elements of supply as well as of demand.
The meaning most commonly attached to the concept in Scholastic literature is
“amount desired in relation to what is available” (i.e., demand in the face of scar-
city). As we now recognize, genuine analytical progress in value theory required the
separation (even if artificial) of the two notions “demand” and “supply.” Failure to
separate demand and supply as elements in the value formula was the fundamental
defect in the Aristotelian market model. Unfortunately, the Scholastics, despite their
long, inquisitive tradition, never quite remedied the defect. In fact, the remedy was
not forthcoming until the full flowering of marginalism in the nineteenth century.
Progress, however slow, was nevertheless made by the Scholastics. Just as
Aquinas had directed Albertus’s analysis toward demand factors instead of costs, so
Henry tipped Aquinas’s formula in favor of aggregate (i.e., market) demand. Henry
advanced the somewhat mixed notion that value is determined by “the common
need of something scarce.” This concept acknowledged that as long as there is
abundance in the face of strong demand, indigentia will not raise price.
Odd Langholm has aptly pointed out that a theory of exchange value can start at
any one of three stages of deduction. It can start with the conditions of the market,
that is, with the abundance or scarcity of goods. Or it can start with the properties of
goods that make the market conditions relevant. Or it can start with the wants of the
people that make these properties in goods relevant, proceeding to market condi-
tions from there. The medieval theory, which was rooted in Aristotelian soil and nur-
tured all the way into modern economics, started at the third level. Although the
Scholastics were not alone in discussing economic matters in relation to human
wants, they deserve credit “for taking this concept through aggregation and scarcity
into a workable argument in the price formula” (Langholm, Price and Value, p. 115).
Effective Demand: The Contribution of Jean Buridan. The next major step
in the evolution of value theory was taken by the rector of the University of Paris,
Jean Buridan. Buridan was a master logician and thoroughgoing Aristotelian whose
contributions to social science and philosophy are contained in some three dozen
commentaries on Aristotle’s works. He maneuvered the Scholastic notion of indi-
gentia much closer to the modern concept of effective demand. Buridan described
poverty as a state in which someone does not have that which he desires, which
meant that indigentia could be applied to “luxuries” as well as “necessities” (the
narrower sense given to it by Aquinas). In addition, Buridan made indigentia into
desire backed by ability to pay.
This modification, as insignificant as it may seem, provided a way out of a net-
tlesome problem in medieval value theory. Both Aquinas and his fellow prelate,
John Duns Scotus, were spokesmen for a “double rule” in medieval price theory. A
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32 Part I ■ Preclassical Economics

seller who parted with a commodity at unusually high sacrifice to himself could,
with the blessing of the Church fathers, compensate for his loss by charging a
higher than normal price. But if the sacrifice was “ordinary,” he could not charge a
higher price merely to increase his profit. In the latter case, Aquinas argued that by
profiting exorbitantly, the seller in effect sold something that was not his own (the
same rationale applied to Scholastic condemnations of usury). Duns Scotus main-
tained that something is not precious in itself merely because of the buyer’s strong
preference. Both writers were basically arguing that it is wrong to take advantage of
a buyer’s intense wants.
There are several problems with this double rule. The most obvious is its basic
analytical asymmetry: It is all right for a seller to do one thing if his want is high but
not to do the same thing if the buyer’s want is high. The other problem is how to
define “unusually high want.” Borrowing from both Aquinas and Henry of Friemar,
Buridan advanced a line of thought that distinguished between individual “wants”
and aggregate “wants.” He tied value to aggregate wants, by which he meant effec-
tive demand, and argued that the conjunction of numbers of consumers and their
purchasing power works to establish a just and normal state of affairs in the mar-
ketplace. A buyer, therefore, however desirous, must comply with the valuation of
the market. This is the identical line of thought that led centuries later to the laissez-
faire morality of Nicholas Barbon and Thomas Hobbes, the latter declaring that “the
market is the best judge of value.”
What is interesting about Buridan’s achievement is that it was developed within
an Aristotelian framework that permitted the metamorphosis of a narrow medieval
concept, indigentia—which originally took the vague connotation of need into the
indiscriminate generalization, “every desire which moves us to set store by things.”
It is to this notion that European price theory—as opposed to British classical value
theory—owes its later success. Buridan spawned a tradition of economic inquiry
that permeated not only his native France but eventually also Italy and, most espe-
cially, Austria. This tradition, with tentacles reaching all the way back to Aristotle,
culminated in the nineteenth-century formulation of utility, and finally in the fusion
of this last concept to the notion of the margin. This success was in no small part
explained by an “emphasis on utility as a psychological experience, playing down
considerations of the properties in goods which cause men to desire them, a preoc-
cupation which is sure to take theorists away from the main point” (Langholm,
Price and Value, p. 144).
Toward a Synthesis: Odonis and Crell. All through the Middle Ages, discus-
sions of value theory constantly pitted a generalized concept of supply (based on
labor costs) against a demand theory, so that the two were continually rubbing
against each other. In these circumstances one would have expected a synthesis to
be forthcoming, yet the Scholastic tradition stopped short of what we today call the
“neoclassical synthesis.” One man more than any other brought value theory close
to this now familiar synthesis. He was a resourceful German sectarian theologian
named John Crell (1590—c. 1633), whose powerful insight came from joining Buri-
dan and another Scholastic, Gerald Odonis. Odonis was a French monk of the Fran-
ciscan order, which developed its own tradition in exchange theory. He had
inherited a market model that exceeded that of Aquinas and bore the imprint of
Henry of Friemar. The Franciscan tradition focused on raritas, by which it meant
scarcity in the face of wants (the reverse of Henry’s indigentia, which was wants in
the face of scarcity).
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 33

Odonis rejected a simple labor-quantity theory of value and focused on the scar-
city and quality of human productive skills. This led him to a theory of wage differ-
entials that recognized the relative efficiencies of different skills and the relative
cost of acquiring those skills. It was an important step on the path to ultimate recog-
nition of the synthetic nature of labor and demand theories of value. Odonis’s the-
ory could explain, for example, why an architect earned more than a stonecutter,
and it led to the inference that scarce labor commands a higher product price
because of product scarcity. A complete synthesis requires an additional step: the
recognition that every kind of labor is always to some extent scarce, and so brings
forth a scarce product. Indeed, it is in this way that labor serves as a regulator of
value. The inference was a long time coming; it was not made by Buridan because it
required joining his own insight to that of Odonis, who had not yet written when
Buridan wrote his commentaries. Born in the following century, a resourceful
thinker like Crell was able to put the two together.
History tells us that the problem of value was not solved completely until econ-
omists came to understand that the cost theory and the demand theory were merely
components of a single principle. Like a two-legged stool, the single principle rested
on two legs. The first leg is that labor is a regulator of value only if it is spent on
something useful. The second leg is that all labor is always (to some extent) scarce.
Wants and costs are, to use Alfred Marshall’s felicitous analogy, but two blades of
the same scissors. Yet, it took a very long time to get that far in economic analysis.
Ironically, in the seventeenth and eighteenth centuries a very able line of Italian and
French economists had the two theories marching separately, with scarcity and util-
ity carrying the burden of explanation. The British classical tradition somehow got
off on the monotonous track of costs and failed to unite the two concepts, even
though the idea that labor regulates product value through scarcity is very much in
evidence in Nassau Senior’s work (see chapter 7). In nineteenth-century France
there was a sudden flash of genius, but this was not fully reflected in economic the-
ory until after a hiatus of nearly three decades (see chapters 12–17).
The most interesting thing to surface from recent research into Scholastic eco-
nomics is the remarkable continuity of the Aristotelian tradition through the years.
The Scholastic economists advanced the Greek tradition, a fact that unfortunately
serves to detract from the originality of their contributions. But one by one, they laid
the bricks and mortar on which the edifice of value theory was slowly built. The
chief architects of this edifice and the nature of their contributions are summarized
in figure 2-2 on the following page.

The Doctrine of Usury

Insofar as interest is generally regarded as the price of money, a modern theory
of interest is treated merely as a subset of the general theory of value. But medieval
writers were concerned primarily with commutative justice, so they regarded the
theory of interest primarily as an ethical issue. Few topics evoked as much contro-
versy as the conditions under which interest was to be allowed. The Church, more-
over, had an official position on the subject.
Although the idea that interest, or “profit,” from loans is wrong can be traced
back to the Old Testament (Exodus 22:25), the Roman Catholic Church did not
make the injunction against usury (defined as a transaction “where more is asked
than is given”) part of its official doctrine until the fourth century AD when the
Council of Nicaea banned the practice among clerics. During the reign of Char-
lemagne, the prohibition was extended to all Christians. Subsequent practice made
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34 Part I ■ Preclassical Economics

Law of Reciprocity Law of

Costs Aristotle Demand
(384–322 BC)

Labor & expenses Human wants

Albertus Magnus Thomas Aquinas
(1206–1280) (1225–1274)

Aggregation & scarcity

Henry of Friemar
(1245–1340)

Effective demand
Jean Buridan
(c.1295–1358)

Synthesis
Gerald Odonis (1290–1349)
John Crell (1590–c. 1633)

Adam Smith, et al.

Figure 2-2 Aristotle, Aquinas, Albertus, Henry of Friemar, Buridan, Odonis, and Crell
all helped lay the foundation for the development of value theory.

the ban an absolute prohibition, and for many centuries usury laws enjoyed wide-
spread and official support. During the Middle Ages, usury and the doctrine of “just
price” were the main economic topics that occupied the Scholastics.
In Latin, usura, from which the word “usury” derives, means payment for the
use of money in a transaction that results in gain (i.e., net profit) for the lender;
whereas interesse, from which the word “interest” derives, means “loss” and was
recognized by ecclesiastic and civil law as a reimbursement for loss or expense.
Interest was commonly regarded as compensation for delayed repayment or for loss
of profits to the lender who could not employ his capital in some alternative use
during the term of the loan. Risk was not generally considered as a justification for
interest, because loans were usually secured by property worth many times the
money advanced. Thus, the usury prohibition was not intended to curb the high
profits of risk enterprise. For instance, the societas (partnership) was a recognized
form of commercial organization dating back to Roman times. Its profit objective
was officially sanctioned, and gains from trade were treated as earnings for effort
and risk. The census was a kind of early financial instrument that combined ele-
ments of a mortgage and an annuity. Under the terms of this contract, the borrower
incurred “an obligation to pay an annual return from fruitful property,” usually a
landed estate. By its nature, a census was not considered usurious.
In addition, bank deposits had become a form of investment by the thirteenth
century. Merchant bankers paid interest on deposits. As early as the twelfth century,
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 35

bills of exchange combined foreign exchange with credit, although interest was
often concealed in a high exchange rate. In other words, during the Middle Ages,
the Church doctrine on usury, existing alongside legitimate forms of interest taking,
helped promote a double standard that became increasingly arbitrary over time,
thereby creating opportunities for exploitation by those who made the rules.9
Over the years, medieval economic doctrine frequently came into conflict with
medieval economic practice. Up to the thirteenth century, the sweeping condemna-
tion of usury by the Church was accompanied by civil prohibitions, which varied
widely from country to country. Yet, despite its widespread prohibition, usury was
never entirely eradicated in any large part of Europe or for any important period of
time. Professional pawnbrokers, though sometimes underground, probably always
existed in medieval Europe. In fact, where they operated openly, they were licensed
by the state, which received license fees.10
Because the Church’s arguments in defense of usury make little sense in the
context of modern economics, the whole topic is usually considered an analytical
dead end. The chief flaws of the Scholastic analysis were its failure to recognize the
productivity of money as an economic resource and its concomitant failure to recog-
nize the time value of money. Some historians blame the Church’s doctrine of usury
for retarding the development of capitalism by suppressing the growth of credit
markets. But up until recently, little research has been directed at explaining the
anomalies between Church doctrine and Church policy on this subject.
In an attempt to break this pattern, Robert Ekelund, Robert Hébert, and Robert
Tollison (see Notes for Further Reading) approached the subject by analyzing the
medieval Church’s behavior on the basis of its “monopoly” position among religious
institutions. They conclude that it was in the Church’s interest to selectively use the
usury doctrine in order to keep its own cost of funds low, to prevent the entry of com-
peting “firms,” and to otherwise preserve its monopoly status. In the final analysis,
therefore, the ultimate disappearance of the usury doctrine may have been a result
of increased doctrinal competition in the wake of the Protestant Reformation rather
than the effect of a systematic belief in the weakness of its underlying premises.

■ THEORY MEETS HISTORY: ECONOMIC IMPACT OF CHRISTIANITY

AND THE MEDIEVAL CHURCH
State and religion—and the combination’s impact on economics—has been a
feature of all ancient and modern societies. Temple civilizations, such as the Assyr-
ian, Mesopotamian, and Egyptian cultures, were fundamentally a marriage of
church and state where, in many cases, resources were directed, sometimes in mas-

9 According to Raymond de Roover (“Scholastics, Usury and Foreign Exchange,” p. 266), pawnbro-
kers and small moneylenders were the main victims of the church’s campaigns against usury, “but
the big bankers with international connections were left undisturbed. Far from being censured,
they were called ‘the peculiarly beloved sons of the Church’ and prided themselves on being the
Pope’s exchangers.”
10
Before the Renaissance, the legal limits on personal loans from pawnshops ranged from a low of
10 percent in Italy to 300 percent in Provence, France. In the fourteenth century, the Lombards
(Italian bankers) often charged 50 percent, although the most common legal pawnshop limit in
effect was 43 percent. Monarchs, such as Emperor Frederick II (1211–1250), often paid interest of
30 to 40 percent to creditors, especially when collateral was not liquid. Commercial loans com-
monly fetched interest rates between 10 and 25 percent depending on the adequacy of commercial
credits (see Sidney Homer, History of Interest Rates, pp. 89–103).
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36 Part I ■ Preclassical Economics

sive quantities (for example, the pyramids) to religious and “afterlife” ends. In the
first century of the Common Era, a new religion emerged based upon the teachings
of Jesus Christ. The resulting religion, Christianity, had to “out compete” other
pagan and ethnic religions and used apostle-entrepreneurs such as St. Paul to offer
a belief product with certain advantages compared to Judaism and Greco-Roman
paganism. Multideity religions, such as Greco-Roman paganism, created large
transaction costs for its “believers.” Judaism blunted its monotheistic advantage by
imposing costly rituals. By comparison Christianity offered a well-defined and
happy afterlife contract with assurances of eternal salvation attached. It also pro-
pounded a “loving God” in place of a vengeful one. Moreover, its emphasis on social
and charitable works and services quickened its spread throughout the East and
large parts of Europe through the proselytizing efforts of disciples in enclaves
within cities.
A problem emerged over the first three centuries of the Common Era: Christ
did not return and multiple Christianities sprang up. The Emperor Constantine’s
call of the Council of Nicaea (325 CE) may be seen as the initial and principal ele-
ment of the cohesiveness and “product” monopoly of the Christian religion. At
Nicaea the template of Christianity was spelled out with the books of the New Tes-
tament, with competing Christianities labeled “heresy.” Clear definition at Nicaea
was necessary to avoid the emergence of alternative Christian “products” and to
collect control rents (monetary returns) accruing to the legitimized Church and to
civil governments as well. The council set in motion a long history of efforts by the
Roman Catholic Church to expand and entrench its monopoly power in the West
through reciprocity—one that gave civil governments and monarchs, such as the
Merovingian and Carolingian rulers, Christian legitimacy in return for protection
from all forces that challenged the Church or its properties. These developments,
along with a high degree of voluntary and forced conversions at the lower geo-
graphic levels of Christian practice (Vikings were ultimately Christianized) and a
lasting split with the Eastern Church (in the eleventh century) led to a high period
of Church monopoly across much of Western Europe.
By all historical accounts, the medieval period marked a critical transition from
the ancient world to the modern one, as we have already seen in this chapter with
the inventions of Church-affiliated scholars. However, even a careful recitation of
“who said what” provides an incomplete picture of this vital passage. It is widely
agreed that the medieval Roman Catholic Church—the longest running institution
of the West—played a pivotal role in the ultimate development of liberal capitalism,
but opinions differ on whether the overall influence of the Church was favorable or
not. In this final section, therefore, we review some of the issues that marked the
transition from one age to the next.

Church Organization
After the twelfth century, Roman Catholicism faced only fringe religious com-
petition from Jews and Moors, so it came to dominate large parts of Western
Europe. Canon law (the legal system of the Church) was beginning to supplant and
eventually dominate civil law in the loosely organized states and other political enti-
ties of the West. Ecclesiastical officials enacted laws respecting all aspects of the
“supply” decision of various Church products, such as assurances of eternal salva-
tion, political support of reigning monarchs, and various social services (e.g., hospi-
tals, alms for the poor, etc.). The Church’s web of influence was gradually extended
to the establishment of marriage regulations, trade practices, and all manner of
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 37

social and economic behavior. Kings, princes, and aristocrats owed much of their
power to the approbation of the Roman Catholic authorities who, with an extensive
coterie of clerical agents, helped rulers wage wars, maintain armies, and negotiate
trade deals. The Church, moreover, was immensely wealthy and was a huge land-
holder during the medieval period. It collected revenues not only from voluntary
contributions, but also from the sale of relics and indulgences, taxes, and land rents.
The organization of the medieval Church was analogous to what Oliver William-
son (Markets and Hierarchies, p. 137) calls an M-form corporation. This kind of firm
is characterized by a central office that controls overall financial allocations and
conducts strategic long-term planning (the Vatican) but allows divisions, usually
regional, to have a high degree of autonomy in managing day-to-day operations
(dioceses, or bishoprics). The pope assumed duties analogous to that of a CEO, and
the Vatican had its own bank (the papal camera) and board of directors (the College
of Cardinals). Its “retail” operations were extensive and widespread. The primary
role of the Vatican central office was to provide doctrine and dogma relating to the
essential principles of membership (e.g., interpretations of Holy Writ) and to collect
rents from its many divisions and franchises. Downstream from the Vatican were the
geographically dispersed purveyors of local Roman Catholicism, the monasteries,
bishoprics, and parishes. While rents were collected at all levels, primary revenues
came from these retail agencies of the downstream Church. Like all good corpora-
tions, the medieval Church set up enforcement policies and assigned jurisdiction to
central and local authorities to prevent opportunistic behavior by its many agents.

Maintenance of the Church Monopoly and Doctrinal Manipulations

In order to preserve and protect its monopoly status, the medieval Church
sought to prevent the entry of rival religions. Heretics were roundly condemned and
shunned by Church leaders and Church members. Interdict, whereby the “sinner”
was forbidden contact with other Christians, was one form of punishment. A more
severe form of punishment was excommunication, which imposed total separation
of the wrongdoer from the body Catholic and a sentence of eternal damnation if
repentance was not made. Many heretics were put to death during warfare (e.g., the
Crusades) or the dreaded Inquisition. Moreover, the medieval Church established
an elaborate penal system for transgressors of all kinds.
In an attempt to protect its market dominance, the medieval Church also
resorted to doctrinal manipulations in order to increase the demand for its services
or to make consumer demand more inelastic. One manner of protection from rival
firms in contemporary enterprise is product differentiation. Throughout the Middle
Ages the Church manipulated the conditions attached to its chief product, assur-
ances of eternal salvation. Marriage markets, mostly a matter of secular and civil
concern prior to the Church monopoly, were invaded by the Church, which then
issued regulations that allowed the Church a measure of control over dynastic fami-
lies—one of the chief threats to its autonomy. Church officials practiced forms of
price discrimination in meting out penance, establishing marriage policy, and sell-
ing indulgences. The doctrines of usury and just price were almost manipulated out
of recognition. When the Church was a debtor, it seems, usury prohibitions were
enforced, but not when it was a creditor. Similar manipulations extended to Church
rules respecting monastery tithes and taxes, the granting of indulgences, jubilee
attendance, and benefices granted to bishops and cardinals. Eventually the Church
pushed its monopoly practices too far, encouraging doctrinal reforms that eventu-
ally coalesced in what we call the Protestant Reformation (see chapter 4).
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38 Part I ■ Preclassical Economics

A theory of rational behavior promotes understanding of the Church as an eco-

nomic entity—one that benefited from increasing secularization of European soci-
ety but also recognized that science, technology, and humanism would ultimately
weaken the kind and form of product the Church was selling. If “belief in Christ and
Christian principles” were the main issue, it would be difficult to explain how
Church officials could wage war against other nations (the Crusades), or against
other Christians (religious wars against Protestants), much less other Catholics
(conflicts with the Eastern Orthodox Christian Church). Moreover, aggressive cen-
sorship of all kinds in the sixteenth and earlier centuries is also difficult to rational-
ize (e.g., the persecution of Galileo, a devout Catholic) except in an economic
context, that is, the context of monopoly, market dominance, and profitability.
Economists objectively viewing these policies and doctrines see them as examples
of monopoly behavior and all that the model entails. Economic analyses of histori-
cal transformations approach the subject of institutional behavior on one of two
grounds: public interest or private interest. If religious organizations, in this case
the medieval Church, acted solely in the public interest, they would behave as a
“good government”—one that provides the faithful with information, spiritual
goods, and social goods at competitive prices (i.e., marginal cost). An economic
examination of the behavior of the medieval Church provides little if any support
for this view.
Protestantism was another transformative force of the medieval era. It
emerged—significantly in northern Europe and England—mainly in response to
opportunistic practices of the established Church. The net result was a lessening of
the hold of the Roman Catholic version of Christianity in Europe. Some great schol-
ars of the past found a force in the new creed that stimulated and encouraged the
rise of capitalism (e.g., Max Weber, see Notes for Further Reading). The proponents
of this view maintained that the Catholic Church’s attack on excessive “money mak-
ing” (an ancient idea as we have seen in the present chapter), on science, and on
free thought, among other practices, retarded the development of liberal capitalism
as espoused later by Adam Smith and the classical writers. But this view is far from
universal. Other writers have insisted that the Catholic Church, despite its dogma
and market dominance, encouraged economic development rather than retarded it.
In short, the historical reasons for the emergence of liberalism are complex and var-
ied and, at this distance in time, may never be fully understood. We shall revisit this
issue in the next chapter, which examines yet another ideational and historical
argument for the decline of authoritarian economies and the emergence of eco-
nomic liberalism.

■ CONCLUSION
Although the period from Greek antiquity to the end of the Middle Ages consti-
tutes roughly two thousand years, the fundamental economic structure of Western
civilization changed little during that time. Both Greek antiquity and European feu-
dalism were characterized by small, insular, self-sufficient economies with little
capital and low levels of production. At the level of basic production, serfdom was
akin to slavery, except for the legalistic difference that serfs maintained property
rights over their own bodies. In effect, serfs were tied to the land, regardless of
owner, whereas slaves belonged to a particular owner, regardless of whether or not
the owner possessed land.
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 39

Throughout the first two millennia, isolated exchange in the East and the West
predominated over what we now call market exchange. Consequently, the learned
treatises of the day, whether derived from China, Arabia, or Europe, focused primar-
ily on the question of fairness, not on the origin of prices. This focus was sustained
in an intellectual tradition that stretched from Aristotle to the European Scholastics.
The continuity of this tradition was preserved by Islamic nations, which served as a
conduit for the reintroduction of ancient Greek ideas to the European continent.
In the seventeenth century, John Crell capped a Western tradition in value anal-
ysis that began with the early Scholastics four hundred years earlier. But it was a
tradition within a tradition, so to speak. The Scholastic tradition in Europe was
cohesive and tight-knit, because the Church in the Middle Ages enjoyed an intellec-
tual monopoly on learning. Its scholars all spoke the same language, Latin. They
were each trained by an educational system that was the same in every country.
Each figure in that tradition professed the same fundamental beliefs and acknowl-
edged the same authority of God and Church. Albert, Henry, and Crell were Ger-
man; Aquinas was Italian; Buridan and Odonis were French. This heterogeneity was
hardly noticed, however. As Schumpeter has said of the Scholastics: “Their country
was Christendom, their state the Church” (History, p. 75). At the peak of this tradi-
tion, economic analysis was slowly being displaced by an early modern form of
inquiry. The new economists of the eighteenth century, however, all had classical
educations, so theirs was by no means a de novo approach to economic analysis.
From an institutional perspective, the Middle Ages were dominated by a single
entity—the Roman Catholic Church—which had an enormous influence on secular
states and society in general. Its practices were monopolistic in that it thwarted the
entry of new religions by threat and by violence (e.g., excommunications, interdict,
Crusades); by product differentiation (e.g., the invention of limbo, purgatory, and
confession), and by taking control of fundamental social customs (e.g., law and
marriage). Only when this monopoly began to break down in the sixteenth century
did rival religions make serious inroads into the states of Western Europe. The
interplay of religion, religious belief, political structures, and the self-interest of
individuals and groups in late medieval and early modern societies combined to
shift the economic axis of Western Europe. There is a kind of duality at work in
major historical transformations that can be difficult to disentangle: Ideas shape
events and have consequences, but events also mold ideas and help establish theo-
ries. The ideas that emerged from a “mercantile” economic organization and the
consequences of economic self-interest that took place in the sixteenth and seven-
teenth centuries paved the way for another important transition from hegemonic
mercantilism to economic liberalism, as we shall see in the following two chapters.

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NOTES FOR FURTHER READING

The ancient world is practically a never-never land to most historians of economic
thought, although there is a fairly large literature on the economics of the period. A sam-
pler of original sources, including selections from Xenophon, Aristotle, Aquinas,
Oresme, and Molina, can be found in A. E. Monroe, Early Economic Thought (Cam-
bridge, MA: Harvard University Press, 1924). For more sweeping treatments of the
period, see M. L. W. Laistener, Greek Economics (London: Dent, 1923); Moses I. Finley,
The Ancient Economy, 2d ed. (Berkeley: University of California Press, 1985); Marshall
D. Sahlins, Stone Age Economics (Chicago: Aldine-Atherton, 1972); J. J. Spengler, Ori-
gins of Economic Thought and Justice (Carbondale, IL: Southern Illinois University
Press, 1980); and A. M. Andreades, History of Greek Public Finance, rev. ed., 2 vols.
(Cambridge, MA: Harvard University Press, 1933). The latest, and arguably the best,
analysis of the Greek tradition, however, is S. Todd Lowry’s The Archaeology of Eco-
nomic Ideas (see references), from which this chapter draws freely. For a complementary
study emphasizing different themes, see Christos P. Baloglou, The Economic Thought of
the Ancient Greeks (Thessaloniki: Historical and Folklore Society of Chalkidike, 1995). A
useful overview of the entire period stretching from Greek to Roman to medieval eco-
nomic thought is contained in Barry Gordon, Economic Analysis before Adam Smith:
Hesiod to Lessius (New York: Harper & Row, 1975).
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 41

Much of the periodical literature on ancient economic thought centers on Aristotle,

though not exclusively so. On some general topics, see A. H. M. Jones, “The Economic
Basis of the Athenian Democracy,” Past & Present, vol. 1 (February 1952), pp. 13–31;
Kurt Singer, “Oikonomia: An Inquiry into the Beginnings of Economic Thought and Lan-
guage,” Kyklos, vol. 11 (1958), pp. 29–54; Cosimo Perotta, “The Legacy of the Past:
Ancient Economic Thought on Wealth and Development,” The European Journal of the
History of Economic Thought, vol. 10 (Summer 2003), pp. 177–229; E. Simey, “Economic
Theory among the Greeks and Romans,” Economic Review, vol. 10 (October 1900), pp.
462–481; S. Todd Lowry, “The Archaeology of the Circulation Concept in Economic The-
ory,” Journal of the History of Ideas, vol. 35 (July–September 1974), pp. 429–444; Gregor
Sebba, “The Development of the Concepts of Mechanism and Model in Physical and
Economic Thought,” American Economic Review, Papers and Proceedings, vol. 43 (May
1953), pp. 259–271; and William Baumol’s delightful excursus, “Economics of Athenian
Drama: Its Relevance for the Arts in a Small City Today,” Quarterly Journal of Econom-
ics, vol. 85 (August 1971), pp. 365–376.
The economic ideas of other writers who fit into the ancient scheme but whose ideas
have not directly impinged on this chapter are examined by J. J. Spengler, “Herodotus on
the Subject Matter of Economics,” Scientific Monthly, vol. 81 (December 1955), pp. 276–
285; William F. Campbell, “Pericles and the Sophistication of Economics,” History of
Political Economy, vol. 15 (Spring 1983), pp. 112–135; Stanley B. Smith, “The Economic
Motive in Thucydides,” Harvard Studies in Classical Philology, vol. 51 (1940), pp. 267–
301; Panayotis Michaelides, Ourania Kardasi, and John Milios, “Democritus’ Economic
Ideas in the Context of Classical Political Economy,” The European Journal of the History
of Economic Thought, vol. 18.1 (2011), pp. 1–18.
The periodical literature on Plato’s economic ideas is relatively sparse. William F.
Campbell explores Plato’s use of economic analogies in “The Free Market for Goods and
the Free Market for Ideas in the Platonic Dialogues,” History of Political Economy, vol. 17
(Summer 1985), pp. 187–197; C. B. Welles delves into the underpinnings of Plato’s ideal
society in “The Economic Background of Plato’s Communism,” Journal of Economic His-
tory, suppl., vol. 8 (1948), pp. 101–114; in a different vein, see Laurence C. Moss, “Pla-
tonic Deception as a Theme in the History of Economic Thought: The Administration of
Social Order,” History of Political Economy, vol. 28 (Winter 1996), pp. 533–557. Vernard
Foley examines the parallels between Plato and Adam Smith in “The Division of Labor in
Plato and Smith,” History of Political Economy, vol. 6 (Summer 1974), pp. 171–191. For a
critique of the conventional view that Plato’s Republic endorses specialization, see Dan-
iel Silvermintz, “Plato’s Supposed Defense of the Division of Labor: A Reexamination of
the Role of Job Specialization in the Republic,” History of Political Economy, vol. 42
(Winter 2010), pp. 747–772. Silvermintz argues that Plato actually criticized specializa-
tion on grounds that it prevents individuals from achieving spiritual harmony and
impedes philosophizing. Of course, Adam Smith, too, was of two minds regarding spe-
cialization (see Chap. 5).
The ideas of Protagoras have come to us mostly from the commentaries of Plato.
See R. Hackforth, “Hedonism in Plato’s Protagoras,” Classical Quarterly, vol. 22 (1928),
pp. 39–42, for a treatment of the hedonistic elements in Greek thought.
Aristotle’s discussion of exchange has drawn the most attention from historians of
economic thought. The problems of equality and proportion that concerned Aristotle are
analyzed (without, however, mention of Aristotle) by L. B. Shaynin, “Proportions of
Exchange,” Economic Journal, vol. 70 (December 1960), pp. 769–782. Search for mean-
ing in the cryptic passage of The Nichomachean Ethics continues to fan a lively debate
among Aristotelian scholars. The following works trace the evolution of the debate in
chronological order: Van Johnson, “Aristotle’s Theory of Value,” American Journal of
Philology, vol. 60 (October 1939), pp. 445–451; Josef Soudek, “Aristotle’s Theory of
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42 Part I ■ Preclassical Economics

Exchange: An Inquiry into the Origin of Economic Analysis,” Proceedings of the Ameri-
can Philosophical Society, vol. 96 (1952), pp. 45–75; Karl Polyani, “Aristotle Discovers the
Economy,” in K. Polyani et al. (eds.), Trade and Market in the Early Empires: Economies
in History and Theory (New York: Free Press, 1957), pp. 64–94; Whitney J. Oates, Aristo-
tle and the Problem of Value (Princeton, NJ: Princeton University Press, 1963); Barry
Gordon, “Aristotle and the Development of Value Theory,” Quarterly Journal of Econom-
ics, vol. 78 (February 1964), pp. 115–128; S. Todd Lowry, “Aristotle’s Mathematical Anal-
ysis of Exchange,” History of Political Economy, vol. 1 (Spring 1969), pp. 44–66; and
Ralph Dos Santos Ferreira, “Aristotle’s Analysis of Bilateral Exchange: An Early Formal
Approach to the Bargaining Problem,” The European Journal of the History of Economic
Thought, vol. 9 (Winter 2002), pp. 568–590. William Jaffé traces Aristotle’s influence on
the development of neoclassical price theory in “Edgeworth’s Contract Curve: Part 2.
Two Figures in Its Protohistory: Aristotle and Gossen,” History of Political Economy, vol.
6 (Fall 1974), pp. 381–404. Scott Meikle, Aristotle’s Economic Thought (Oxford: Claren-
don Press, 1997), argues that Aristotle developed a coherent theory of economic value,
wealth, exchange, and money, but it cannot be assimilated to what we call economics
because its metaphysical foundation is incompatible with the Humean metaphysics on
which economics rests. From an Aristotelian standpoint, ethics and economics are com-
petitors over the same ground, as rival sources of reasons for decision making in the
public realm, and they cannot be reconciled.
On the utilitarian premises of Aristotle’s thought, see Kenneth D. Alpern, “Aristotle
on the Friendships of Utility and Pleasure,” Journal of the History of Philosophy, vol. 21
(July 1983), pp. 303–315. Aristotle’s distrust of market activity is based on the supposed
absence of constraints on acquisitive behavior. On this topic, see S. Todd Lowry, “Aristo-
tle’s ‘Natural Limit’ and the Economics of Price Regulation,” Greek, Roman and Byzan-
tine Studies, vol. 15 (1974), pp. 57–63; T. J. Lewis, “Acquisition and Anxiety: Aristotle’s
Case against the Market,” Canadian Journal of Economics, vol. 11 (February 1978), pp.
69–90; William S. Kern, “Returning to the Aristotelian Paradigm: Daly and Schumacher,”
History of Political Economy, vol. 15 (Winter 1983), pp. 501–512; and the exchange
between Kern and Spencer J. Pack in the same journal, vol. 17 (Fall 1985), pp. 391–394.
“Unnatural” acquisition is also the basis for Aristotle’s condemnation of usury. For a
competent analysis of this complex issue, see Odd Langholm, The Aristotelian Analysis
of Usury (Bergen, Norway: Universitetsforlaget, 1984).
Related matters, both general and specific, have attracted the attention of numerous
other scholars. Moses I. Finley, “Aristotle and Economic Analysis,” Past & Present, vol.
47 (May 1970), pp. 3–25, finds “not a trace” of economic analysis in Aristotle’s Ethics and
Politics; whereas Barry Gordon, “Aristotle and Hesiod: The Economic Problem in Greek
Thought,” Review of Social Economy, vol. 21 (1963), pp. 147–156, is more generous in his
assessment. Additional facets of Aristotle’s thought are explored by J. J. Spengler, “Aris-
totle on Economic Imputation and Related Matters,” Southern Economic Journal, vol. 21
(April 1955), pp. 371–389; and Stephen T. Worland, “Aristotle and the Neoclassical Tradi-
tion: The Shifting Ground of Complementarity,” History of Political Economy, vol. 16
(Spring 1984), pp. 107–134; see also the exchange between Worland and Richard Tem-
ple-Smith in History of Political Economy, vol. 18 (Fall, 1986), pp. 523–529. T. H. Deaton,
R. B. Ekelund, and R. D. Tollison, “A Modern Interpretation of Aristotle on Legislative
and Constitutional Rules,” Southern Economic Journal, vol. 11 (February 1978), pp. 69–
90, look at Aristotle in a public-choice perspective.
Ancient Jewish literature has rarely been mined for economic gems, but two promi-
nent exceptions are Ephraim Kleiman, “Just Price in Talmudic Literature,” History of
Political Economy, vol. 19 (Spring 1987), pp. 23–45; and same author, “Opportunity Cost,
Human Capital, and Some Related Economic Concepts in Talmudic Literature,” History
of Political Economy, vol. 19 (Summer 1987), pp. 261–287. The classic reference on
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 43

Roman social and economic history is M. Rostovtzeff, Social and Economic History of
the Roman Empire, 2d ed., 2 vols. (London: Oxford University Press, 1957). Very little
has been done on the history of economic analysis of the period, with the exception of
Joseph Schumpeter’s encyclopedic History of Economic Analysis (see references).
On the practical problem of price fixing in ancient economies, see H. Michell, “The
Edict of Diocletian: A Study of Price Fixing in the Roman Empire,” Canadian Journal of
Economics and Political Science, vol. 13 (February 1947), pp. 1–12; and R. L. Schuettinger
and E. F. Butler, Forty Centuries of Wage and Price Controls (Washington, DC: The Heri-
tage Foundation, 1979). For some insights into early Christian economic thought, see
Anastassios D. Karayiannis, “The Eastern Christian Fathers (AD 350–400) on the Redistri-
bution of Wealth,” History of Political Economy, vol. 26 (Spring 1994), pp. 39–68.
A brief summary of ancient Chinese economic thought is given by James L. Y.
Chang (see references), as well as a useful bibliography that serves as a guide to further
reading. Two translations into English of works that are especially serviceable in this
respect are Guan Zhong, Guan Zi, 2 vols., W. Allyn Rickett (trans.) (Princeton, NJ: Princ-
eton University Press, 1985 and 1998); and Hu Jichuang, A Concise History of Chinese
Economic Thought (Beijing: Foreign Language Press, 1988).
On Islamic economics see Louis Baeck, “The Economic Thought of Classical Islam,”
Diogenes, No. 154 (Summer 1991), pp. 99–216; M. Y. Essid, “Islamic Economic Thought,”
in S. T. Lowry (ed.), Pre-Classical Economic Thought: From the Greeks to the Scottish
Enlightenment (Norwell, MA: Kluwer Academic Press, 1987); Hamid Hosseini, “Under-
standing the Market Mechanism before Adam Smith: Economic Thought in Medieval
Islam,” History of Political Economy, vol. 27 (Spring 1995), pp. 539–561; and Timur
Kuran, “The Discontents of Islamic Economic Morality,” American Economic Review,
vol. 86 (May 1996), pp. 438–442.
Ghazanfar and Islahi (see references) provide a detailed analysis of Ghazali’s eco-
nomic analysis. Other writers in the medieval Muslim tradition are covered in S. M. Gha-
zanfar (ed.), Medieval Islamic Economic Thought: Filling the Great Gap in European
Economics (London: Routledge/Curzon, 2003). Also see J. D. Boulakia, “Ibn Khaldun: A
Fourteenth-Century Economist,” Journal of Political Economy, vol. 79 (Sept–Oct 1971),
pp. 1105–1118; Abdol Soofi, “Economics of Ibn Khaldun Revisited,” History of Political
Economy, vol. 27 (Summer 1995), pp. 387–404; and J. J. Spengler, “Alberuni: Eleventh
Century Iranian Malthusian?” History of Political Economy, vol. 3 (Spring 1971), pp. 92–
104. For a modern treatment of economics and Islamism, see Timur Kuran, Islam and
Mammon: The Economic Predicaments of Islamism (Princeton, NJ: Princeton University
Press, 2004).
Even after Christendom reclaimed parts of Europe from the Moors, the Ottoman
Empire continued to spread the sphere of Muslim influence from the late thirteenth cen-
tury on. We cannot do justice to this tradition here, but the interested reader should con-
sult two works by leading economic historians: Sevket Pamuk, The Ottoman Empire and
European Capitalism, 1820-1913: Trade, Investment Production (Cambridge University
Press, 2010); and Timur Kuran, “The Scale of Entrepreneurship in Middle Eastern His-
tory: Inhibitive Rules of Islamic Institutions,” in David S. Landes, Joel Mokyr, and Wil-
liam J. Baumol (eds.), The Invention of Enterprise: Entrepreneurship from Ancient
Mesopotamia to Modern Times (Princeton, NJ: Princeton University Press, 2010).
Many historians looking for important analytical developments in economics pass
over medieval European thought in silence. Still, there are important writers who find
great insights in medieval doctrine. For a trenchant survey, see J. A. Schumpeter, History
of Economic Analysis, chap. 2 (see references); or Henry W. Spiegel, The Growth of Eco-
nomic Thought, chap. 3 (Englewood Cliffs, NJ: Prentice-Hall, 1971), to which is
appended an excellent bibliography on medieval economics. Oscar De-Juan and Fabio
Monsalve, “Morally Ruled Behaviour: The Neglected Contribution of Scholasticism,” The
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44 Part I ■ Preclassical Economics

European Journal of the History of Economic Thought, vol. 13 (Spring 2006), pp. 99–112,
provide an overview of neglected contributions of Scholasticism to anthropological top-
ics. The Scholastics provided alternatives to individualist and utilitarian economics.
They argued that human beings are “morally ruled” by a sense of duty and that as social
beings people compete and cooperate in order to achieve certain ends. Advantages are
bestowed on market participants by special information or privilege, but these advan-
tages should not be abused.
Odd Langholm has done more to mine the field of scholastic economics than any
other writer; see, Wealth and Money in the Aristotelian Tradition: A Study in Scholastic
Economic Sources (Bergen: Universitetsforlaget, 1983); same author, Economics in the
Medieval Schools (Leiden: E. J. Brill, 1992); and again, The Legacy of Scholasticism in
Economic Thought: Antecedents of Choice and Power (Cambridge: Cambridge Univer-
sity Press, 1998). Langholm scores again in “The German Tradition in Late Medieval
Value Theory,” The European Journal of the History of Economic Thought, vol. 15 (Spring
2008), pp. 555–570, which explores German economic thinking in regard to the Canon
law requirement that goods should not be resold at a profit without some alteration, and
explains how the Germans reinterpreted this principle to reflect the idea of “alteration in
estimation” in the market rather than alteration in physical terms.
This chapter draws heavily on Langholm’s work, as he is by far the most meticulous
and convincing proponent of the view that modern value theory is a direct descendant
from Aristotle. Much earlier the Scholastics were defended by Bernard W. Dempsey (see
references) and Raymond de Roover, “The Concept of Just Price: Theory and Economic
Policy,” Journal of Economic History, vol. 18 (December 1958), pp. 418–438; and “Scho-
lastic Economics: Survival and Lasting Influence from the Sixteenth Century to Adam
Smith,” Quarterly Journal of Economics, vol. 69 (May 1955), pp. 161–190. The same
author has traced developments in monopoly theory back to the Church fathers in
“Monopoly Theory Prior to Adam Smith: A Revision,” Quarterly Journal of Economics,
vol. 65 (November 1951), pp. 492–524. The thread of natural law that runs throughout
medieval economics and beyond is reviewed by Jeffrey T. Young and Barry Gordon in
“The Natural Law Tradition: Thomas Aquinas to Francis Hutcheson,” Journal of the His-
tory of Economic Thought, vol. 14 (Spring 1992), pp. 1–17. Also see Barry Gordon’s com-
parative analysis on Greeks and Scholastics, “Aristotelian Analysis and the Medieval
Schoolmen,” History of Economics Review, vol. 20 (Summer 1993), pp. 1–12. João César
das Neves, “Aquinas and Aristotle’s Distinction on Wealth,” History of Political Economy,
vol. 32 (Fall 2000), pp. 649–657, stresses Aquinas’s independence from Aristotle on a key
point in the development of medieval economics. Odd Langholm, “Buridan on Value and
Economic Measurement,” History of Political Economy, vol. 38 (Summer 2006), pp. 269–
289, provides a closer look at the secular cleric commonly thought to represent the high
point of medieval economic thought.
Some other noteworthy contributions to the understanding of just price and to the
wider significance of medieval economics are John W. Baldwin, “The Medieval Theories
of Just Price,” Transactions of the American Philosophical Society, n.s., vol. 49, part 4
(Philadelphia, 1959); Albino Barrera, “Exchange Value Determination: Scholastic Just
Price, Economic Theory and Modern Catholic Social Thought,” History of Political Econ-
omy, vol. 29 (Spring 1997), pp. 83–116; E. A. J. Johnson, “Just Price in an Unjust World,”
International Journal of Ethics, vol. 48 (January 1938), pp. 165–181; Samuel Hollander,
“On the Interpretation of the Just Price,” Kyklos, vol. 18 (1965), pp. 615–634; and Ste-
phen T. Worland, Scholasticism and Welfare Economics (Notre Dame, IN: University of
Notre Dame Press, 1967). George W. Wilson extends Polyani’s “status” interpretation of
Aristotle’s exchange model to Aquinas as well, in “The Economics of the Just Price,” His-
tory of Political Economy, vol. 7 (Spring 1975), pp. 56–74, but his view has been chal-
lenged by Odd Langholm (see references) and by Stephen T. Worland in “Justium
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Chapter 2 ■ Ancient and Medieval Economic Thought and Institutions 45

Pretium: One More Round in an Endless Series,” History of Political Economy, vol. 9
(Winter 1977), pp. 504–521; and in Worland’s review of Langholm’s book in the same
journal, vol. 12 (Winter 1980), pp. 638–642. André Lapidus, “Norm, Virtue and Informa-
tion: The Just Price and Individual Behavior in Thomas Aquinas’ Summa Theologiae,”
European Journal of the History of Economic Thought, vol. 1 (Autumn 1994), pp. 435–
473, returns to this timeless issue. Fabio Monsalve, “Economics and Ethics: Juan de
Lugo’s Theory of the Just Price, or the Responsibility of Living in Society,” History of
Political Economy, vol. 42 (Fall 2010), pp. 495–519, examines the thought of the “last
great representative” of the Scholastics, particularly with regard to the just-price doc-
trine. Finally, on the dissolution of Scholasticism, see Wim Decock, “Lessius and the
Breakdown of the Scholastic Paradigm,” Journal of the History of Economic Thought,
vol. 31 (March 2009), pp. 57–78.
The literature on usury itself is fairly extensive, but it sheds more economic heat
than light. For historical perspective, see Carl F. Taeusch, “The Concept of ‘Usury’: The
History of an Idea,” Journal of the History of Ideas, vol. 3 (June 1942), pp. 291–318; and
Raymond de Roover (see references, pp. 257–271).
Finally, a good perspective on the development of markets—especially in the period
that marks the transition between the subject matter of this chapter and the next—can
be found in two articles by R. H. Britnell: “English Markets and Royal Administration
before 1200,” Economic History Review, vol. 31 (May 1978), pp. 183–196; and same
author, “The Proliferation of Markets in England, 1200–1349,” Economic History Review,
vol. 34 (May 1981), pp. 209–221. R. B. Ekelund, Jr., R. F. Hébert, and R. D. Tollison
explore historical reasons for the emergence of liberalism and market economies as a
response to religious change in several particular and general works, among them: “An
Economic Model of the Medieval Church: Usury as a Form of Rent Seeking,” Journal of
Law, Economics, and Organization, vol. 5 (Fall 1989), pp. 307–331; “An Economic Analy-
sis of the Protestant Reformation,” Journal of Political Economy, vol. 110 (June 2002), pp.
646–671; and “The Economics of the Counter-Reformation: Incumbent Firm Reaction to
Market Entry,” Economic Inquiry, vol. 42 (October 2004), pp. 690–705.
A nontechnical overview of the impact of the medieval Church on economic devel-
opment incorporating views just cited may be found in R. B. Ekelund, Jr., R. F. Hébert, R.
D. Tollison, G. Anderson, and A. B. Davidson, Sacred Trust: The Medieval Church as an
Economic Firm (New York: Oxford University Press, 1996). The impact of the Church on
the medieval marriage market is developed in A. B. Davidson and R. B. Ekelund, Jr.,
“The Medieval Church and Rents from Marriage Market Regulations,” The Journal of
Economic Behavior and Organization, vol. 32 (February 1997), pp. 215–245. For more
general treatments, see R. B. Ekelund, Jr., R. F. Hébert, R. D. Tollison, The Marketplace
of Christianity (Cambridge, MA: M.I.T. Press, 2006); and R. B. Ekelund, Jr., and R. D.
Tollison, Economic Origins of Roman Christianity (Chicago: The University of Chicago
Press, 2011). Those who read French may consult Jean-Dominique Lafay, “L’Eglise
médiévale sous le regard de l’analyse économique,” Socíétal, vol. 26 (September 1999),
pp. 108–111.
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Mercantilism

Institutional changes underway in Western Europe by the beginning of the six-

teenth century led to the decline of feudalism and the rise of an alternate set of
socioeconomic institutions. The new era was distinguished by the emergence of
stronger, more centralized nation-states and was encouraged and supported by a
new doctrine. The term mercantilism is applied to the doctrine or policy that the
economic interests of the nation as a whole are more important than those of indi-
viduals or parts of the nation; that a preponderance of exports over imports, with a
corresponding accumulation of bullion, is desirable; and that agriculture, industry,
and commerce should be directed toward this end. It was a policy that, not surpris-
ingly, allowed the emergent nation-states to flex their newfound economic muscles.
By the nineteenth century, however, the intellectual and institutional environ-
ment had changed again to allow much more individual freedom and much less
concentration of economic and political power. The term capitalism (coined by its
chief antagonist, Karl Marx) came into use to describe the more decentralized eco-
nomic organization of this new era. Thus, mercantilism refers to an intervening
period between feudalism and economic liberalism. It describes an economic creed
that prevailed at the dawn of capitalism, before the Industrial Revolution took hold.
There are two basic ways to analyze the economics of the system of thought
called mercantilism. One way considers mercantilism to be a fairly cohesive, “static”
set of ideas—that is, a body of thought summarized in the events of the day. We call
this the doctrinal approach. Another approach sees mercantilism as an important
historical process. It concentrates on the dynamics of competing interests and their
role in defining economic and political institutions. We call this the process approach.
Both approaches view mercantilism as a system of power, but the former features a
set of distinctly mercantilist propositions, or “central tendencies,” that characterize
the thought of the age. In this approach, the propositions of mercantilism presum-
ably withered away as mercantilism eventually was replaced by a competing set of
ideas. The doctrinal approach suggests that humans and their ideas may be arranged
on a continuum with “mercantile” at one extreme and “liberal” at the other. By con-
trast, the policy view spotlights those self-interested forces in the economic system
that generate changes in power and wealth. It concentrates on the specific regula-
tions of the mercantilist period and how each affected the competing groups of inter-
ests held by the monarch, parliament, courts, and producers. Compared to the
doctrinal, or ideational, approach it emphasizes permanence because it assumes that
the driving force of individual behavior in the mercantilist period is the same as the
driving force of contemporary capitalism, namely, the self-interested pursuit of gain.

46
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Chapter 3 ■ Mercantilism 47

Despite a tendency to view these two approaches as rival theories, there is no rea-
son why they cannot be treated as complementary. It is likely that our most complete
understanding of mercantilism will come through the application of both approaches.
For pedagogic reasons, however, we treat them separately in this chapter.

■ MERCANTILISM AS DOCTRINE: THE ECONOMICS OF NATIONALISM

The term mercantilism was coined by Mirabeau in 1763 to describe that loose
system of economic ideas that dominated economic discourse from the beginning of
the sixteenth century to almost the end of the eighteenth century. Mercantilist writ-
ers were a disparate group. Many of them were merchants who simply espoused
their own interests. Despite its international scope—mercantilism was a creed
shared by England, Holland, Spain, France, Germany, Flanders, and Scandinavia—
there was less consistency and continuity among mercantilists than among the
Scholastics of the previous age. This lack of cohesion among mercantilist writers
may be due to the absence of common analytical tools that could be shared and
passed on to a generation of successors. Moreover, communication among mercan-
tilists was poor or nonexistent, in contrast to the strong network of interrelations
among modern economists. Nevertheless, mercantilism was based on several unify-
ing ideas—doctrines and policy pronouncements that appear and reappear through-
out the period.
An early, condensed summary of mercantilist principles was provided by Philipp
Wilhelm von Hornick, an Austrian lawyer who published a nine-point mercantilist
manifesto in 1684. Von Hornick’s blueprint for national eminence emphasizes inde-
pendence and treasure. Not all mercantilists accepted every point in von Hornick’s
program, but his nine points are sufficiently representative of the loose system of
ideas that has come to be known as mercantilism.
Von Hornick’s nine principal rules of national economy are:
1. That every inch of a country’s soil be utilized for agriculture, mining, or manu-
facturing
2. That all raw materials found in a country be used in domestic manufacture, since
finished goods have a higher value than raw materials
3. That a large, working population be encouraged
4. That all export of gold and silver be prohibited and all domestic money be kept in
circulation
5. That all imports of foreign goods be discouraged as much as possible
6. That where certain imports are indispensable they be obtained at firsthand, in
exchange for other domestic goods instead of gold and silver
7. That as much as possible, imports be confined to raw materials that can be fin-
ished at home
8. That opportunities be constantly sought for selling a country’s surplus manufac-
tures to foreigners, so far as necessary, for gold and silver
9. That no importation be allowed if such goods are sufficiently and suitably sup-
plied at home
In the discussion that follows, we shall be concerned primarily with the general
nature of these premises rather than with their elaboration by specific individuals.
Readers should be mindful of the fact that the resulting characterization is a simpli-
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48 Part I ■ Preclassical Economics

fication and an idealization that may not apply specifically to any single mercantile
nation. British, French, Dutch, and Spanish mercantilism differed in many essential
respects, for instance. This disclaimer applies even more to individuals, a fact that
may be easily verified by reading and comparing the writings of at least two mer-
cantilists. (Some of the references provided at the end of this chapter may be con-
sulted to that end.) No single individual held all the ideas that are expressed below
as representing mercantilist thought, and what follows is only one of a number of
possible characterizations of mercantilist ideas. The mercantilist period was one
during which the threads of many ideas were being spun; as a consequence mer-
cantilism as a set of ideas remains something of a patchwork quilt.
We will focus attention on several areas of interest: “real-world” ideas, views on
international trade and finance, and examples of “dualism” in domestic policy. After
an assessment of mercantilist ideas, we consider the historical process of mercantil-
ism and its eventual role in the emergence of liberalism.

The Mercantilists and Real-World Ideas

Unlike writers from the feudal period, mercantilist writers showed less concern
for moral issues (e.g., justice and salvation) and more concern for secular matters
(e.g., wealth and power). On some issues a few writers of the mercantilist period
looked backward, whereas others looked forward to laissez-faire, but en masse they
were concerned with material, objective economic means and ends. And although
their overall social goal of “state power” was subjective, their opinions on the work-
ings of the economic system were a clear reflection of real-world habits of thought.
We have seen that the Scholastics built on the precept of divine law. As a rule,
mercantilists rejected divine law in favor of natural law. Sir William Petty (see chap-
ter 4), a trained physician, illustrated how conclusions about economic behavior
could be drawn from analogies with natural sciences. In his best-known economic
treatise, Political Arithmetick, Petty noted that:
We must consider in general, that as wiser Physicians tamper not excessively with
their Patients, rather observing and complying with the motions of nature, than
contradicting it with vehement Administrations of their own: so in Politicks and
Oeconomicks the same must be used. (Economic Writings, I, p. 60)

Though Petty wrote late in the mercantilist period, theories of social causation
grounded in natural law appeared as early as the mid-sixteenth century. The idea of
natural law grew into a fundamental tenet of the economic liberalism of the eigh-
teenth century, providing, in one important respect, an almost seamless transition
away from earlier preoccupation with the divine. As Eli Heckscher, a recognized
authority on the period, emphasized: “There was little mysticism in the arguments of
the mercantilists . . . they did not appeal to sentiment, but were obviously anxious to
find reasonable grounds for every position they adopted” (Mercantilism, II, p. 308).

International Trade
These real-world concerns of the mercantilists were reflected in their intense
focus on the material gain of the state. They saw society’s material resources as a
means to achieve the goals of national enrichment and well-being. They insisted
that the nation’s resources be used in such a way as to make the state as powerful as
possible both politically and economically. Following the Age of Exploration, the
sixteenth and seventeenth centuries witnessed the rise of great trading nations, as
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Chapter 3 ■ Mercantilism 49

nation-states used exploration, discovery, and colonization to build power and influ-
ence. The major topic considered by mercantilist writers was, understandably, inter-
national trade and finance. Gold, and means to acquire it, was never far from the
center of their concerns.
The Role of Money and Trade in Mercantilism. Money and its accumulation
were prime concerns of the growing nation-states of the mercantilist era, because
treasure was seen as a necessary element of national power. As already noted, a
flourishing international trade followed the age of discovery and colonization, and
gold bullion was the unit of international account. The acquisition of gold through
trade and trade restrictions of many types were essential mercantilist ideas, and
money, not real goods, was commonly equated to wealth.
Production and trade are vital steps to increased prosperity. To mercantilists,
however, prosperity in the sense of increased per-capita income was secondary to
the concentration of economic power in the hands of the state. National prosperity
was to be accomplished through an export-import policy that led to a stockpiling of
bullion. This stratagem, often referred to as “favorable balance-of-trade” policy,
encouraged importation of (low-value) raw materials and exportation of (high-
value) finished goods, thus assuring a net flow of money to the mercantilist country.
All this might sound quite reasonable if the mercantilists had been rationalizing
preexisting comparative advantages within trading nations, but the disappointing
truth is that many of them looked on trade and bullion accumulation as a zero-sum
game, where more for country A meant less for countries B, C, and so forth. They
did not appear to understand that increased total output and appropriate (dual)
gains from trade might accrue simultaneously to trading partners. Given this zero-
sum mentality, protectionism and “beggar-thy-neighbor” policies were justified as a
means to increase national wealth, which would, in turn, increase national power
and prestige.
International Trade and Specie Flow. Some writers, such as Gerard de Maly-
nes (1586–1623), were confirmed bullionists, opposed to any export of specie (i.e.,
gold/silver coins) whatsoever. He condemned the practice of specie export by the
East India Company, which was the leading avenue of Britain’s trade with the East
in the early seventeenth century. Although he had previously taken Malynes’s posi-
tion, Edward Misselden (1608–1654) attacked the extreme bullionist view, which
amounted to an absolute prohibition of specie export even on individual transac-
tions. Instead, Misselden advanced the notion that governmental policies should be
directed to maximizing specie earnings on the basis of an overall balance of trade.
However contradictory and misdirected their orientation toward money seems
to have been, the mercantilists produced the first real awareness of the monetary
and political importance of international trade and, in the process, supplied a
framework for international settlements that included both visible (products) and
invisible (shipping expenses, insurance, etc.) items. In the course of attacking the
bullionists, for example, Misselden developed the fairly sophisticated concept of a
trade balance couched in terms of debits and credits. In The Circle of Commerce
(1623), he actually calculated a balance of trade for England (from Christmas 1621
to Christmas 1622). He concluded, with disappointment, that it was a bad year.
We see it to our griefe, that wee are fallen into a great Underballance of Trade with
other Nations. Wee felt it before in sense; but now we know it by science: wee
found it before in operation; but now we see it in speculation: Trade alas, faile’s
and faint’s, and we in it. (Circle of Commerce, p. 46)
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50 Part I ■ Preclassical Economics

Misselden wished to emphasize the “scientific” nature of his calculations, and it is

this fact, rather than the accuracy of his data, that sets his accounting apart from the
mere collection of numbers, a practice that was widespread in early Egypt and Mes-
opotamia. Misselden arranged data for the purpose of understanding economic
effects and promoting social ends, a more productive enterprise in a scientific sense.
One of the anomalies in mercantilist literature is the pervasive belief that
wealth would be maximized through specie accumulation resulting from a trade
surplus. Many mercantilists misunderstood the effects of an increase in the domes-
tic money supply (monetization) that usually followed a trade surplus. One common
error was the persistent belief that a favorable balance of trade—and thus specie
accumulation—could continue over long and indefinite periods without adverse
consequences. This error was fully exposed by David Hume (1711–1776), the phi-
losopher-economist contemporary of Adam Smith. He identified a price-specie flow
mechanism that linked the quantity of money in an economy to its prices, and alter-
ations in prices to balance-of-trade surpluses and deficits.
Hume’s idea, like most good ideas, appears simple in retrospect. Imagine a sur-
plus in England’s balance of trade. As a result, gold flows into England, but if all of
the new gold is monetized (i.e., coined)—a distinct likelihood under a strict mone-
tary gold standard—England’s money stock increases in the same proportion. More
money in circulation drives up domestic prices, including the prices of goods in the
export sector of the economy, so that England’s trading partners tend to buy fewer
English goods in the face of higher prices. Faced with less money from the sale of
exports, English consumers tend to buy fewer imports, so that in England the price
of foreign goods falls relative to English goods. Foreign countries now buy fewer
English goods and English consumers now buy more foreign goods. The result is to
reverse the trade balance so that gold subsequently flows out of England and into
the treasuries of its trading partners. In this manner, any initial trade imbalance
tends to correct itself; and the misguided attempt to accumulate gold indefinitely
becomes self-defeating. Hume’s analysis deprived mercantilism of a key tenet of its
logical foundation.
Hume expressed a more enlightened, and underappreciated, view of money:
“’Tis none of the wheels of trade: ’Tis the oil,” he wrote. Nevertheless Hume foresaw
short-term salutary effects in the acquisition of specie. He wrote:
In my opinion, ’tis only in this interval or intermediate situation, betwixt the acqui-
sition of money and rise of prices, that the increasing quantity of gold and silver is
favorable to industry. When any quantity of money is imported into a nation, it is
not at first disperst into many hands; but is confin’d to the coffers of a few persons,
who immediately seek to employ it to the best advantage. (“Of Money,” in Writings
on Economics, p. 38)

Hume believed that money is a “veil” that obscures the real workings of the economic
system, and whether a nation’s stock of money is large or small is of no great conse-
quence after its stock of money adjusts to changes in the level of domestic prices.
The underlying principle behind Hume’s specie-flow mechanism is the quantity
theory of money, an idea anticipated by the political philosopher John Locke (1632–
1704). The quantity theory of money poses a direct, predictable, and positive con-
nection between the quantity of money in circulation and the domestic price level,
such that increases in the money supply lead to increases in the price level. Most
mercantilist writers, however, failed to understand the quantity theory of money. In
most early expressions, the “theory” is no more than a tautology affirming that a
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Chapter 3 ■ Mercantilism 51

given increase in money (say, a doubling) produces a given increase (doubling) of

the price level. A more sophisticated variant equates the money stock multiplied by
velocity (the number of times money turns over per year) to the price level multi-
plied by the number of income-generative transactions per year. In formulaic fash-
ion, it is written as MV = Py. As a theory of the price level that identifies dependent
variables (prices) and independent variables (money, velocity, and transactions), it
is alternately expressed as P = MV/y or, more generally, P = f (M, V, y). When V and
y are assumed to be constant, an increase in M leads to proportionate increases in P.
Although this more sophisticated version did not appear until long after Locke and
Hume (but see the discussion of Richard Cantillon in chapter 4), the mercantilists,
to the detriment of their analysis, did not see even the simplest connection.

The Nation-State: Mercantilism as Domestic Policy

Many mercantilists feared the consequences of too much freedom, so they
relied on the state to plan and control economic life. The list of policies specially
designed to promote the interests of the nation-state was long and varied, consist-
ing of many different regulations of the domestic and international economy. The
domestic economy came under less scrutiny than the international economy and
was subject to varying degrees of control; some sectors were heavily regulated,
some only lightly so. Similarly, taxation and subsidization of particular industries,
and measures restricting entry, varied widely across markets.
It was common practice during the mercantilist era for the state to establish
legal monopolies in the form of franchises and patents. A franchise granted exclu-
sive trading rights to a particular merchant or league of merchants, such as the East
India Company. Some franchises also received massive subsidies from the king. The
effect of all of this was a “mixed” economy, but with the mix far less on the side of
individual freedom than was the case during the first half of the nineteenth century
in England or in the United States. Some historians have treated the mercantilists
as mere individual merchants pleading their own narrow interests. In a governing
system in which the monarch controls virtually all property rights, perhaps the only
way for a merchant class to develop is by an alliance of power between the monarch
and the merchant-capitalist. The monarch depended on the merchant’s economic
activity to build up his or her treasury while the merchant depended on the author-
ity of the monarch to protect his or her economic interests. Use of the political pro-
cess to secure monopoly gains was by no means confined to that era, however. The
practice is what economists now call rent seeking, where “rent” refers to the profits
that are attributable to the existence of monopoly rather than to competitive advan-
tage. In a later section, we shall probe more deeply into this particular idea as it
relates to mercantilism.
“Ambiguity” in Mercantile Policies. From the very beginning we find mer-
cantilist writings that on the one hand extolled international economic controls for
society’s enrichment but on the other hand presented eloquent pleas for domestic
noninterference. In the doctrinal approach this dualism is somewhat of an embar-
rassment. At times, individual mercantilists could sound like impassioned economic
liberals (in the nineteenth-century sense). An anonymous tract (attributed to John
Hales) entitled A Discourse on the Common Weal of This Realm of England (1549)
exhibited an early and prophetic distrust of the effectiveness of legislative controls
in promoting society’s welfare. Investigating the economic consequences of subdi-
viding common land for individual ownership (i.e., the enclosure movement), the
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52 Part I ■ Preclassical Economics

author argued that market forces are more efficient allocators of resources than
government decree because profit provides the proper incentive to act. Underscor-
ing the stupidity and futility of governmental regulation of grazing land, the author
pointed out the difficulty of enacting such legislation (vested interests will inevita-
bly arise to challenge it) and, if passed, the difficulty of enforcing the legislation
(those who seek profits will find a way to subvert the law by one means or another).
Moreover, economic regulations are often defeated by “natural” responses. For
example, government-imposed price controls invariably give rise to black markets,
regardless of when enacted. If Hales was indeed the writer in question, he made it
clear by the following statement that self-interest is both natural and powerful:
“everie man naturally will follow that wherein he seeth most profit.” According to A.
F. Chalk, “This is surely a very close approximation to Adam Smith’s views concern-
ing the self-interest motive in economic activity” (“Natural Law,” p. 335).
The anonymous writer of 1549 was only one of many who advanced views dur-
ing the mercantilist era advocating more liberal economic activity. Pleas for free
internal trade became increasingly vigorous as the mercantile system devolved,
especially in the writings of John Locke, Sir Dudley North, Charles Davenant, and
Bernard de Mandeville. The emerging “liberal” beliefs relating to domestic policy
not only stand in strong contrast to adamant mercantilist views on external trade
restrictions, they represent a harbinger of persuasive challenges to state-controlled
economies that reached an apex in Adam Smith’s Wealth of Nations. A sympathetic
assessment of mercantilism maintains that “what had begun as opportunistic and
sporadic protests against commercial controls thus emerged, almost two centuries
later, in the form of a systematized philosophy of economic individualism which
proclaimed the beneficence of the laws of nature” (Chalk, “Natural Law,” p. 347).

Labor and the “Utility of Poverty”

The interests of the moneyed merchant class and the landed aristocracy con-
verged on the question of domestic policies toward labor and wages. Mercantilists
considered the maintenance of low wages and a growing population as a means of
national aggrandizement. The argument that labor should be kept at the margin of
subsistence runs throughout the mercantilist age. In his classic work, The Position
of the Laborer in a System of Nationalism, Edgar Furniss called it the “utility of pov-
erty” argument. In the extreme it is premised on a belief that “suffering is therapeu-
tic” and that, given the opportunity, menial workers would be lazy and improvident.
It was believed that the generally low moral condition of the lower classes inclined
them toward drunkenness and debauchery if wages were too high. In other words,
if wages were beyond subsistence, the quest for physical gratification would lead
workers to excess, vice, and moral ruin. On the other hand, workers facing poverty
because of the high price of subsistence and/or low wages would be encouraged
toward industry, which meant that they “lived better.” Reflecting the common atti-
tude of the era, Arthur Young noted in his The Farmer’s Tour Through the East of
England (1771): “Everyone but an idiot knows that the lower classes must be kept
poor or they will never be industrious.” The conventional wisdom of the day held
that unemployment was simply the result of indolence.
Bernard de Mandeville (paradoxically, a “liberal” in other contexts) represents
one extreme. He argued that children of the poor and orphans should not be given
an education at public expense but should be put to work at an early age. Education
ruins the “deserving poor,” he argued, so that
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Chapter 3 ■ Mercantilism 53

Reading, Writing and Arithmetick are very necessary to those whose Business
requires such qualifications, but where People’s livelihood has no dependence on
these Arts, they are very pernicious to the Poor. . . . Going to School in comparison
to Working is Idleness, and the longer Boys continue in this easy sort of Life, the
more unfit they’ll be . . . for downright Labour, both as to Strength and Inclination.
(Fable of the Bees, p. 311)

Various proposals were put forward to limit debauchery and to make the poor
industrious. In 1701, John Law proposed a tax on consumption in order to encour-
age frugality among the rich and industriousness among the poor. David Hume,
who contributed to the liberal movement in other respects, supported “moderate”
taxes to encourage industry, but he thought that excessive taxes destroyed incen-
tives and provoked despair. These writers seemed to be aiming at a real wage that
would support an “optimal level of frustration,” one high enough to provide incen-
tives for “luxuries” but low enough so that they could never be attained. As Furniss
observed, it was of the utmost importance to mercantilist writers that
the lowest ranks of the laboring classes be kept as full as possible, for upon the
members of this group England relied for that economic power which was to bring
her forth victorious from the struggle of nations after world supremacy. Thus, the
nation’s destiny was conditioned upon a numerous population of unskilled labor-
ers, driven by the very competition of numbers to a life of constant industry at min-
imum wages: “submission” and “contentment” were useful characteristics for such
a population and these characteristics could be fostered by a destruction of social
ambition amongst its members. (Position of the Laborer, p. 150)

A Summary of Mercantilism as a System of Ideas. The major theoretical de-

fects in mercantilist doctrine (always granting exceptions) were an inability to
grasp the cyclical nature of international accounts and the linkage between domes-
tic money supply and prices. In short, the mercantilists failed to integrate the
Locke–Hume price-specie flow mechanism (or the quantity theory of money) into
their analysis, which is ironic in view of their careful collation of trade statistics and
systematic record keeping. Indeed, this penchant for assembling and keeping statis-
tics on real-world quantities may well be the mercantilists’ most important legacy to
modern economics. Analytical insights in the mercantilist period, such as they were,
sprang from careful empiricism. Mercantilists were among the first economic writ-
ers to be more concerned with actual experience than with metaphysical specula-
tion. They brought economic questions to prominence, and in so doing, set the stage
for advances made in the next period of economic thought.
In the meantime, economic processes within the mercantile economy (espe-
cially of England) were introducing institutional changes that taken together pro-
vide a cogent explanation for the historical rise and decline of mercantilism. This
explanation pays little attention to what mercantilists said. It concentrates instead
on what they did and why they did it.

■ MERCANTILISM AS AN ECONOMIC PROCESS

The doctrinal approach to mercantilism gives us insight into how certain writ-
ers reacted to their environment in formulating a national creed, but it implies that
only nationalistic ends were appropriate to mercantilist policies. What we call the
process approach seeks to explain why and how mercantilism arose when it did and
why it eventually gave way to a distinctly different economic system. This latter
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54 Part I ■ Preclassical Economics

approach examines the economic motivations of individuals or coalitions within a

national economy. It focuses on the gains to economic agents of using the state in
order to acquire profits. Such profits, in the vernacular of modern economics, are
called rents (i.e., monopoly returns). Thus, mercantilism is presented here as a form
of rent seeking. Rather than rationalize a body of thought, this process view focuses
on the factors that motivated historical change.

Some Basic Concepts in the Modern Theory of Regulation

In understanding the rise and fall of mercantilism, it is helpful to look forward for
a mechanism to understand events of the past. Hence, a brief look at some contempo-
rary ideas in the theory of economic regulation and politics is in order (a fuller expla-
nation is contained in chapter 24). The term “rent seeking,” conveys self-interested
behavior of any or all parties to income distribution. When applied to the contempo-
rary analysis of economic regulation, the idea is that, in their own interests, politi-
cians (members of Parliament, Congress, state legislators, city councilors, etc.) will
supply government monopoly privileges and regulations to individual businesspeople
or merchants or to any group whose self-interest leads it to demand regulation. This
self-interested activity does not (necessarily) mean that politicians will accept direct
cash payments, although we shall see that such payments were far more common in
the mercantilist era than they are today. The modern world involves more subtlety.
Lobbyists can bestow favors on lawmakers outside of a strict cash nexus. Since most
politicians are members of law firms, patronage via company retainer fees is a less
obvious manner of accepting side payments. Contributions to electoral campaigns
may be made at arm’s-length from the candidate herself. Modern analysis seeks to
explain the existence or absence of monopoly privileges in some realms of economic
activity by examining the costs and benefits to the individuals engaged.
The formal specification of costs and benefits need not concern us here, but a
couple of examples might help to understand how the process view works as an
explanation. Consider “industry representatives,” or lobbyists, as potential demand-
ers of regulation. Their demand for monopoly privileges from government (e.g.,
entry control and/or subsidies) would obviously be related to how much profit they,
or their clients, could expect from the privileges. For example, anything increasing
the uncertainty of the duration of a monopoly privilege would reduce the value of the
monopoly franchise to the industry. So would any costs imposed on the regulated
firm (e.g., taxes and/or periodic inspections) as a quid pro quo for the franchise.
Now consider regulation from the supplier’s side. Contemporary economics
tells us that self-interested politicians will maximize their benefits (e.g., reelection
and/or side payments) by supplying regulation in return for votes and/or money.
People adversely affected by legislation face a major problem: the cost of organiz-
ing opposition. Large, diverse groups, such as retailers, may find it difficult to over-
come the high costs of combining in order to establish an effective lobby. Small,
narrow groups, such as undertakers, may find it easier to organize lobbying activi-
ties but may be unable to afford the expense of a successful lobby effort. The
amount of regulation politicians will offer depends on the costs and benefits of
doing so, as well as the coalition and organization costs necessary to actually supply
the regulation. Ordinarily the larger the group required to pass special-interest leg-
islation, the higher the coalition costs.
From an analytical standpoint, regulation may be treated as a “good” that is
supplied and demanded like other goods in more conventional markets. A decrease
in the net benefit to those who stand to gain from regulation would, other things
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Chapter 3 ■ Mercantilism 55

being equal, lead to a reduction in the amount of regulation demanded. Likewise, an

increase in the costs of supplying regulation—such as when the ability to supply
regulation is transferred from a single individual (a monarch or dictator) to a group
of individuals (a parliament or city council)—would, other things being equal, lead
to a reduction in the supply of regulation.
In the mercantilist era, the prospect of obtaining a monopoly gave merchants a
powerful incentive to seek regulation from the monarch. In this respect, the eco-
nomic logic of mercantilism is the same as that driving much present-day politico-
economic activity. Some groups (e.g., artisans then, telecommunications firms now)
possess inherent organizational advantages in lobbying for state regulatory protec-
tion from competition (e.g., lobbying local justices of the peace responsible for
enforcing the Statute of Artificers then, the Federal Communications Commission
now) relative to other groups, such as consumers in general. Usually, then, the gains
of successful interest groups consist of transfers of wealth from the consumers of
regulated products to those who benefit from the regulations.
A particular kind of monopolistic activity takes place when firms combine to
form a cartel, which is a formal combination of firms acting as a single monopolist
under some form of central control. (OPEC, for example, is an international cartel
run by the ministers of various oil-producing countries). Prices and/or output shares
are ordinarily assigned to the members of the cartel, and their behavior is monitored
or policed by an administrative board. Cartels may be privately or publicly orga-
nized, but in either case, strict entry controls are maintained. Private cartels are
inherently unstable because there is a strong incentive to cheat on cartel price or
output agreements if the cartel cannot be effectively policed. Most privately orga-
nized cartels are therefore unstable because enforcement is difficult. Cartels orga-
nized and/or sustained by governments, however, are more stable because
governments have inherent advantages in enforcement. One of the advantages is
that the cost of enforcement can be shifted to taxpayers. In instances where enforce-
ment costs are a major consideration, therefore, certain firms may willingly submit
to specific regulations as an inexpensive way to organize themselves into a virtual
cartel. By putting themselves under the protection of government these firms relin-
quish direct control over entry, prices, or profits, but the other side of the bargain is
that they gain protection from competitors, enjoy lower costs of enforcement, and
are often able to influence the nature and substance of the regulations imposed.
Whether analyzing the old mercantilism of monarchical Europe or its more sin-
ister twin in contemporary democracies, economic regulation can be seen as the
outcome of a competitive process whereby interest groups seek the state’s protec-
tion against rival interests. In the mercantilist setting, the relevant interest groups
were most often local administrators, merchants, and laborers in the domestic econ-
omy, and import/export firms the international economy.

Entrepreneurship: Productive and Unproductive

Putting the concept of entrepreneurship in historical perspective underscores
the fragile nature of entrepreneurism within the pantheon of economic ideas
because culture and institutions determine whether entrepreneurial efforts result in
the creation of wealth or its mere distribution (what economists today call rent seek-
ing). What we call the “competitive process” may be focused on gaining special
privileges from a central authority, or organizing the production and sale of goods
to gain consumers’ favor. In either case it is driven by a human actor motivated by
profit. We call this actor an enterpriser, or entrepreneur.
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56 Part I ■ Preclassical Economics

Most likely entrepreneurial activity is as old as human history. But entrepre-

neurship takes on different guises depending on institutional and cultural context.
In premarket societies property rights were concentrated in the hands of a tribal
leader, and in later societies they were in the hands of the monarch. The nature of
entrepreneurial activity conforms to the institutional makeup of society. Centralized
authority and concentrated property rights give one form to entrepreneurship;
highly dispersed property rights and highly developed markets give it another. Nor-
matively speaking, enterprising behavior can be productive or unproductive.
Unproductive entrepreneurship redistributes wealth but does not add to it; produc-
tive entrepreneurship adds to society’s wealth.
William Baumol and Robert Strom remind us that unproductive entrepreneur-
ship in bygone eras was a response to different institutional and cultural incentives:
For much of human history there was no guarantee that the individual whose
efforts enhanced the magnitude of the pie would reap rewards. Indeed, history is
replete with examples of the opposite, as monarchs readily expropriated the prop-
erty of others. In many cultures, the monarch theoretically owned everything, and
in some societies, the king chose to transform this theory into reality quite often.
Likelihood of expropriation is surely the ideal disincentive to productive effort.
(“‘Useful Knowledge’ of Entrepreneurship,” pp. 531–532)

In an age that takes its name, mercantilism, from the growing pool of merchants
who engaged in buying and selling activities throughout the Western world, it
would be surprising to find a low level of entrepreneurship. But what kind? The fol-
lowing hypothetical elaborates the issue within a mercantilist context.
Suppose a king or queen gives a grant to a favored courtier for the exclusive
right to import and sell wine. The recipient will restrict output to what can be pro-
duced at the monopoly price, receiving monopoly profits (or rents) at the expense of
consumers. One of the consequences of this action is that wealth is redistributed
from consumers to suppliers. But suppose instead that the monarch puts the right to
import and sell wine out for competitive bid. The winning bidder will be able to earn
monopoly profits, but he will have to expend resources (lobbying the queen, engag-
ing in legal pleadings, and so on) to obtain the right. In this case consumers lose as
before, but there is an additional loss of resources expended by the winning bidder
(as well as the losers, too). This kind of entrepreneurial activity, namely competition
to secure exclusive privilege rather than to produce and sell what consumers want
at an attractive price, is called rent seeking. It constitutes unproductive entrepre-
neurial activity. It may include bribery, larceny, and other forms by which rents and
special privileges are sought.
During antiquity, cultural attitudes and practices placed a low value on produc-
tive entrepreneurial activity. The Age of Exploration opened up vast new markets
and allowed commerce to expand at an accelerating pace, which gave entrepre-
neurs, a conspicuous part of the practical makeup of mercantilist society, expanded
opportunities to engage in productive entrepreneurship. The explorers and their
backers took unprecedented risks in the search for and development of new markets
and resources. If successful, they increased the wealth of society at the same time
they secured profits for themselves. Naturally the rent-seeking mode of wealth pro-
duction was still operative. Monarchs, for example, were lobbied for the exclusive
rights to import particular goods (for example, tobacco or spices). But productive
entrepreneurship was, slowly but surely, gaining a foothold. Productive entrepre-
neurship, practiced by individuals engaged in enterprising activities that require
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Chapter 3 ■ Mercantilism 57

independence of thought and action geared toward the acquisition of wealth, power,
and prestige, adds net value to society. The key point that cannot be stressed enough
is that the direction of entrepreneurial activity, at any particular time and in any par-
ticular place, depends heavily on the prevailing institutional arrangements and rela-
tive payoffs to activities that promote or retard economic growth.
In many societies today strong centralized governments have supplanted the
monarchs of old. Not surprisingly, rent seeking is still commonplace. However, the
cultural and institutional context is different than that associated with mercantilism.
In contemporary society unproductive entrepreneurship may be exercised by per-
sons who employ novel approaches to opportunistic, criminal, or socially damaging
activities—opportunists who, rather than expand the economic pie by creating more
wealth, seek to grab a larger slice of the pie for themselves by redistributing existing
wealth. Individuals who worm their way into the bribe-taking bureaucracy, or attor-
neys who foment novel, potentially lucrative lawsuits, provide ready examples. Lob-
bying of politicians for privileges by industry (energy, agricultural, pharmaceutical)
is an example of so-called “corporate capitalism” or unproductive entrepreneurship.1
The mercantilist era marked a kind of passage from medievalism to modern-
ism. During this transition old attitudes and institutions weakened and the venues
for productive entrepreneurship expanded. However, until about the time of the
British Industrial Revolution the prevailing institutions in most countries encour-
aged redistributive activity by enterprising individuals, chiefly through rent seek-
ing. During and after capitalism took root the structure of payoffs began to change
again, as we shall soon see, putting entrepreneurship in a more positive light.

Internal Regulation in English Mercantilism

Unproductive entrepreneurship and rent seeking permeated both internal and
external commerce in England over the fifteenth and sixteenth centuries, continu-
ing to a degree in later centuries. Economic regulation at all levels of government
took basically the same form in English mercantilism as it does in contemporary
societies. Governments granted licenses, thereby offering the favored few protec-
tion from competitors. Important differences existed, however, between the conduct
of institutions involving local as opposed to national regulation and monopoly.
Local regulation of trades, prices, and wages in mercantilist times was vested in the
medieval guild system. Enforcement of guild regulations in the Tudor period prior
to Elizabeth I (1485–1558) was the responsibility of the guild bureaucracy, in combi-
nation with the town or shire administrative machinery. Elizabeth attempted to cod-
ify and strengthen these detailed regulations in the Statute of Artificers, a law that
outlined the specific enforcement duties of local justices of the peace (JPs), alder-
men, and local administrators. JPs and other administrative enforcers of local regu-
lations were paid either very little or not at all for these services, a fact that led to
local alignments of economic interests. These interests ultimately rendered the local
provision of monopoly rights ineffective.
At the national level industrial regulation was created in three ways: (1) by stat-
utes of Parliament, (2) by royal mandates, and (3) by decrees of the Privy Council of

1
It must be noted that no type of entrepreneurship can take place without property rights establish-
ment and enforcement—a central role of government in all but the most primitive societies. This
role extended into the establishment of military installations to protect the great trading compa-
nies, partly established by the Crown in England (for example, the Africa Company, East India
Company, and so on).
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58 Part I ■ Preclassical Economics

the king’s court. It should be noted that merchants and monarchs alike stood to
gain from rent seeking. The meshing of private interests of monarch and monopo-
list was firmly enshrined in English commerce as early as the fourteenth century,
perhaps even earlier. The nature of this alliance was underscored in debate on the
issue of monopoly in the House of Commons in 1601:
First, Let us consider the word monopoly, what it is; Monos is Unus, and Polis, Civi-
tas: So then the Meaning of the Word is; a Restraint of any thing Publick, in a City
or Common-Wealth, to a Private Use. And the User called a Monopolitan; quasi,
cujus privatum lucrum esturbis et orbis Commune Malun. And we may well term
this Man, The Whirlpool of the Prince’s Profits. (Tawney and Power, Tudor Eco-
nomic Documents, II, p. 270)

These revealing definitions of monopoly and the monopolist remind us that the
motives of economic actors are usually recognizable and have not changed over the
centuries. But it would be a mistake to carry the analogy too far. Although the basic
nature of mercantilism then and now is the same, there are important differences in
the two rent-seeking environments. The most important difference for the purposes of
the discussion here concerns the supply side of the market for regulatory legislation.
Mercantilist regulations at the national level were supplied by a single ruler, or
monarch. Monarchy represents a uniquely low-cost opportunity for rent seeking,
especially when compared with modern, democratic societies where the power to
supply regulatory legislation is dispersed among various (sometimes conflicting)
governmental powers. The consolidation of national power under the mercantile
monarchies provides a logical explanation for the widespread rent seeking and eco-
nomic regulation during this period of English history. We shall soon see how the
growth and ultimate takeover of the power to supply regulatory legislation by Par-
liament dramatically altered the costs and benefits to buyers and sellers of monop-
oly rights in such a way as to lead to the decline of mercantilist regulation. But first
we must consider the pattern and fate of local regulation.

The Enforcement of Local Economic Regulation

The legal framework for the enforcement of mercantilist economic regulation
at the local level was set forth by the Elizabethan Statute of Artificers. This statute
attempted to codify older rules for the regulation of industry, labor, and welfare, the
important difference being that such regulations were to be national rather than
local in scope. Some writers have pointed to the enormous increase in wages after
the Black Death as the impetus to national regulation. The immediate economic rea-
son was much more likely the inability of the towns to restrict cheating on local car-
tel arrangements. Towns petitioned the king to establish a nationally uniform
system of regulation with the intent to protect local monopoly rights against
encroachment, especially by outsiders. There were many attempts by self-interested
merchants and town administrators to regulate economic activity and to prevent
interlopers on local franchises. The city of London, especially, wished to restrict
aliens and foreign technology that inhibited town profits. The solution most often
proffered was to banish to the countryside aliens or those workers who did not meet
“legal” qualifications for various trades. These sentiments are expressed in numer-
ous Tudor documents.
The nationally uniform system of local monopolies was to be enforced by the
JPs. In Eli Heckscher’s words, “The Justices of the Peace were the agents of unified
industrial legislation” (Mercantilism, I, p. 246). A primary feature of the system was
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Chapter 3 ■ Mercantilism 59

that the JPs were not paid; and Heckscher argues that the absence of pay for the JPs
led to lax enforcement through ineptitude and laziness. But it is more likely that low
or no pay created a situation ripe for malfeasance by encouraging a self-interested
pattern of enforcement—one suggesting both sub rosa activities and selective cartel
enforcement of industries in which the JPs themselves had vested interests. Evi-
dence suggests that the JPs’ holdings in regulated enterprises increased as a conse-
quence of the way the regulations were enforced. This could generally be
accomplished either through preferential treatment—the firm in which a JP had an
interest could be allowed to cheat on the cartel, while other firms could not—or
through bribes made to minor enforcement personnel. The Queen’s Council dic-
tated that the JPs themselves be policed by high constables, who, having less civil
authority than the JPs, were often on the receiving end of bribes. By the time of
James I it was openly acknowledged that the JPs could be easily “bought.” In 1620,
the following testimony was given before Parliament by a Committee of Grievances:
There are some patents that in themselves are good and lawful, but abused by the
patentees in the execution of them, who perform not the trust reposed in them
from his maj[esty]; and of such a kind is the Patent for Inns, but those that have
the execution abuse it by setting up Inns in forests and bye villages, only to har-
bour rogues and thieves; and such as the justices of peace of the shire, who best
know where Inns are fittest to be, and who best deserve to have licenses for them,
have suppressed from keeping of alehouses; for none is now refused, that will
make a good composition (Corbbett, Parliamentary History, pp. 1192–1193).

The reference to “a good composition” implied side payments by innkeepers in

order to be granted licenses.
In every age it is difficult to find accurate records of illegal transactions because
there is no incentive to report them. In the case of mercantilism, however, the testi-
mony of contemporary observers seems to corroborate the view that the enforcers
of internal mercantile regulations were self-interested parties. Thus, the claim that
enforcers were indifferent and careless because they were not paid seems naive in
retrospect. Modern economic theory leads us to expect malfeasance as the predict-
able response to low pay in occupations where an element of trust is dominant.2
That is because the opportunity cost to the wrongdoer of being caught (and fired) is
low. From this self-interested standpoint, the behavior of the JPs during the mercan-
tilist era was quite efficient and predictable, given the constraints imposed by the
Statute of Artificers.
Local Regulation and Resource Mobility. Another difficulty in enforcement
of the Elizabethan system of local regulation is that those regulated could escape
the jurisdiction of the law by moving outside the towns. Evidence exists that the
rules were blatantly disregarded, despite attempts to limit mobility. Movement of
artificers to the countryside was in fact blamed for the decay, impoverishment, and
ruin of the cities (Tawney and Power, Tudor Economic Documents, I, pp. 353–365).
As long as buyers and sellers could migrate to an unregulated sector in the suburbs
and the countryside, the local cartel arrangements in the towns could be subverted.
France, however, differed from England in this regard. According to Heckscher,
“The most vital difference was that many important districts were set free from the
application of the statutes in England, while in France nothing remained unregu-

2
For example, see Gary Becker and G. J. Stigler, “Law Enforcement, Malfeasance, and Compensa-
tion of Enforcers.”
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60 Part I ■ Preclassical Economics

lated in principle, apart from purely accidental exceptions or subordinate points”

(Mercantilism, I, p. 266). It does not appear that the English countryside was “set
free” in any conscious, deliberate act of policy. Instead economic resources merely
responded to the incentives produced by a local pattern of enforcement pursued by
the JPs. Movement out of the towns was simply a way for some artisans and mer-
chants to lower their costs of operation.
Migration to escape local cartel regulations did not have to involve much dis-
tance. The suburbs of towns were filled with handicraftsmen who either could not get
into the town guilds or wanted to escape their control. Because the nature of the trade
involved was akin to that of a widely dispersed flea market, various efforts to bring
these “cheaters” under control proved futile. Adam Smith illustrated this point nicely:
“If you would have your work tolerably executed, it must be done in the suburbs
where the workmen, having no exclusive privilege, have nothing but their character
to depend upon, and you must then smuggle it into town as well as you can” (The
Wealth of Nations, p. 313). Cheating on the local cartels thus became the economic
order of the day, and the state’s lack of success in dealing with enforcement problems
is ample testimony to the inefficient nature of the Elizabethan cartel machinery.
Occasionally the crown struck back by creating institutional arrangements that
made enforcement more efficient. For example, Elizabeth made a practice of grant-
ing to her favorite courtiers the right to collect fines for violations of the regulatory
code. Eventually these rights came to be sold to the highest bidder, the successful
bidder keeping for himself whatever he could collect. Enforcement remained
uneven, and a sizable unregulated sector of the economy persisted, however,
because some infringements (e.g., patents) were more lucrative to collect on than
others. In the end the Statute of Artificers contained the seeds of its own destruc-
tion. The behavior of the unpaid or low-paid JPs and the ability of firms to escape
regulation were the two major factors that helped undo local mercantilist regulation
in the long run. We now turn to a consideration of the important part played by the
mercantilist judiciary in the gradual demise of national economic regulation.

The Mercantilist Judiciary and the Breakdown of National Monopolies

In a system of national regulations, the only way to escape legal jurisdiction is
to leave the country, which is more difficult and more costly than moving from city
to suburb. Thus, the absence of a viable, unregulated alternative brought about
more stable cartel arrangements in national markets than in local ones. The undo-
ing of the national monopolies must therefore be explained by other factors, namely
the changing constraints on economic activity in mercantilist England.
English Common Law and the Courts. The English judiciary system devel-
oped slowly and intricately. Basically, three common law courts evolved in the
period between the Norman invasion and the mercantile era: the Court of King’s
Bench, the Court of Common Pleas, and the Court of Exchequer. These courts pre-
sided over civil matters, and all were initially under the crown’s direct control, with
the king often rendering decisions in the early period. During the thirteenth
through the fifteenth centuries the courts grew increasingly independent of the
crown, although the king retained the power to appoint and remove judges.
Up to the time of the Tudors, jurisdiction between the three courts was unde-
fined and payment of judges depended in part on the collection of court fees. This
led to a great deal of jurisdictional competition between the courts. Moreover, the
functional separation of the branches of government toward the end of the four-
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Chapter 3 ■ Mercantilism 61

teenth century intensified the division of interests between the King’s Council, the
Court of King’s Bench, and Parliament: The Council identified and allied with the
executive branch of government (monarch), the King’s Bench united with the judi-
cial branch, and Parliament became a legislative body, but with some vestiges of a
judiciary (the House of Lords remains the highest appellate court in England). The
separation of governmental functions brought with it a self-interested alignment
between the common law courts and Parliament. The common law courts recog-
nized Parliament as the source of laws that the courts were charged to enforce. In
turn the many common lawyers in Parliament came to believe that errors in the
judiciary should be corrected by Parliament, not by the King’s Council.
This alliance between the common law courts and Parliament began centuries
before the mercantilist period, by which time the courts had cartelized and estab-
lished firm bureaucracies and jurisdictions. By 1550 the coincidence of interests
between the courts and Parliament had intensified, owing principally to the rise of a
competing legal system in the form of the royal courts that were established by the
time of Elizabeth I.
The competing judicial system emerged from a tradition in Roman law (curia
regis) that regarded the powers of the crown as outside normal legal jurisdictions,
therefore, outside the common law courts. These other courts became entrenched
in branches of the Royal Council, its subordinate court (the Court of Star Chamber),
and in other parts of the executive branch of government, such as, the Court of
Chancery. As the Court of Chancery and the Court of Star Chamber extended their
jurisdictions into that of the common law courts, they met with fierce resistance
from the judicial “cartel.” Persistent attacks by the common lawyers successfully
destroyed one of the courts of Chancery (Maitland, Selected Historical Essays, p.
115), and the confrontation served to cement the alliance between the common law
courts and Parliament. In order for Parliament to enhance its power relative to the
crown, it needed support for its legal actions, a support the common law courts
were eager to provide. Besides its composition of individuals of similar training and
interest, the common law courts were further drawn into Parliament’s orbit
because, inasmuch as the House of Commons could overturn any decision by a
common law court, Parliament itself was regarded as simply another common law
court. Interdependence was further motivated by the fact that whereas Parliament
could control jurisdictional boundaries and other matters before the courts, it was
dependent on the courts for the permanence and security of its legislation. This
intertwined, complex judicial system formed the backdrop against which national
mercantilist regulations were enacted and applied.

Effects of Judicial Competition on the Durability of Monopoly Rights

Competition between the king’s courts and the common law courts created
uncertainty over the durability of a monopoly right granted by a single governmen-
tal authority because a monopoly right valid in one court would not necessarily be
considered valid in another. Hence, the security of monopoly privilege depended on
the shifting fortunes of each court system, because monopoly rights become less
valuable as they become less certain, and durable attempts by the crown to estab-
lish monopoly privileges met with less and less success over time.
Example 1. On grounds of national defense, Queen Elizabeth claimed regalian
rights to the production of saltpeter and gunpowder in the 1580s. She granted a
monopoly right to manufacture these products to George and John Evlyn. The Evlyn
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62 Part I ■ Preclassical Economics

family subsequently enjoyed lucrative benefits from rent splitting with the crown for
almost fifty years, but persistent counteraction by other merchants and the common
law courts finally brought down the monopoly privilege, after which the manufac-
ture of both saltpeter and gunpowder became the object of open competition.
Example 2. Elizabeth tried to imitate the French king’s successful and lucra-
tive salt tax but did not meet with the same success. Five years after a patent
monopoly in salt was established, the patentees abandoned their investment, leav-
ing huge salt pans rusting on the English coast. Private capitalists without any
exclusive privileges thereafter entered the industry and profitably produced and
sold salt over the next three decades, despite repeated attempts by the crown to
reestablish monopoly rights.
Example 3. In 1588, a paper monopoly was granted to John Spilman, who
claimed to have a new process for producing white paper. Ordinarily, patents issued
to protect a new invention or process were unopposed by Parliament and the com-
mon law courts, but sometimes the patent was extended to enable its holders to
“engulf” closely related products. Spilman gained this comprehensive benefit in
1597 when he was granted a monopoly over all kinds of paper manufactory. The
monopoly proved impossible to enforce, however, and according to John Nef
(Industry and Government, p. 106), within six years Spilman had to content himself
with “such a share of the expanding market for papers as the efficiency of his
machinery, the skill of his workmen, and the situation of his mills enabled him to
command.” Elizabeth’s luckless experiences with franchising and rent-seeking
activities ended in 1603, when, beseeched to grant a monopoly of playing cards, she
personally declared that such patents were contrary to common law. Nevertheless,
her successors often made new attempts to supply various regulations.
Example 4. During the monarchy of James I (1603–1625), successor to Queen
Elizabeth I, the House of Commons and the common law courts consolidated their
power and succeeded in blocking the establishment of enforceable, national
monopolies that interfered with their interests or the profits of merchants aligned
with them. This opposition to the crown’s supposed right to supply regulation
reached its zenith in 1624, when the celebrated Act Concerning Monopolies legally
stripped the king of all means to monopolize industry.
Example 5. Upon the death of James I in 1625, his son, Charles I, ascended to
the British throne and promptly tried to reassert regalian rights to grant monopoly
by letters patent or by order of the Privy Council. With the aid of his powerful and
persuasive minister, Sir Francis Bacon, he found a loophole in the 1624 statute and
tried to make deals with large producers in many industries, particularly in alum
and soap. Between 1629 and 1640 the alum patent brought in £126,000 and the soap
patent an additional £122,000. King Charles’s brazen move ultimately led to a head-
to-head confrontation with Parliament and the constitutionalists, a battle that he
ultimately lost, along with his head, in 1649.
These examples demonstrate that the returns from seeking national monopolies
through the state fell drastically in the sixteenth and early seventeenth centuries as
the conflict between Parliament and the crown intensified. History is unclear
whether the conflict itself was motivated by monopoly policy, but regardless of ori-
gin, the conflict generated important side effects in the rent-seeking economy of Eng-
land during the mercantilist era. Whereas the crown’s concern for “public interest”
may have played a role in the transition of power from the king to Parliament, the
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Chapter 3 ■ Mercantilism 63

institutional facts of the centuries-old alliance between common law courts and Par-
liament plus Parliament’s control over jurisdictional disputes between the two court
systems suggest a very powerful, self-interested economic motivation. One important
question remains, however: Why was Parliament unable to reinstitute and sustain
mercantilist policies when it became the sole supplier of regulatory legislation?

The Decline of Mercantilism and the Rise of Parliament

The focal point of the conflict between Parliament and the crown in the struggle
to supply monopoly rights concerned patents. Parliament wanted to restrain the
unlimited power of the crown to grant monopoly privileges. The struggle was not
over free trade versus government control but rather over who would have the
power to supply economic regulations.
This became abundantly clear in 1624 when the House of Commons petitioned
King James I to cease and desist from granting monopoly privileges in the form of
letters patent. The petition was provoked by public controversy regarding a light-
house on the English coast known as the Wintertonness Lights. Parliament had orig-
inally issued a patent to the master of Trinity House to erect and maintain the
lighthouse. Under the provisions of this patent ships carrying coal past the light-
house were to be charged sixpence for every 640 bushels of coal transported. In the
meantime, Sir John Meldrum successfully petitioned King James I for a patent to the
lighthouse, upon receipt of which he began to charge a rate for coal that was nearly
seven times the rate allowed the master of Trinity House under the initial patent.
Parliament was incensed, and invoked “public welfare” as the rationale for wresting
economic control from the crown. Such displays of public virtue are, however, most
often transparent attempts to gain control over a powerful means of patronage.
Although Parliament ultimately beat the crown at its own game and became the
sole supplier of legislation in England, it was unable to consistently exploit its new
power because of the high costs of multiparty decision making. It is invariably more
costly to each individual for decisions to be made by many parties rather than by a
single party, such as the monarch. Unable to delegate authority to an effective
bureaucracy (which did not exist in this period), Parliament found it costly to legis-
late and even more costly to enforce economic regulations. It is a wry twist of his-
tory that after struggling long and hard with the crown for the right to operate a
national system of economic regulation, Parliament discovered that the costs of sus-
taining the system were much larger than the pro rata benefits. On this fact, mer-
cantilism ultimately floundered, and significant deregulation of the British economy
subsequently ensued. Historically, mercantilism waned in the eighteenth century,
only to resurface with more contemporary visages in the future. During antiquity,
cultural attitudes and practices placed a low value on entrepreneurial activity.

The Force of Ideas: Mercantilism, American Style

Colonization was both an expression of mercantilism and an extension of it. All of the great
nations of the sixteenth through the eighteenth centuries—Spain, Portugal, Holland, France,
and England—engaged in colonizing activities around the globe. In the process of creating
profits for Europeans, of course, great discoveries were made, including the modern discovery
of the Americas. The desire to accumulate wealth and power (often through conquest) was a

(continued)
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64 Part I ■ Preclassical Economics

driving force in what we call mercantilism. The dominance of nation-states and the process of
state building over the mercantilist period was, in large part, an expression of economic inter-
ests within those states. Supply and demand provides a ready explanation: Colonies provided
a source of cheap raw materials and a ready market for the finished goods and services pro-
duced by the mother countries.
Mercantilist ideas, policies, and practices had an enormous impact on the history of the
United States. The new overseas markets were relatively free and competitive, so that English
and other European immigrants in the North American colonies were free to sell their wares
to all demanders and to buy needed products (mostly finished goods) from any willing sellers.
But as a legal extension of the English state, American colonists had to toe the line established
by the mother country.
Practically from the beginning, the North American colonists were shackled with regula-
tions that created profits (rents) for English economic interests. The Stuart kings claimed
“regalian rights” over the economic development of the colonies and cut deals with, for exam-
ple, the Virginia tobacco growers and merchants for a “take” in the form of taxes. Later, after
England’s constitutional revolution (1650–1660) and the restoration of the monarchy, Parlia-
ment gained new powers, so that both the monarchs and the Parliament regulated economic
activities in the New World.
Although such rules were extensive, a small sample of them is illustrative of their impact.*
Under a series of Navigation Acts (such as those passed in 1660, 1663, 1673, and 1696), Amer-
ican colonists were required to ship their exports in English-built ships. Particular exports of
the colonists were “enumerated,” that is, required by Parliament to be exported only to Eng-
land or to English colonies. Tobacco, sugar, and indigo were on the list in 1660. The Navigation
Act of 1663 benefited English merchants even more. It required that all European goods (with
a few self-serving exceptions) transported to the colonies be shipped from England and on
English-built ships. This had the effect of protecting British manufacturing and ship-building
interests from foreign competition as well as allowing the crown to tax those goods that were
excepted from the regulation.
Later, Parliament assigned customs officials in the colonies extraordinary powers of search
and seizure and voided all colonial laws contrary to parliamentary decrees. English rulers,
merchants, and politicians, as well as colonial governors, took advantage of the situation, and
rent seeking became rife. One example makes clear the motives: The Hat Act passed Parlia-
ment in 1732 under pressure from London felt makers. Already facing French competition,
London hat makers were fearful of the establishment of a hat industry in the North American
colonies. The act prohibited the exportation of hats from one colony to another, required col-
onists wishing to enter the trade to undergo a seven-year apprenticeship, limited apprentices
to two per shop, and barred the employment of Negroes in hat making altogether. A Molasses
Act, passed the following year, had the same intent and purpose.
Naturally, these kinds of mercantilist policies had to be enforced, and the distance between
colony and mother country made enforcement costly. Despite rampant piracy, smuggling, and
privateering (capture of “enemy” ships during wartime), England’s economic regulations were
surprisingly effective, in part because independent colonial trade was hampered by a legally
prescribed lack of money and credit institutions. Mercantilist laws and regulations forced a
high degree of “self-sufficiency” on the American colonists, even though the colonists gener-
ally carried trade deficits with England. Rent-seeking activity in England finally created a huge
reduction in the welfare of the average colonist, and rebellion was the inevitable outcome.
Thus, the collision course with England, which ended in the Declaration of Independence and
the birth of a new nation, was set much earlier in a course of action that taxed and regulated
colonial trade and reduced the well-being of the average colonial citizen. This type of protec-
tionism was (and remains today) associated with mercantilism and “neomercantilism.”
* These examples are drawn from Richard B. Morris (ed.), Encyclopedia of American History, pp. 510–514.
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Chapter 3 ■ Mercantilism 65

Some historians emphasize the “dual” nature of mercantilist thought, which

became increasingly manifest near the end of the mercantilist era. Many later mer-
cantilists rejected domestic controls while they simultaneously defended protection-
ist measures in foreign trade. This apparent contradiction is less paradoxical if
mercantilism is viewed as a form of rent-seeking activity. One particular incident,
though small in itself, reveals that self-interested rent seeking was never far from
the surface when mercantilist policies were shaped. King Charles I battled Parlia-
ment over his “ancient right” to customs duties, but lost his fight in 1641. Refusing
to yield, the king reasserted his claim of absolute authority to levy taxes while Par-
liament was dissolved. Leaning on the support of Parliament, import merchants
refused to pay customs to the king, who retaliated by seizing the merchants’ goods.
Some of the merchants resisted and were brought before the Privy Council. Mer-
chant Richard Chambers brazenly declared that “merchants are in no part of the
world so screwed as in England. In Turkey they have more encouragement” (Taylor,
Origin and Growth of the English Constitution, p. 274).

■ TRANSITION TO LIBERALISM
Major historical turning points in the distant past are always difficult to pin-
point. Such is the case with the transition from a heavily regulated national econ-
omy to one of relatively free trade. In practice, no pure laissez-faire economy has
ever existed, but significant structural changes in the British economy were detect-
able between the seventeenth and nineteenth centuries. To some extent, doctrinal
and policy views of mercantilism offer different reasons for this transition.

The Doctrinal Transition: Mandeville

The doctrinal view maintains that mercantilism broke down because it lost
intellectual respectability. In the century prior to 1776, liberal criticism of mercantil-
ism reached a high pitch. One of the most effective proponents of the new liberal-
ism during this period was Bernard de Mandeville.
Mandeville, who was mentioned previously as a sponsor of the mercantile doc-
trine of the utility of poverty, published an allegorical poem in 1705 entitled The
Grumbling Hive; or Knaves Turn’d Honest. In this satirical work he argued that indi-
vidual vices (self-interest) produce public virtues (maximize society’s welfare), one
of the central themes of Smith’s Wealth of Nations. Later the poem was reprinted
and enlarged in The Fable of the Bees, published in two parts (part I in 1714 and part
II in 1729). The book was a sensation.
Rejecting a rationalist, metaphysical view of knowledge, Mandeville empha-
sized a theory of human nature based on the empirical proposition that sense
impressions are all we can know of the world. Reasoning must come from facts, not
from any rationalist or a priori considerations. In this important sense, he foreshad-
owed the liberal revolution, whose most effective voice was Adam Smith. Since sen-
sations are the source of knowledge and since each individual receives different
external stimuli, early empiricists argued that the optimal social organization would
be one allowing a maximum degree of individual freedom.3

3
Although he does not do so consistently, Mandeville suggests at several places in The Fable that
man’s central motivating force is pleasure. Thus, some may regard him as an anticipator of utili-
tarian thought (see chap. 6 of this text).
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66 Part I ■ Preclassical Economics

Mandeville thus rejected absolute criteria as the foundation for social systems
or for individual behavior. He insisted that right and wrong are relative, and he
wrote: “Things are Good and Evil in reference to something else, and according to
the Light and Position they are placed in” (Fable, p. 367). This passage is reminis-
cent of Xenophon’s earlier subjectivism (see chapter 2). Although Mandeville’s
empiricism and moral relativism were roundly attacked during his lifetime, his posi-
tion gradually gained acceptance, popularizing the view (still current) that norma-
tive problems cannot be handled effectively by science.
Further, Mandeville’s belief that despite being “full of vice” (or self-interest)
individuals nevertheless promote public benefits was a clear anticipation of liberal
thought. Humans are at base selfish creatures since they “give no Pleasure to others
that is not repaid to their Self-Love, and does not at last center in themselves, let
them wind it and turn it as they will” (Fable, p. 342). But as he pointed out, “Pride
and Vanity have built more Hospitals than all the Virtues together” (Fable, p. 261).
Although Mandeville cannot be regarded as a consistent exponent of liberal-
ism, he nevertheless presented a clear discussion of the philosophical underpin-
nings of nineteenth-century liberal thought. Even though he did not apply his
system of self-interest to actual problems of commerce, as writers such as Richard
Cantillon (see chapter 4) did, he nevertheless remains an important harbinger of
economic liberalism.

The Institutional Transition

Regardless of which interpretation one applies to mercantilism, the system
retarded economic growth as an unintended consequence of its principles and prac-
tices. The conventional, doctrinal interpretation emphasizes the misguided effort to
accumulate gold and specie, whereas the process view underscores how societal
wealth was dissipated through monopoly creation and rent seeking at different levels
of government. According to the doctrinal view, mercantilism declined as its “errors”
were slowly but surely exposed. The process view emphasizes the unintentional con-
sequences of rent-seeking activity, which spawned institutional changes that gradually
made rent seeking and internal regulation by the central government less feasible.
Under either interpretation liberalism and free trade emerged as viable alternatives.
Pure laissez-faire never existed in England (or anywhere else) even after Parlia-
ment wrested the ability to supply regulation from the crown. The landed class
retained control of Parliament and continued to pass legislation favorable to that
class. But historians acknowledge that the deregulation of the British economy at
this time was significant, even if their characterization of the dissolution of the old
order has been willy-nilly. Whether deregulation eventually occurred because better
ideas won out or because there was an increase in the cost to Parliament of supply-
ing regulation, it should also be noted that the seventeenth and eighteenth centuries
were periods of rapid technological advancement and that such quick-paced inno-
vation in a reasonably competitive environment will tend to reduce the demand for
legal cartels. This feature, too, may have played an important role in the decline of
regulation in seventeenth-century England.

■ CONCLUSION
The analysis of mercantilism presented in this chapter has focused on the Brit-
ish economy. Intellectual and institutional forces interacted in the eighteenth cen-
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Chapter 3 ■ Mercantilism 67

tury to nudge England and eventually other countries toward liberalism. Even at the
height of its regulatory activity, however, the British economy was a pale reflection
of its European counterpart—the French economy administered by Colbert, Louis
XIV’s finance minister. French mercantilism is often called “Colbertism,” thus bear-
ing the personal stamp of the man who shaped its policy. What made French mer-
cantilism different was its very high degree of centralization and very efficient
system of policing, factors that were never so great in England. The liberal reaction
to French mercantilism reached its height in the writings of the Physiocrats, a group
of French economists discussed in the following chapter.

REFERENCES
Baumol, William, and Robert Strom. “‘Useful Knowledge’ of Entrepreneurship: Some
Implications of the History,” in D. S. Landes, Joel Mokyr, and W. J. Baumol (eds.),
The Invention of Enterprise: Entrepreneurship from Ancient Mesopotamia to Modern
Times. Princeton, NJ: Princeton University Press, 2010.
Becker, Gary, and G. J. Stigler. “Law Enforcement, Malfeasance, and Compensation of
Enforcers,” Journal of Legal Studies, vol. 3 (January 1974), pp. 1–18.
Chalk, Alfred F. “Natural Law and the Rise of Economic Individualism in England,” Jour-
nal of Political Economy, vol. 59 (August 1951), pp. 330–347.
———. “Mandeville’s Fable of the Bees: A Reappraisal,” Southern Economic Journal, vol.
33 (July 1966), pp. 1–16.
Corbbett, W. Parliamentary History of England, vol. I. London: R. Bagshaw, 1966 [1806].
Furniss, Edgar S. The Position of the Laborer in a System of Nationalism. New York: Kel-
ley and Millman, 1957.
Hales, John. A Discourse of the Common Weal of This Realm of England, E. Lammond
(ed.). London: Cambridge University Press, 1929.
Heckscher, Eli. Mercantilism, 2 vols., Mendel Shapiro (trans.). London: G. Allen, 1935.
Holdsworth, Sir William. A History of English Law, 4 vols. London: Methuen, 1966 [1924].
Hornick, P. W. von. “Austria Over All If She Only Will,” in A. E. Monroe (ed.), Early Eco-
nomic Thought. Cambridge, MA: Harvard University Press, 1965.
Hume, David. Writings on Economics, E. Rotwein (ed.). Madison: University of Wiscon-
sin Press, 1970.
Maitland, F. W. Selected Historical Essays of F. W. Maitland, Helen M. Cam (ed.). London:
Cambridge University Press, 1957.
Mandeville, Bernard de. The Fable of the Bees, F. B. Kaye (ed.). London: Oxford Univer-
sity Press, 1924.
Misselden, Edward. “The Circle of Commerce,” in Philip C. Newman, Arthur T. Gayer,
and Milton H. Spencer (eds.), Source Readings in Economic Thought. New York:
Norton, 1954, pp. 43–48 [1623].
Nef, John U. Industry and Government in France and England, 1540–1640. New York:
Russell and Russell, 1968 [1940].
Morris, Richard B. (Ed.). Encyclopedia of American History. New York: Harper and
Brothers, 1961.
Petty, William. The Economic Writings of Sir William Petty, 2 vols., C. H. Hull (ed.). New
York: A. M. Kelley, 1963.
Smith, Adam. The Wealth of Nations. New York: Random House, 1937 [1776].
Tawney, R. H., and Eileen Power. Tudor Economic Documents, 3 vols. London: Long-
mans, 1924.
Taylor, Hannis. The Origin and Growth of the English Constitution, part II. Boston:
Houghton Mifflin, 1898.
Young, Arthur. The Farmer’s Tour Through the East of England, 4 vols. London: W. Stra-
han, 1771.
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68 Part I ■ Preclassical Economics

NOTES FOR FURTHER READING

The dominant the custom in economic literature has been to treat mercantilism as a
set of ideas rather than as a set of individual and group interests spawned and shaped by
prevailing institutions. Within this ideational/doctrinal view there have been two sepa-
rate traditions, one “absolutist” in approach, the other “relativist.” The absolutists tend to
view the history of economics as a more or less steady progression from error to truth,
whereas the relativists view past doctrines as justified within the context of their times.
The former emphasize the presence of grave errors in mercantilist logic, errors exposed
by David Hume and the classical economists. The primary instance of such faulty rea-
soning was the failure of mercantilist writers to recognize the self-regulating effects that
the “specie-flow mechanism” imposed on attempts to realize a perennial trade surplus.
The relativists, beginning with the German historical school and their English disciples,
generally defend mercantilism as historically acceptable, given its aim of national power
and wealth. Gustave Schmoller, The Mercantile System and Its Historical Significance
(New York: Smith, 1931), represents the German historicist view. English disciples of the
German Historicists include W. J. Ashley, An Introduction to English Economic History
and Theory, vol. 1 (New York: Putnam, 1892); and W. Cunningham, The Growth of Eng-
lish Industry and Commerce, 2 vols. (New York: A. M. Kelley, 1968).
Jacob Viner is the clearest exponent of the absolutist view. His two classic papers on
mercantilism were originally published in 1930 as “English Theories of Foreign Trade
before Adam Smith,” parts 1 and 2, Journal of Political Economy, vol. 38 (1930), pp. 249–
301, 404–457, reprinted as the first two chapters of Viner’s Studies in the Theory of Inter-
national Trade (London: G. Allen, 1937). Viner viewed the mercantilists’ trade theory as
“objectionable from the point of view of modern doctrine,” arguing that the “simplicity
and brevity of the early analysis at least resulted in fallacies of comparable simplicity,
but the later writers were able to assemble a greater variety of fallacies into an elaborate
system of confused and self-contradictory argument” (Studies, p. 109). In a trenchant
criticism of the relativist position, Viner wrote:

The economic historians . . . seem to derive from their valid doctrine, that if suffi-
cient information were available the prevalence in any period of particular theories
could be explained in the light of the circumstances then prevailing, the curious
corollary that they can also be justified by appeal to these special circumstances.
There are some obvious obstacles to acceptance of this point of view. It would lead
to the conclusion that no age, except apparently the present one, is capable of seri-
ous doctrinal error. It overlooks the fact that one of the historical circumstances
that has been undergoing an evolution has been the capacity for economic analy-
sis. More specifically, to be invoked successfully in defense of mercantilist doctrine
it needs to be supported by demonstration that the typical behavior of merchants,
the nature of the gains or losses from trade, the nature of the monetary processes,
and the economic significance of territorial division of labor have changed suffi-
ciently since 1550, or 1650, or 1750 to make what was sound reasoning for these
earlier periods unsound for the present-day world. (Studies, pp. 110–111)

An interesting exploration of Viner’s point is presented by W. R. Allen, “Modern Defend-

ers of Mercantilist Theory,” History of Political Economy, vol. 2 (Fall 1970), pp. 381–397.
Eli Heckscher’s magisterial two-volume work, Mercantilism, published in Swedish
in 1931 and translated into English (see references) and revised by the author in 1935,
spans both the absolutist and relativist positions. Heckscher treats mercantilism as a
coherent and interrelated system of power and economic controls in which attempts
were made to maximize the well-being of the state. He argues that: “The state must have
one outstanding interest, an interest which is the basis for all its other activities. What
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Chapter 3 ■ Mercantilism 69

distinguishes the state from all other social institutions is the fact that, by its very nature,
it is a compulsory corporation or, at least in the last instance, has the final word on the
exercise of force in society” (Mercantilism, II, p. 15). Though Heckscher’s interpreta-
tions are open to dispute on specific points, his book remains the essential work on the
subject. On a more elementary level, Max Beer’s Early British Economists (London: G.
Allen, 1938) presents a less intricate discussion of mercantilism than Heckscher or Viner.
The original works of many of the major mercantilist writers, e.g., Gerard de Maly-
nes, Thomas Mun, and Daniel Defoe, have been reprinted and published by A. M. Kelley.
A rich lode of secondary materials exists focusing on mercantile doctrine and on individ-
ual mercantilists. R. C. Wiles discusses the shifting aims and analysis of mercantilist
writers in “The Development of Mercantilist Thought,” in S. Todd Lowry (ed.), Pre-Clas-
sical Economic Thought (Boston: Kluwer, 1987). The dualistic or “mixed” nature of mer-
cantilist thought is emphasized in excellent papers by A. F. Chalk (see references) and W.
D. Grampp, “The Liberal Elements in English Mercantilism,” Quarterly Journal of Eco-
nomics, vol. 66 (November 1952), pp. 465–501.
George D. Chosky focuses on the economic thought of a famous pair of mercantil-
ists in “Previously Undocumented Macroeconomics from the 1680s: The Analytical
Arguments and Policy Recommendations of Sir Dudley North and Roger North,” History
of Political Economy, vol. 24 (Summer 1991), pp. 515–532; and same author, “The Bifur-
cated Economics of Sir Dudley North and Roger North: One Holistic Analytic Engine,”
History of Political Economy, vol. 27 (Fall 1990), pp. 477–492. Marina Bianchi, “How to
Learn Sociality: True and False Solutions to Mandeville’s Problem,” History of Political
Economy, vol. 25 (Summer 1993), pp. 209–240, explores the thought of one of the most
provocative writers of the era.
Three papers by E. A. J. Johnson probe mercantilist doctrine on the question of
labor, unemployment, and the relation between labor intensity and international trade.
As such, they form a useful accompaniment to the volume by Furniss cited in the refer-
ences at the end of this chapter. See Johnson, “The Mercantilist Concept of ‘Art’ and
‘Ingenious Labour,’” Economic History, vol. 2 (January 1931), pp. 234–253; “Unemploy-
ment and Consumption: The Mercantilist View,” Quarterly Journal of Economics, vol. 46
(August 1932), pp. 698–719; and “British Mercantilist Doctrine Concerning the Exporta-
tion of Work and ‘Foreign Paid Incomes,’” Journal of Political Economy, vol. 40 (Decem-
ber 1932), pp. 750–770. Also see D. Woodward, “The Background to the Statute of
Artificers: The Genesis of Labor Policy, 1558–63,” Economic History Review, vol. 33 (Feb-
ruary 1980), pp. 32–44.
Some intellectual detective work into authorship and doctrinal influences is
reflected in M. Dewar, “The Memorandum ‘For the Understanding of Exchange’: Its
Authorship and Dating,” Economic History Review, vol. 18 (April 1965), pp. 476–487; and
G. H. Evans, “The Law of Demand: The Roles of Gregory King and Charles Davenant,”
Quarterly Journal of Economics, vol. 81 (August 1967), pp. 483–492. On the same sub-
ject, with an extension to classical economics, see A. M. Endres, “The King–Davenant
‘Law’ in Classical Economics,” History of Political Economy, vol. 19 (Winter 1987), pp.
621–638.
Philosophy conditioned political, social, and economic thought in the mercantilist
era and during the transition to liberalism. A reading of Thomas Hobbes’s Leviathan
(London: Dent, 1914) or Niccolo Machiavelli’s The Prince (New York: Modern Library,
1950) exposes power as the central theme of the period. The amoral character of mer-
cantilist thought is perhaps nowhere better expressed than in Machiavelli’s advice to the
prince: “Thus it is well to seem merciful, faithful, humane, sincere, religious, and also to
be so; but you must have the mind so disposed that when it is needful to be otherwise
you may be able to change to the opposite qualities” (The Prince, p. 65). The dualism in
economic thought is explained partly by the philosophic dualism of the time. For an
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70 Part I ■ Preclassical Economics

explanation of the impact of the “new” philosophies of Hume and Locke on liberalism
and classical economics see Werner Stark, The Ideal Foundations of Economic Thought
(New York: Oxford University Press, 1944), and Carl Becker, The Heavenly City of Eigh-
teenth-Century Philosophers (New Haven, CT: Yale University Press, 1932).
Philosophers who developed certain theoretical tools of economic analysis also
spurred the intellectual evolution of laissez-faire. In this regard, see Karen I. Vaughn,
John Locke: Economist and Social Scientist (Chicago: University of Chicago Press,
1980); M. L. Myers, “Philosophical Anticipations of Laissez-Faire,” History of Political
Economy, vol. 4 (Spring 1972), pp. 163–175; and same author, The Soul of Modern Eco-
nomic Man (Chicago: University of Chicago Press, 1983).
What we have called the process, or policy, view of mercantilism derives from the
historical conception of Heckscher and the contemporary application of self-interested
behavior and property-rights theory to understanding institutions and institutional
change. Specifically, the policy view features economic and political “actors” maximizing
individual self-interest. This view of mercantilism was suggested early on in Adam
Smith’s Wealth of Nations (see references), but it was more forcefully stated in reviews
of Heckscher’s Mercantilism. A highly regarded scholar, Heckscher nevertheless irri-
tated economic historians by his generalized treatment of economic policy and his
excessive emphasis on the cohesiveness of mercantilism as doctrine and policy unaf-
fected by actual economic events. On this point, see C. H. Heaton, “Heckscher on Mer-
cantilism,” Journal of Political Economy, vol. 45 (June 1937), pp. 370–393.
Some historians charged that Heckscher’s treatment, embedded as it was in ideas,
practically ignored all reference to the political process through which the so-called uni-
fying mercantilist policies were made. For example, D. C. Coleman, “Eli Heckscher and
the Idea of Mercantilism,” Scandinavian Economic History Review, vol. 5 (1957), pp. 3–
25, concluded that the term mercantilism, as a label for economic policy, “is not simply
misleading but actively confusing, a red herring of historiography. It seems to give a
false unity to disparate events, to conceal the close-up reality of particular times and cir-
cumstances, to blot out the vital intermixture of ideas and preconceptions, of interests
and influences, political and economic, and of the personalities of men” (pp. 24–25).
Coleman argues that policy cannot be treated in a vacuum, nor can the role and interests
of parties to the political process be ignored. Thus, the application of contemporary pos-
itive economic theory dealing with economic regulation and public choice goes far in fill-
ing this important gap in Heckscher’s treatment.
This policy view as described in the present chapter is expanded by R. B. Ekelund,
Jr., and R. D. Tollison, “Economic Regulation in Mercantile England: Heckscher Revis-
ited,” Economic Inquiry, vol. 18 (October 1980), pp. 567–599; and, same authors, “Mer-
cantile Origins of the Corporation,” Bell Journal of Economics, vol. 11 (Autumn 1980),
pp. 715–720; elaborated further by B. Baysinger, R. B. Ekelund, Jr., and R. D. Tollison,
“Mercantilism as a Rent-Seeking Society,” in J. M. Buchanan et al. (eds.), Towards a The-
ory of the Rent-Seeking Society (College Station: Texas A & M University Press, 1980),
which also includes other papers of interest on the subject. Ekelund and Tollison’s views
on mercantilism culminate in Mercantilism as a Rent-Seeking Society (College Station:
Texas A&M University Press, 1981) and its extension, Politicized Economies: Monarchy,
Monopoly and Mercantilism (College Station: Texas A&M University Press, 1997), where
applications of property rights, rent-seeking theory, emergence of the modern corpora-
tion, and the neoinstitutional economic framework of the mercantilist economies of
France, England, and Spain come under review. A similar approach along with exten-
sions is found in D. C. North and B. R. Weingast, “Constitutions and Commitment: The
Evolution of Institutions Governing Public Choice in Seventeenth-Century England,”
Journal of Economic History, vol. 49 (December 1989), pp. 803–832; and in H. L. Root,
The Fountain of Privilege: Political Foundations of Markets in Old Regime France and
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Chapter 3 ■ Mercantilism 71

England (Berkeley: University of California Press, 1994), chapters 6 and 7. Some critics
argue, albeit without supporting theory or evidence, that the neoinstitutional approach is
inapplicable to mercantilism or that it neglects or downplays the importance of ideas.
See, for example, Lars Magnusson (ed.), Mercantilist Economics (Boston: Kluwer Aca-
demic Publishers, 1993), which contains the following papers: Salim Rashid, “Mercantil-
ism: A Rent-Seeking Society?” Cosimo Perrotta, “Early Spanish Mercantilism: The First
Analysis of Underdevelopment,” and A. W. Coats, “Concluding Reflections.” Disparate,
largely historiographic and ununified, views of mercantilism that focus on particular
individuals or “theories” have emerged: see, for example, Lars Magnusson, Mercantil-
ism, The Shaping of Economic Language (London: Routledge, 1993); and Cosimo Per-
rotta, “Is Mercantilist Theory of the Favorable Balance of Trade Really Erroneous?”
History of Political Economy, vol. 23 (Summer 1991), pp. 301–336. However, as of yet, no
positive theories of ideology or idea formation have emerged to set against an economic
approach. The historiographic (chiefly scholastic) methodology employed in most
attempts to capture the essence of something called “mercantilism” has not as yet pro-
duced much fundamental understanding of the main developments of the period.
Indeed, one recent account of a single mercantilist (John Cary) and his translation into a
number of languages argues (unconvincingly) that the empire- and power-building para-
digm that mercantilism represents should be the starting point of a canon of economic
theory. That canon would replace the trade-oriented market theory developed by Adam
Smith that has served economics to the present day: see Sophus A. Reinert, Translating
Empire: Emulation and the Origins of Political Economy (Cambridge: Harvard University
Press, 2011). This argument will not bear scrutiny either with evidence or historical
accuracy. Compare, for example, the evidence and conclusions concerning economic
growth and ideational change over the English mercantile period in two works by Joel
Mokyr: “Mercantilism, the Enlightenment, and the Industrial Revolution,” in Ronald
Findlay et al. (eds), Eli Heckscher, International Trade, and Economic History (Cam-
bridge: Massachusetts Institute of Technology Press, 2006), pp. 269–303; and The
Enlightenment Economy: An Economic History of Britain, 1700-1850 (New Haven, CT:
Yale University Press, 2010).
Details of the legal and political system that constituted mercantilism are given in a
number of references in the present chapter. Maitland and Holdsworth provide the clas-
sic sources on the mercantilist judiciary. D. O. Wagner, “Coke and the Rise of Economic
Liberalism,” Economic History Review, vol. 6 (March 1935), pp. 30–44, presents a very
interesting illustration of the duplicity with which common law jurists approached the
subject of free trade. The fields of public choice and regulation, from which much of the
process view of mercantilism takes its foundation, are the subject of chapter 24. However,
there are several specific articles that are vital to understanding mercantilism as a pro-
cess, especially Gary Becker and G. J. Stigler, “Law Enforcement, Malfeasance and Com-
pensation of Enforcers,” Journal of Legal Studies, vol. 3 (January 1974), pp. 1–18; Isaac
Ehrlich and R. A. Posner, “An Economic Analysis of Legal Rule Making,” Journal of Legal
Studies, vol. 3 (January 1974), pp. 257–286; W. M. Landes and R. A. Posner, “The Inde-
pendent Judiciary in an Interest-Group Perspective,” Journal of Law & Economics, vol. 18
(December 1975), pp. 875–901; and G. J. Stigler, “The Theory of Economic Regulation,”
Bell Journal of Economics and Management Science, vol. 2 (Spring 1971), pp. 3–21.
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The Dawn of Capitalism

Mercantilism arose as an economic creed against a backdrop of historical change.

The seventeenth century brought its share of inventions, wars, and upheavals to
Europe. During its term calculus and ice cream were invented, tea and coffee
became popular in Europe, and central banking was introduced in France. Before
mid-century the first permanent settlement was established in North America, the
King James Version of the Bible was completed, Protestantism gained a foothold in
Europe, the Thirty Years’ War devastated Central Europe, the American Indian Wars
began, and civil wars raged throughout France, Scotland, Ireland, and England. The
Dutch tulip-mania bubble burst in 1637, ruining many family fortunes. In the sec-
ond half of the century Protestantism was outlawed in France, the Dutch Republic
went into decline, the Ottoman Empire continued its westward expansion, England
became a constitutional monarchy following the Glorious Revolution, Sir Isaac
Newton published his theory of gravitational forces, Peter the Great became tsar of
Russia, and LaSalle claimed the Louisiana territory for France after exploring the
length of the Mississippi River. In 1666 the Great Fire of London destroyed 373
acres inside the city walls and 63 acres outside, 87 churches (including St. Paul’s
Cathedral), and 13,200 houses. In 1672 the French went to war with the Dutch, and
in 1692 the Salem witch trials were conducted in Massachusetts.
Medicine was enriched by William Harvey (circulation of blood); astronomy by
Kepler and Galileo; mathematics by Newton and Leibnitz, co-inventors of calculus;
philosophy by Bacon, Descartes, Hobbes, Locke, Pascal, and Spinoza; literature and
dramatic arts by Shakespeare, Molière, Racine, Cervantes, Donne, and Milton; and
art by Bernini and Rembrandt. All in all it was an era that greatly distanced itself
from the Middle Ages and the Renaissance by its institutional changes, its challenges
to authority, its preparation for the Enlightenment, and its cultivation of markets.
Old ideas broke down at an accelerated pace, and new ideas quickly filled the void.
By the end of the seventeenth century, mercantilism, too, was in a state of flux.
Sharp reactions to the regulatory state emerged where it was most firmly
entrenched, in France and Spain. French writers like Pierre Boisguilbert (1646–
1714) and Spanish writers like Pedro Rodriguez de Campomanes (1723–1702) held
the state responsible for policies that retarded economic growth, and paved the way
for economic reform in their respective countries. In England, Sir William Petty
(1623–1687) joined a chorus of voices calling for economic and practical reform.
And in France, an Irish expatriate, Richard Cantillon (1680?–1734?), took econom-
ics to new heights in the pre–Adam Smith era. The economics of this era was transi-
tional, displaying a mixture of liberal and mercantilist elements, particularly on the

72
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Chapter 4 ■ The Dawn of Capitalism 73

question of money, the most sensitive of mercantilist subjects. In the middle of the
seventeenth century, the first “school” of economists—later named the
Physiocrats—reflecting the combined influences of Boisguilbert and Cantillon,
broke cleanly with the old economic order. Their ideas represented a wholesale
rejection of mercantilism and an important anticipation of laissez-faire. The ground
for advances in economics that occurred during the emergence of capitalism in
England and Europe was fertilized by the spread of the Enlightenment and the rise
of Protestantism.

■ SIR WILLIAM PETTY

Petty lived in a period of emerging commercial capitalism, marked on the one
hand by a nascent agricultural revolution and on the other by early signs of the
incipient Industrial Revolution. He was many things—traveler, writer, adventurer,
physician, academician, surveyor, businessman, and economist—but above all he
was obsessed with the idea of fame and fortune. An episode from his brief medical
career illustrates his flair for the sensational. As professor of anatomy at Oxford, he
revived and nursed back to health a young woman hanged for infanticide in 1650. It
created a sensation. Shortly afterward, an anonymous pamphlet appeared, entitled
News from the Dead, possibly written (at least in part) by Petty himself, extolling
his miraculous medical powers that defied death and the gallows. Many of Petty’s
efforts, including his forays into economics, were distinguished by such bravado.

Economic Method
Petty was a positivist before positivism became the dominant research criterion
of the natural sciences. As a charter member of the Royal Society (London), he once
proposed, in jest, that the group’s annual meeting should be held on the feast day of
St. Thomas the Apostle, known as “doubting Thomas,” because he believed only in
what he could see or touch. Petty named his method of inquiry “political arithme-
tic,” a term calculated to express his conviction that the introduction of quantitative
methods would produce a more rigorous analysis of social phenomena. The use of
quantitative methods in the social sciences represented the ascendancy of material/
mechanical conceptions over the Aristotelian syllogistic/deductive approach. Petty
rejected the Aristotelian approach in favor of an approach advanced by Francis
Bacon, who fused empiricism and rationalism into what we now call the inductive
method. Bacon used the following metaphor to explain the new method.
[Empiricists] are like the ant, they only collect and use; the reasoners resemble spi-
ders, who make cobwebs out of their own substance. But the bee takes a middle
course: it gathers its material from the flowers of the garden and of the field, but
transforms and digests it by a power of its own. Not unlike this is the true business
of philosophy; for it neither relies solely or chiefly on the powers of the mind, nor
does it take the matter which it gathers from natural history and mechanical
experiments and lay it up in the memory whole, as it finds it, but lays it up in the
understanding altered and digested. (New Organon, p. 93)

The flight from the subjectivism and logico-deductivism of the ancient Greeks
and the Scholastics toward empiricism and objectivism was later woven into British
classical political economy, as we shall see in ensuing chapters. Petty recognized
the novelty of the new approach, and hailed its advantages:
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74 Part I ■ Preclassical Economics

The Method I take . . . , is not very usual; for instead of using only comparative and
superlative words, and intellectual Arguments, I have taken the course (as a Speci-
men of the Political Arithmetick I have long aimed at) to express myself in Terms
of Number, Weight, or Measure; to use only Arguments of Sense, and to consider
only such Causes, as have visible Foundations in Nature; leaving those that depend
upon the mutable Minds, Opinions, Appetites and Passions of particular Men, to
the Consideration of others. (Economic Writings, p. 244)

Petty’s method also attempted to separate morals from science. He claimed that
moral problems arise only in the selection of ends that humans propose to attain by
the use of science. But science does not exist to handle moral problems—it is simply
a means to an end. However contemporary this may sound, Petty did not espouse a
consistent economic philosophy based on this principle. Rather, he advanced
numerous proposals for state intervention even as he supported liberal propositions
of nonintervention. Moreover, because his economic writings were an integral part
of his political and business activities, he was not above defending his own interests
in the halls of power.
In the final analysis, Petty’s investigations were not aimed at producing a gen-
eral system of knowledge but rather at producing solutions to practical problems.
He intended only to produce general guides for policy, which was the real basis of
his political arithmetic. It was meant to collect the essential elements of the practi-
cal problem to be solved. It was not intended to be a perfect or a complete descrip-
tion of reality. Petty knew its limitations. Furthermore, he was aware that each
economic problem confronted in the real world (whether a question of money, inter-
national trade, or whatever) must be treated not as an independent phenomenon
but as an integral part of a larger whole. It is this “systemic” nature of his thought
that lifts Petty above his contemporaries, and it is this same feature that led Karl
Marx to proclaim him “the founder of modern political economy.”

On Money
Petty recognized the three functions of money (standard of value, medium of
exchange, store of value), but emphasized the second function over the others. He
rejected the notion that money is an absolute measure of value, arguing correctly
that its value varies with conditions of supply and demand. He was also aware of the
fiduciary operations of banks, and the “artificial” nature of money as a commodity
that merely facilitates trade. He used the following analogy to underscore his ideas
about money and its role:
Money is but the Fat of the Body-politick, whereof too much doth as often hinder
its Agility, as too little makes it sick. ’Tis true, that as Fat lubricates the motion of
the Muscles, feeds in want of Victuals, fills up uneven Cavities, and beautifies the
Body, so doth Money in the State quicken its Action, feeds from abroad in the time
of Dearth at Home; evens accounts by reason of its divisibility, and beautifies the
whole, altho more especially the particular persons that have it in plenty. (Eco-
nomic Writings, p. 113)

Like the mercantilists, Petty saw a relationship between the quantity of money
and the level of productive economic activity, but he did not fully appreciate the
relationship between the quantity of money and the level of prices, which lies at the
heart of the quantity theory. He considered money to be an indirect cost of produc-
tion, a cost that corresponds to the value of precious metals embodied in the stock
of money. Thus, he viewed an excess of money as a waste because the surplus of
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Chapter 4 ■ The Dawn of Capitalism 75

precious metals could have been exchanged for means of production rather than
being directly employed in the production process.
Petty’s chief contribution to monetary theory was his use of the velocity-of-cir-
culation concept to determine the optimum quantity of money. This makes him an
important predecessor of John Locke and Richard Cantillon. He recognized that
velocity of circulation quickens as the payment period (of wages) shortens, cor-
rectly underscoring the role of institutional factors such as the time intervals defin-
ing receipt of wages, rents, and taxes. True to his “positivist” declarations Petty
argued, in contradistinction to the mercantilists, that the accumulation of money is
a means to an end, not an end in itself. Although favorably disposed to the influx of
money from a positive trade balance, he did not consider this an absolute priority.
Moreover, he considered prohibitions on the export of money useless. What was
important, he argued, was a high level of employment and economic activity, not
the accumulation of mere treasure.

On Value
Petty is remembered often for certain economic slogans more than for his solid
achievements in economic analysis. Chief among the slogans he popularized is his
famous dictum “That Labour is the Father and active principle of Wealth, as Lands
are the Mother” (Economic Writings, vol. 1, p. 63). Although this statement signals
an early and profound recognition of the two “original factors of production,” it con-
tains little analytical merit. It certainly does not constitute a theory of value. Of much
more importance was Petty’s inquiries into a “natural par” between land and labor.
He tried to relate the values of land and labor to each other by determining how
much land is required to produce “a day’s food of an adult man,” taking the value of
such output to be equivalent to the value of a day’s labor. His objective was to estab-
lish a unit of measurement by which to reduce the available quantities of the two
original factors, land and labor, to a homogeneous quantity of “productive power,”
which could then serve as the (land-labor) standard of value. Like all such efforts to
find an absolute standard of value, this one, too, proved to be an analytical dead end,
but it inspired Petty’s successor, Richard Cantillon, to undertake similar research.
Despite the econometric flavor of Petty’s economic studies, he did not produce
a satisfactory theory of prices. In particular, he failed to recognize the importance of
relative prices, which constitutes the core of modern microeconomics. And Marx’s
admiration for him notwithstanding, Petty did not develop a labor theory of value. If
anything, Petty had a land theory of value, although it is misleading to call his
achievement a genuine theory of value. What was missing was a fundamental mech-
anism capable of explaining exchange ratios between economic goods that are
bought and sold.
Although Petty had the disposition of a theorist, his greatest accomplishment
was providing a decisive new turn in economic method. His invention, Political
Arithmetick, was a primitive form of econometrics, a field that was formalized in
the 1930s and blossomed in the post–World War II era. As Joseph Schumpeter
noted, Petty “was quite ready to fight for . . . [this methodological creed] and to start
what would have been the first controversy on ‘method.’ But nobody attacked. A
few followed. Many admired. And the vast majority very quickly forgot” (History of
Economic Analysis, p. 211). Faced with the same issue a century later, Adam Smith
chose safety over novelty, declaring in The Wealth of Nations (Book IV, chap. 5) that
he had little faith in Political Arithmetick. Under Smith’s guidance, classical eco-
nomics reclaimed the logico-deductive method.
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76 Part I ■ Preclassical Economics

■ NASCENT LIBERALISM IN FRANCE:

BOISGUILBERT, CANTILLON, AND THE PHYSIOCRATS
France greeted the eighteenth century gripped in a long secular decline. Histo-
rians attribute its falling levels of output and national income to the costly wars and
personal extravagances of Louis XIV. At least one writer, however, blamed his coun-
try’s wretched state of affairs on its misguided mercantilist policies.

Boisguilbert (1646–1714)
Pierre le Pesant de Boisguilbert, a provincial magistrate in the city of Rouen,
published five major works between 1665 and 1707, each directed toward the
causes and cures of France’s economic decline. He never attempted a systematic
treatment of basic principles but aimed instead at solving specific economic prob-
lems, which he traced back to France’s mercantilist policies.
Boisguilbert’s attack on mercantilism was three-pronged. First, he rejected the
mercantilist identity between money and wealth in favor of the notion that national
wealth consists of goods and services. Money, he said, was merely the means of
acquiring wealth; the proper goal of economic activity is the commodities useful to
life (Détail, p. 198): “Gold and silver are not and never have been wealth in them-
selves, and are of value only in relation to, and in so far as they can procure, the
things necessary for life, for which they serve merely as a gauge and an evaluation
(in Cole, French Mercantilism, p. 242). Alongside Petty, Boisguilbert was one of the
earliest writers to recognize the importance of circulatory velocity and of money
substitutes, such as bills of exchange. He argued that it is not the quantity of money
alone that is important but the amount of work money does. Accordingly, effective
demand, not nominal money balances, is the key to national well-being. He adopted
the distinctively Keynesian perspective that national income is determined by flows
of money expenditure (see chapter 21 on Keynes).
The second aspect of Boisguilbert’s critique focused on agriculture. He said that
mercantilism produced national harm by directing resources away from agriculture
toward manufacturing (especially luxuries). Trade restrictions, such as French min-
ister Colbert’s prohibition of grain exports, made matters worse. During times of
plenty, the surplus grain could not find external markets, its price plunged, and
lower prices drove down the income of farmers. The consequent decline in con-
sumption spread from the farm sector throughout the economy, thus precipitating a
general crisis. Boisguilbert proposed free trade as an antidote to Colbert’s harmful
policies. Free trade, he argued, would stabilize grain prices, expand agricultural
production, and improve income distribution. Although apparently advocating lais-
sez-faire, his true commitment to this principle was suspect because he proposed
direct government action to support grain prices once they reached a “suitable” level
(Traité de la nature, p. 369). Although he examined short-run cyclical movements of
national income, Boisguilbert was more concerned with the long-run problem of
secular decline. He estimated that between 1665 and 1695 the national income of
France declined by about 50 percent (Détail, p. 163)—a direct consequence of the
failure of aggregate demand dampened by an oppressive system of taxation.
The third aspect of Boisguilbert’s critique of mercantilism focused on the
French tax system. The specific taxes that came under his scrutiny were those
known as the taille, the aides, and the douanes. The taille was a property tax, subdi-
vided into a levy on real property and another on personal property. According to
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Chapter 4 ■ The Dawn of Capitalism 77

Boisguilbert the problem was not so much with the taxes themselves as with their
incidence. Nobility and clergy were exempt from tax, which meant that the full bur-
den landed almost exclusively on the poorest proprietors. Under the Bourbon
dynasty, administration of these property taxes was capricious, often depending on
an arbitrary assessment of ability to pay and the aggressiveness and persistence of
the local tax collector. Even in the same parish the effective tax rate could vary
between 0.33 and 33 percent (Détail, p. 172).
To Boisguilbert the aides and the douanes were almost as damaging to con-
sumption as the taille. The former were originally general sales taxes, but by the
end of the seventeenth century they had become excise taxes, confined to a few
products only, particularly wine. The wine tax became so oppressive that French
workers practically stopped drinking wine (the ultimate sacrifice for a French per-
son), foreign buyers turned elsewhere, and vineyards were taken out of cultivation.
In 1779 the economist Le Trosne estimated that sales taxes (aides), which brought
in thirty million in revenue for the king, cost the people of France one-hundred-forty
million of lost income. The douanes were nearly as bad. They consisted of duties on
goods moving into or out of the kingdom as well as between provinces within the
kingdom. The effect of these duties was either to restrict movement of goods alto-
gether or to raise the prices of delivered goods to a prohibitive level, at least for the
poor. Taken together, French excise taxes greatly restrained trade, both domestic
and foreign. Boisguilbert blamed them for the destruction of France’s foreign mar-
kets in wines, hats, playing cards, tobacco pipes, and whalebone (Détail, p. 196).
The Physiocrats (see below) later reacted strongly against the same oppressive
tax system that roiled Boisguilbert and his contemporaries. But links between Bois-
guilbert and the Physiocrats are tenuous. The Physiocrats regarded Boisguilbert’s
reform measures as arbitrary, and they strove to substitute a natural system of
finances in place of the existing one. Moreover, Boisguilbert did not anticipate the
physiocratic concept of net product or their assertion regarding the exclusive pro-
ductivity of agriculture. On matters of tax reform, however, the Physiocrats shared
many of the same concerns as Boisguilbert, namely a desire to end the regressive
nature of taxes and establish a more equitable distribution of the tax burden. Bois-
guilbert sought reform in order to liberalize consumption, whereas the Physiocrats
aimed their tax reforms at the enhancement of capital accumulation and agricul-
tural entrepreneurship.

■ RICHARD CANTILLON
In 1755 a brief but remarkable book, Essai sur la nature du commerce en
général (An Essay on the Nature of Trade in General), was published under bizarre
circumstances. Most likely printed in Paris, it carried the imprint of a London book-
seller no longer in business. The subterfuge was probably designed to circumvent
strict French censorship laws. The manuscript had been written more than two
decades earlier; its author, Richard Cantillon, was a Paris banker and London mer-
chant of Irish extraction. Some facts of his life and his influence are known, but the
circumstances of his death (in 1734?) are shrouded in mystery. The popular account
is that he was murdered in his sleep by a servant he had discharged weeks before.
As the account goes, the disgruntled servant set his former master’s house afire in
order to make Cantillon’s death appear accidental. Antoin Murphy (Richard Cantil-
lon) has challenged this version of Cantillon’s demise, making the case that Cantil-
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78 Part I ■ Preclassical Economics

lon faked his own death in order to escape certain economic and political
entanglements. We may never know what actually happened, but one way or the
other, Cantillon disappeared from public life after 1734.
Cantillon’s Essai represents state-of-the-art economics before Adam Smith (see
chapter 5). It is a general treatise of penetrating insights and remarkable clarity, fea-
tures that have not dimmed with the passage of time. Whereas Boisguilbert
attacked the economic problems of French society, Cantillon focused on the discov-
ery of basic principles. A checklist of his original contributions to economics under-
scores his importance. He was one of the first to:
1. Treat population growth as an integral part of the economic process
2. Develop an economic explanation of the location of cities and sites of production
3. Make a distinction between market price and intrinsic value (i.e., equilibrium
price) and show how the two may converge over time
4. Demonstrate that changes in velocity are equivalent to changes in the stock of
money
5. Trace the channels through which changes in the stock of money influence prices
6. Describe the mechanism by which prices adjust in international trade
7. Analyze income flows between major sectors of the economy
In addition to this impressive list of accomplishments what set Cantillon miles
apart from the mercantilists was his Newtonian cast of mind, which is displayed on
almost every page of Essai. Cantillon probed the economy much as Newton had
probed the cosmos. Each writer viewed his subject as an interconnected whole
made up of rationally functioning parts. For Cantillon this meant that the economy
was constantly adjusting to basic changes in population, production, tastes, and so
forth. The animus of this adjustment process was the self-interested pursuit of
profit, a motive of such universal application that it takes the position in Cantillon’s
inquiry that Newton’s “universal principle of attraction” (i.e., gravity) took in his.
Although Cantillon’s manuscript circulated among a small cadre of writers in
France and England before its eventual publication in 1755, its merit was quickly
overshadowed by the power and influence of Physiocracy (see below). The full
import of Cantillon’s contribution was not appreciated until late in the nineteenth
century, when the British neoclassical economist William Stanley Jevons (see chap-
ter 15) rediscovered Essai. Jevons called it “the cradle of political economy,” saying
of its author that “the first systematic treatise on economics was probably written by
a banker of Spanish name, born from an Irish family of the County Kerry, bred we
know not where, carrying on business in Paris, but clearly murdered in Albermarle
Street [London]” (see “Richard Cantillon,” p. 360). Cantillon’s work shows some
concern for traditional mercantilist issues, but it is far more a disinterested inquiry
into the workings of a nascent market economy. He drew on the works of promi-
nent English writers such as Sir William Petty and John Locke, but his mantle of
influence fell mostly on writers in his adopted country, France. Only later did his
influence spread to such neoclassical writers as Jevons and to the neo-Austrian
economists (see chapter 23).
In assessing Cantillon’s place in the history of economic thought we emphasize
three major themes of his work: (1) his view of the market and its operation, (2) the
critical role and importance of the entrepreneur in economic activity, and (3) chan-
nels by which changes in the aggregate supply of money influence the economy.
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Chapter 4 ■ The Dawn of Capitalism 79

The Market System

Cantillon conceived an economy as an organized system of interconnected mar-
kets that operate in such a manner as to achieve a kind of equilibrium. The inhabit-
ants of the economy are bound together by mutual dependence, and the institutions
of the system evolve over time in response to “need and necessity.” The free play of
self-interested entrepreneurs keeps the system in adjustment by their conduct of
“all the exchange and circulation of the State” (Essay, p. 77). Considering the age in
which Cantillon wrote, he assigns “the prince” a remarkably low profile, a fact
underscoring his conviction that a market system works best without interference
from government. Entrepreneurs, like other market participants, are bound
together in reciprocity, as they “become consumers and customers one in regard to
the other.” Their number is therefore regulated by the number of customers, or total
demand, for their services, and their decisions are made under conditions of uncer-
tainty about the future.
Cantillon’s economic system is hierarchical. Landlords sit atop the economic
and social order and are represented as financially independent, although they
derive income from the inhabitants of a state, who in turn rely on the proprietors to
supply natural resources in production. Private property rights are deemed essen-
tial to the successful operation of a system of markets. Although entrepreneurs
occupy the middle rank in Cantillon’s hierarchy, their role is vital and pervasive. It is
they who continually react to price movements in specific markets in order to bring
about a tentative balance between particular supplies and particular demands.
Seeing the economy as a network of reciprocal exchanges, Cantillon provided
one of the clearest early explanations of market price. His notion of intrinsic value
(the measure of the quantity and quality of land and labor entering into production)
underscores an early attempt to base price on some measure of “real” costs, at least
insofar as equilibrium long-run values are concerned. When it came to short-run
“market” price, however, Cantillon seemed ready to admit subjective assessments.
He noted that “it often happens that many things which actually have this intrinsic
value are not sold in the market at that value: that will depend on the humors and
fancies of men and on their consumption” (Essay, p. 55). Another reason why mar-
ket prices may be different from intrinsic values is that the plans of producers and
their customers may be uncoordinated. Indeed, it would appear impossible always
to achieve perfect coordination. Cantillon observed that “there is never a variation
in intrinsic values, but the impossibility of proportioning the production of com-
modities and merchandise in a State to their consumption causes a daily variation,
and perpetual ebb and flow of market prices” (Essay, p. 55).
The bargaining process described by Cantillon reflects the information pos-
sessed by market participants and the degree of coordination of individual plans. Dis-
parate plans, he explained, tend to drive prices away from costs (i.e., intrinsic value):
If the farmers in a State sow more wheat than usual, that is to say, much more than
is needed for the annual consumption, the real and intrinsic value of the wheat will
correspond to the land and labor which enter into its production; but as there is an
over-supply and there are more sellers of wheat than buyers, the market price of
wheat will necessarily fall below the cost or intrinsic value. If on the contrary the
farmers sow less wheat than is needed for consumption there will be more buyers
than sellers and the market price will rise above its intrinsic value. (Essay, p. 55)

One has only to substitute the word “natural” in place of “intrinsic” to appreciate
how close this analysis comes to Adam Smith’s (see chapter 5). If Cantillon had
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80 Part I ■ Preclassical Economics

gone no further, he would have still provided an important description of the price
mechanism. But he did go further, providing a rudimentary explanation of the net-
work of price signals that link different markets. The following passage is rich in
suggestions of self-interest as a motive force, relative prices as signals to adjust
resource use, and opportunity costs as a basis of economic decision making:
If some of the farmers sowed more grain than usual, they will feed fewer sheep
and have less wool and mutton to sell. Consequently there will be too much grain
and too little wool for the consumption of the inhabitants. Wool will be expensive,
which will force the inhabitants to wear their clothes longer than usual, and there
will be too much grain and a surplus for the following year. . . . If, however, next
year they have too much wool and too little grain for the demand, they will not fail
to change from year to year the use of the land, until they have arrived at propor-
tioning their production to the consumption of the inhabitants. Thus a farmer who
has appropriately proportioned his output to consumption will have part of his
farm in grass, for hay, another for grain, wool, and so on, and he will not change
his plan unless he sees some considerable change in demand. (Essay, pp. 80–81)

In this way Cantillon demonstrated how initially incompatible plans between

buyers and sellers become mutually compatible over time by self-interested adjust-
ments to changes in relative prices. The same sort of phenomenon manifests itself
in the factor markets. Cantillon explained how labor adjusts itself naturally to the
demand for it. When he described the tradition of raising sons in the same line of
work as their fathers he stressed the natural forces at work allocating labor to dif-
ferent employments. If village workers bring up a number of their sons in one trade,
“the surplus adults will have to leave in order to seek a livelihood elsewhere, which
they generally find in cities. If some remain with their fathers—as they will not all
find sufficient employment—they will live in great poverty and will not marry for
lack of means to raise children” (Essay, p. 49). Although short-term changes in
demand bring about higher or lower returns to various kinds of labor, Cantillon
envisioned an eventual adjustment to equilibrium. He observed correctly that after
out-migration and/or in-migration, “those who remain are always proportioned to
the employment that suffices to maintain them. When there is a continuous increase
of work, there are gains to be made and others will move in to share the business”
(Essay, p. 50). Given a permanent increase in the demand for labor, Cantillon’s
statement of the allocative mechanism compares favorably with that developed by
later neoclassical writers.

Competition and Entrepreneurship

As economic analysis matured in the nineteenth century, the notion of competi-
tion shifted gradually from a description of human activity involving risk and uncer-
tainty to a set of finite conditions that defined one of several market structures. Some
analytical precision was gained in the process, but at the cost of considerable real-
ism. Cantillon developed the “old-fashioned” notion of competition, and he gave the
entrepreneur a pivotal role in his theory of market adjustments. His economy con-
sisted of socioeconomic classes—each class defined by a major economic function.
[I]t may be established that, except for the prince and the property owners, all the
inhabitants of a State are dependent. They can be divided into two classes, entre-
preneurs and hired workers. The entrepreneurs are on unfixed wages while the
others are on fixed wages as long as there is work, although their functions and
ranks may be very unequal. The general who has his pay, the courtier his pension
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Chapter 4 ■ The Dawn of Capitalism 81

and the domestic servant who has wages, all fall into this last class. All the others
are entrepreneurs, whether they are set up with capital to conduct their enterprise,
or are entrepreneurs of their own labor without capital, and they may be regarded
as living under uncertainty; even the beggars and the robbers are entrepreneurs of
this class. (Essay, p. 76)

Clearly for Cantillon there are low entrance requirements to the entrepreneurial
class, and just as clearly, entrepreneurs come and go, depending on the vicissitudes
of the marketplace. As Cantillon described it, the essence of entrepreneurial activity
is bearing risk. In the case of merchant-entrepreneurs, they buy goods at a known
price in order to resell them “in large or small quantities at an uncertain price.” The
marketplace, therefore, is not for the fainthearted or the risk-averse. Cantillon wrote:
These entrepreneurs never know how great the demand will be in their city, nor how
long their customers will buy from them, since their rivals will try, by all sorts of
means, to attract their customers. All this causes so much uncertainty among these
entrepreneurs that every day one sees some of them go bankrupt. (Essay, p. 74)

Cantillon entertained a “general equilibrium” notion of how a market system

works. That is to say, he recognized the interconnectedness between product mar-
kets and resource markets. Entrepreneurs are “allocated” according to the same
mechanism that allocates laborers or goods:
All these entrepreneurs become consumers and customers of each other, the
draper of the wine merchant, and vice versa. In a State, they proportion them-
selves to the customers or their consumption. If there are too many hat makers in a
city or on a street for the number of people who buy hats, the least patronized
must go bankrupt. On the other hand, if there are too few, it will be a profitable
business, which will encourage new hat makers to open shops, and in this manner,
entrepreneurs of all kinds adjust themselves to risks in a state. (Essay, p. 75)

For various reasons presumably motivated by the objective of making econom-

ics more scientific, contemporary economic theory assigns a mere incidental role to
the entrepreneur. Not so for Cantillon, who linked competition and entrepreneur-
ship inevitably. Both were pervasive, and both defined the nature of economic mar-
kets. Hence he proclaimed confidently, “All the exchange and circulation of the
State is carried on by the actions of these entrepreneurs” (Essay, p. 77).
The critical importance of entrepreneurship and its importance to capitalism
must be underlined with what went before Cantillon's understanding of the concept.
For example, James M. Murray (see references) writes paradoxically of medieval
entrepreneurship without visible entrepreneurs in order to emphasize the point that
medieval society could be entrepreneurial almost without anyone noticing. Feudal
society was organized along strict, hierarchical lines of monarch, Church, lords,
merchants, and peasants. The Church’s spiritual lords (abbots, bishops, priests)
behaved in an entrepreneurial manner by establishing monasteries, preserving and
enhancing knowledge, and applying agricultural technology to augment the quan-
tity of food and fiber. Temporal lords behaved in an entrepreneurial manner by
mobilizing and sustaining labor (serfs) and applying agricultural technology to
manor output. They invested in implements and draft animals necessary to till their
fields. They provided capital and incentives to peasants in order to secure their labor
for a variety of purposes, especially clearing forests to acquire more arable land.
Murray further points out that the first use of the word “entrepreneur” comes to
us from the late Middle Ages, when the word (of undisputed French origin) was
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82 Part I ■ Preclassical Economics

used to describe a battlefield commander. Only very gradually was the word
extended to the battlefield of business. As urbanization occurred communities
changed from seigniorial to merchant centers, so that “by the end of the medieval
period, merchants came to direct many of society’s ‘productive forces’ within cities
and were subject to the corrective judgment of a society still bound to Christianity’s
mission to heal the rift between God and humanity and gain individual salvation for
all the baptized” (“Entrepreneurs and Entrepreneurship,” p. 88). Thus, even as
Christianity’s mission made the profit motive more opaque, it could not, and did
not, fully impede the development of markets and entrepreneurial processes.
By Cantillon’s time, a critical mass in the development of markets and networks
had been reached, making qualitative as well as quantitative changes in the nature
of commerce evident. Cantillon captured this transformation of enterprise better
than anyone else, and he did so within an empirical/theoretical framework, thereby
installing the entrepreneur as a vital cog in the market process. He recognized that
the transformation of commerce was stoked by the gold and silver mines of Europe
and the New World, but the interesting aspect of his analysis for the development of
economic theory is the pivotal role he assigned to the entrepreneur, not to precious
metals, in stoking economic growth.

The Effect of Money on Prices and Production

Despite Cantillon’s impressive theoretical treatment of entrepreneurship, mar-
kets, and economic activity, his genius fully blossomed in the area of monetary the-
ory. Cantillon originated the income approach to monetary theory, namely, the
analysis of the causal chain that connects changes in the money stock to changes in
aggregate expenditures, income, employment, and prices (see chapter 22 for a mod-
ern account of this theory). He starts with an account of the “three rents”—the
income and expenditure streams of the agricultural sector. The farmer pays a rent
to the proprietor; he makes a second expenditure for labor, livestock, and manufac-
tured goods; and he earns a residual (the third “rent”) that constitutes his net
income. This rather crude notion of income flows by sector was refined by the
French Physiocrat François Quesnay, in his Tableau économique (see below).
Displaying an empirical bent akin to Petty, Cantillon built on his three-rent con-
cept by making estimates of the stock of money required to make the economy work
smoothly. In the process he provided the first clear explanation of monetary velocity:
In States where money is scarcer, there usually is more barter by valuation, than in
those where money is plentiful, and circulation is more prompt and less sluggish
than in those where money is not so scarce. Thus it is always necessary, when esti-
mating the amount of money in circulation, to take into account the speed of its
circulation. (Essay, p. 127)

Calling on the “quantity theory” of John Locke, which had become part of conven-
tional wisdom, Cantillon recognized that in terms of the connection between money
and prices Locke’s theory did not go far enough:
Everybody agrees that the abundance of money, or an increase in use in exchange,
raises the price of everything. This truth is substantiated in experience by the
quantity of money brought to Europe from America for the last two centuries. Mr.
Locke lays it down as a fundamental maxim that the quantity of goods in propor-
tion to the quantity of money is a regulator of market prices. . . . [However,] the
great difficulty of this question consists in knowing in what way and in what pro-
portion the increase of money raises the prices of things. (Essay, pp. 147–148)
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Chapter 4 ■ The Dawn of Capitalism 83

Reflecting the age of Newton, Cantillon adorned his analytical principles with
empirical research, collecting his data in a “statistical supplement” that was unfor-
tunately lost to posterity. His statistical research convinced Cantillon that the rela-
tion between money and prices was not as simple and direct as was usually
assumed by early adherents of the quantity theory. He had no trouble distinguishing
between relative prices and a price level, and he reasoned correctly that the effect of
monetary changes on relative prices depends on where new money enters the econ-
omy and into whose hands it passes first. If the increased money comes into the
hands of spenders, they will raise expenditures on certain goods, driving up the
prices of those items. Since some goods will likely be purchased more than others,
“according to the inclination of those who acquire the money,” relative prices will
necessarily be altered. If, instead, the increase of money comes initially into the
hands of savers who use it to increase the supply of loanable funds, the current rate
of interest will be driven down, ceteris paribus, and the composition of total output
will change in favor of investment goods (Essay, p. 178). The differential impact of
increased money on different sectors of the economy became known subsequently
as “the Cantillon effect,” and it provided the germ of a distinctly Austrian theory of
business cycles subsequently developed in the 1930s by Friedrich Hayek (see chap-
ter 23).
Cantillon refused to separate monetary theory from value theory. He upheld a
loanable-funds theory of interest, asserting that “the interest of money in a State is
settled by the proportionate number of lenders and borrowers . . . just as the prices
of things are fixed in the altercations of the market . . . by the proportionate number
of sellers and buyers” (Essay, p. 198). With his focus on relative prices, Cantillon
surveyed the effects of new money on interest rates and concluded once again that
the demand-specific aspects are critical:
If the abundance of money in a State comes from the hands of moneylenders, the
increase in the number of lenders will probably lower the rate of interest. How-
ever, if the abundance comes from the hands of people who will spend it, this will
have just the opposite effect and will raise the rate of interest by increasing the
number of entrepreneurs who go into business as a result of this increased spend-
ing, and will need to supply their businesses by borrowing at all types of interest.
(Essay, p. 178)

In effect, Cantillon saw very clearly what many writers of the next century ignored,
namely, that an influx of precious metals can act in two ways: The output of the
mines may be lent—which will tend to lower the rate of interest—or it may be
spent—which will directly stimulate production, increase the demand for loans in
anticipation of making a profit, and raise the rate that people are willing to pay for
such loans.
Some historians of economics insist on placing Cantillon in the mercantilist
camp, even though a close reading of his Essai provides weak support for this view.
He retained some mercantilist notions concerning the balance of trade, and at times
he seemed overly concerned with accumulation of specie, but as a banker his point
of view was grounded more in contemporary business practices rather than in phi-
losophy. Clearly Cantillon presented more theoretical substance than the mercantil-
ists. His performance in this respect was solid. Though unpublished for many years,
his manuscript circulated among a cadre of thinkers in France who emulated his
effort and influenced the next generation of founders: the Physiocrats, and most
likely through them, Adam Smith.
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84 Part I ■ Preclassical Economics

Physiocracy: “The Rule of Nature”

Every new science requires a philosophy, and the audacious philosophy of capi-
talism that Adam Smith would soon present to the world was already emerging,
cocoonlike, by the middle of the eighteenth century. Two decades before Smith’s
magnum opus appeared a group of French writers laid claim to the name “econo-
mists.” This group composed the first real “school of thought” in economics in the
sense that it had a master and a group of like-minded disciples. After the word
“economist” took on a more generic meaning, the group of French thinkers was
renamed “Physiocrats.” The term “Physiocracy” means “rule of nature.” It is espe-
cially appropriate in this instance because the writers in question believed in natu-
ral law and in the primacy of agriculture.
The intellectual leader of the Physiocrats was François Quesnay, court physician
to Madame de Pompadour and Louis XV. Quesnay and the small group of disciples
he attracted pushed back the theoretical frontiers of the new science and infused it
with an underlying philosophy. Physiocracy appealed to rational principles: It
asserted that all social facts are linked together by inevitable laws, which would be
obeyed by individuals and governments once they understood them. Adam Smith
was an acquaintance of Quesnay, and physiocratic doctrine exerted a major influ-
ence on the venerable Scot, although he maintained his distance in some respects.
In this chapter we treat the Physiocrats as a group, although like mercantilists,
they were a heterogeneous band. The publications of this group followed fairly
closely on each other between 1756 and 1778. Its members included the Marquis de
Mirabeau, Mercier de la Rivière, Dupont de Nemours, Guillaume-François Le
Trosne, and Nicolas Baudeau. The French minister Turgot was sympathetic to
physiocratic doctrine but did not consider himself a member of its inner circle.
King Louis XIV, and his successor Louis XV, ignored Boisguilbert’s criticisms as
France marched toward the nineteenth century under crushing debt, accumulated
by numerous costly wars and court extravagance. The repressive system of French
taxation required to support such royal profligacy weighed heavily of France’s
economy. Louis XVI, a reluctant monarch, inherited the debt, not the glamour, of his
predecessors and was never able to right the ship of state. He ultimately became a
high-profile victim of the French Revolution. Inasmuch as the Physiocrats’ period of
influence coincided closely with the reign of Louis XVI, they offered a last-ditch
effort at economic reform before the monarchy was overthrown.
When the last Bourbon monarch ascended the throne, land values in France
were falling because of declining agricultural output. Two thirds of French land was
owned by clergy and nobility, who were exempt from taxation. Common farmers
were required to pay a large share of their produce to the landlord and were heavily
taxed on the remainder, making capital accumulation at the level of production vir-
tually impossible for them. Domestic markets and personal income were further
squeezed by the mercantilist policy of depressing wages and other production costs
in an attempt to encourage exports. As Lewis Haney so aptly put it, “France was like
a great railway or factory which has made no allowance for depreciation or deple-
tion; her productive power was impaired and her credit shaken” (History, p. 176).
The Physiocrats tried to come to the rescue, but ultimately failed. Yet, they left an
important legacy to economic theory.

Physiocratic Economics
The Physiocrats were system builders, on a scale slightly larger than Cantillon
but smaller than Adam Smith. In about 1750 Quesnay and his cohort, Vincent Gour-
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Chapter 4 ■ The Dawn of Capitalism 85

nay, asked themselves “whether the nature of things did not tend towards a science
of political economy, and what the principles of this science were” (in Baur, “Stud-
ies,” p. 100). Under Quesnay’s leadership, Physiocracy devoted itself to the discov-
ery of these principles. Its underlying philosophy was based on the medieval notion
of jus naturae (natural law), but it added John Locke’s concepts of individual rights
and the justification of private property based on those rights. Although Physioc-
racy was basically a reaction against mercantilism, it bowed to expediency by not
challenging the absolute authority of French monarchs; even as it advocated free
trade and individual self-interest. The group drew the following description:
The physiocrats . . . were a court party, though a radical one. The direct criticism of
existing abuses and freedom of language were forbidden them. The only way open
to reformers was to oppose to arbitrary power a higher one—the laws of nature.
This, therefore, is the true origin of their jus naturae. (Baur, “Studies,” p. 106)

Natural law, in other words, was part of the Physiocrats’ scientific method. Contem-
porary methodology considers the concept of natural law outdated. Nevertheless,
what the Physiocrats did is not very different from what economists do today: They
proceeded from methodical observation of their world; they arranged and collated
facts according to their causes; and they tried to form an analytical system based on
a theoretical model—a system that agreed with the sound state of a highly civilized
country. The embodiment of this method is Quesnay’s Tableau économique, which
was the heart and soul of physiocratic economics.
Physiocratic Theory. The Physiocrats argued that the best way to trace out the
full effects of France’s oppressive royal policies was to conceive the mutual-interac-
tion economy in any one year as a circular flow of income and expenditure. (The
idea of a circular flow was incipient in Cantillon’s Essai). Any policy that had the
effect of enlarging the circular flow was consistent with economic growth; whereas
any that restricted it was inconsistent with economic growth. The same concept,
considerably embellished and elaborated, is central to modern macroeconomic the-
ory. Quesnay then picked out a key factor in the circular-flow process and analyzed
the effects of various economy-wide policies by observing their impact on this key
factor. (Note the familiar methodology, which economists continue to follow).
The key factor that Quesnay selected—and what stands today as the most out-
standing fallacy of physiocratic doctrine—was the exclusive productivity of agricul-
ture. In the Tableau économique, which was the name Quesnay gave to his visual
representation of the circular flow, manufacturing and service industries are consid-
ered “sterile” in the sense that they contribute nothing to society’s net product
(produit net), which is the true source of real wealth. To the Physiocrats, production
meant creating a surplus: An industry is productive, therefore, if it makes more than
is consumed in the process. According to the Physiocrats manufacturing merely
changes the form of goods by converting inputs into outputs. They did not deny that
such goods become more useful in the process, but they reasoned that only agricul-
ture is capable of adding more to output than the mere sum of inputs. In other
words, only agriculture is capable of creating a net product. If this unique meaning
is kept in mind, however strange it may seem from a modern perspective, the doc-
trines of the Physiocrats will be more easily understood.
The original Tableau was an intricate numerical table that connected aggregate
income flows between socioeconomic classes by zigzag lines. Rather than repro-
duce the cumbersome original diagram, we present a simpler graphical representa-
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86 Part I ■ Preclassical Economics

tion that nevertheless captures the essence of Quesnay’s model. Figure 4-1 divides
the economy into three classes, or sectors: (1) a productive class made up entirely
of agriculturalists (perhaps also of fishermen and miners); (2) a sterile class consist-
ing of merchants, manufacturers, domestic servants, and professional people; and
(3) a proprietary class, including not only landlords but also those who have the
slightest title to sovereignty of any kind. Income flows in clockwise motion, show-
ing that the net product (i.e., net income, in money terms) is produced entirely by
the first class and subsequently used to support its own activities or those of the
other two classes.
Using Quesnay’s figures and starting with a total wealth of five billion francs,
which represents net product inherited from the previous production period, the
flow chart shows that two billion francs is necessary for the upkeep of the produc-
tive class and its livestock during the year. In figure 4-1 this is represented as pay-
ments from the farm sector to the farm sector. This portion does not circulate. In
addition, the farm sector spends one billion francs on manufactured goods (and ser-
vices), which are also necessary to sustain the farmers during the year. The remain-
ing two billion francs goes to the proprietors in the form of rents and taxes. This last
two billion represents the net product, or surplus over necessary costs (rents and
taxes were not considered necessary costs of production).

I II III
Farmers Artisans Proprietors

(Each line represents expenditure of one billion francs)

Figure 4-1 Each expenditure made by the farm sector for upkeep, manufactured
goods, rents, and taxes is returned to the farm sector by the artisans, proprietors, and
the farmers themselves.

The circuit is completed when the proprietors and those in the sterile class
spend their income (proprietors: one billion for food and one billion for manufac-
tures; sterile class: one billion for food and one billion for raw materials). In sum,
the three billion francs originally spent by the agriculturalists returns to them, one
billion coming from the proprietors and two billion from the artisans, and the pro-
cess continues indefinitely. Note, however, that the agriculturalists are the only ones
who produce a net product, that is, more than the costs of sustaining themselves
and their agricultural activities.
Physiocratic Policy. At best this summary gives only a faint idea of the vast
complexities involved in tracing the growth of revenues over time—which was the
main concern of the Physiocrats. The circular flow model, however, gives us impor-
tant insights into their policy prescriptions. The Physiocrats sought policies to
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Chapter 4 ■ The Dawn of Capitalism 87

encourage the accumulation of capital, which was retarded under the existing
regime by an excessive tax burden on farmers. Thus, they argued for tax reform.
Quesnay had calculated the amount and productivity of capital necessary to
attain a sound state of agriculture, and following Cantillon, he was convinced that
the application of capital to agriculture was the only way of obtaining a taxable net
product. The trick was to meet the needs of the treasury while at the same time
doing away with a burdensome tax system that impeded agricultural development.
The physiocratic solution to both problems was simply to tax the landlord instead of
the farmer. The Physiocrats argued that tax collection in prerevolutionary France
was highly inefficient because the tax was not levied on the group that ultimately
paid the tax. They reasoned that since taxes can be paid only out of the net product,
they should be levied against those who receive the net product.
Because landlords were responsible for improvements to their land, land rents con-
stituted a potential source of capital accumulation for agricultural investment. Mercan-
tilist restrictions on the free trade of agricultural products, however, kept farm prices
(and therefore land rents) low by limiting demand. Thus, the Physiocrats argued for
free trade. Removal of these restrictions, they felt, and a general “hands-off” policy by
government, would allow capital to flow freely into the agricultural sector and enable
the size of the circular flow to grow over time, in accordance with the “laws of nature.”
It might be insinuated that the Physiocrats were antagonistic toward the landed
class (nobility) because they wanted to shift the tax burden to them. This might
have been the case if the Physiocrats were sympathetic to the revolutionists. But the
Physiocrats neither showed animosity toward the nobility nor challenged the insti-
tution of private property. They considered landlords and their goodwill essential to
the development process. After all, it was the proprietor who made the initial invest-
ment in clearing arable land and making certain improvements prior to turning the
land over to the farmers for cultivation—and for this he was entitled to a share of
the annual output. Later, Karl Marx, who was duly impressed with the physiocratic
notion of surplus, but who freely inserted his socialist fervor into his economic writ-
ings, treated the landed proprietors as social parasites, even though this view was
no part of physiocratic doctrine.
The Physiocrats presented a more enlightened view of landlords and their func-
tion. They believed that any immediate disadvantage to the proprietors caused by
the tax would be more than offset in the long run by consequential increases in agri-
cultural investment, net product, and rents. In short, although the landlords were a
privileged class, their responsibilities were considered by the Physiocrats to be
commensurate with their elevated position in society.
In the final analysis, it is perhaps as important to understand how the
Physiocrats reasoned as it is to understand what they said. Like many social writers
who succeeded them they conceived of the economy as fundamentally organic—an
extremely complex and delicate amalgam of constituent parts, linked by the mecha-
nism of market exchange, in which any disturbance to one part eventually commu-
nicated itself to all other parts through the process of interaction and reaction.
Theirs might be called the first general-equilibrium analysis (see chapter 17). Much
has been made of the analogy Quesnay drew between the operation of the economy
and the performance of the human body. Anatomically, a disturbance to one part of
the body—the stomach, for example—is sooner or later transmitted to other parts,
which interact and react to compensate for the initial disturbance. In the economy, a
disturbance in production brings about a disturbance in demand and vice versa,
because of the interdependence of the two.
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88 Part I ■ Preclassical Economics

Criticisms of Physiocracy
Physiocracy attracted a fair amount of criticism in its heyday, but by and large,
as a body of systematic principles it held sway for merely two decades before The
Wealth of Nations made its appearance in 1776. The Italian economist, Galiani,
reacting against Physiocracy, opposed both the idea of a natural order and the
attempt to construct economic systems. The French philosopher Condillac correctly
refuted the idea that manufacturers are sterile and helped establish a subjective the-
ory of value, an issue that only tangentially concerned the Physiocrats, who were
more interested in production and distribution than in the theory of exchange. But
these complaints did not seriously threaten the prestige of the French economists.
Modern criticisms of Physiocracy usually take one of two forms: (1) their pure
theory did not sufficiently accord with the facts of their day, or (2) their theory was
overshadowed by normative considerations. The latter criticism implies that their
doctrine can be reduced to a mere rationalization of class interests. Each argument
has some merit.
The first argument centers on the charge that manufacturing is sterile. But what
did the Physiocrats really mean by that term? As explained earlier, by “productive”
they did not mean the mere capability of creating utility or adding value. Those
actions that were looked on as productive by the Physiocrats certainly had this
capability, but so, too, did most “sterile” occupations. According to Ronald Meek,
“The real essence of a ‘productive’ occupation, according to the normal physiocratic
use of the term, lay in the inherent capacity to yield a disposable surplus over neces-
sary cost; and the real essence of a ‘sterile’ occupation lay in its inherent incapacity
to yield such a surplus” (Economics of Physiocracy, p. 379).
The Physiocrats believed that manufacturing was sterile insofar as it was inca-
pable of yielding a surplus only under conditions of free competition. They were
perfectly willing to admit that under monopoly conditions, a value surplus over nec-
essary costs might result from manufacturing. Contemporary economic theory tells
us that under competitive conditions, long-run (equilibrium) price is just equal to
average total costs of production. And in eighteenth-century France, this observa-
tion seemed in accord with the experience of the Physiocrats.
Where they erred badly was in maintaining that manufacturing is “naturally
and inherently incapable of yielding a surplus over cost.” They mistakenly con-
cluded that because manufacturing was not yielding a value surplus over necessary
costs under competitive conditions, it never could do so under competitive condi-
tions (in the short run, for example). In this they were wrong, but their error was
based on weak prophecy rather than deficient facts. And perhaps we ask too much
if we demand that economists be seers as well as scientists.
Resolution of one question brings up another, however. If competition reduces
the price of manufactured products to the level of necessary costs, why does it not
do the same in agriculture, thus wiping out rent? At several points in their writings
the Physiocrats seemed to toy with a monopoly explanation of land rent, but their
answer was ambiguous. They regarded the net product as simply a gift of nature, or
of God—a familiar argument in the early history of economic thought. While nature
might explain a surplus of physical output in agriculture, it cannot explain the exis-
tence of a value surplus. The latter can be explained only by a general theory of
value capable of explaining the determination of product and factor prices. The
Physiocrats had certain notions of value, but they did not develop a theory of value.
This task fell to Adam Smith, who responded awkwardly, as we shall soon see, but
he at least directed attention to a serious void in economic theory.
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Chapter 4 ■ The Dawn of Capitalism 89

The twentieth century produced two conflicting interpretations of Physiocracy,

both of which are aimed at explaining class interests in eighteenth-century France.
One view holds that the Physiocrats were merely neomedievalists, seeking to
negate the tenets of mercantilism and repair the shortcomings of the old order
(Beer, Inquiry). The other takes the contrary position that the Physiocrats were
reformists seeking to serve the needs and interests of the newly established com-
moner-landowners (Ware, “Physiocrats”).
There seems to be an element of truth in both. A more likely interpretation is
that the Physiocrats looked in both directions—backward toward feudalism and for-
ward toward capitalism. If this interpretation is correct, then their position in the
history of economic thought is both pivotal and transitional. The Physiocrats sought
to preserve the exalted position of the landlord (i.e., the nobility) and the institution
of private property, remnants of feudalism, but they also attempted to create condi-
tions favorable to the emergence of agricultural capitalism. In other words, they
were cautious reformers, unwilling to eclipse the old order entirely but eagerly pro-
moting a new one that promised expanded national output.
In the end, the Physiocrats’ most permanent imprint on the development of eco-
nomic analysis may have been their influence on Adam Smith. Smith became
acquainted with the Physiocrats during his travels in France. He was attracted to
their systematic turn of mind, which he cultivated in his own reflections and expres-
sions. For lack of this same systematic turn of mind in others, a general theory of
economics had not yet surfaced in England.

■ THE SPANISH ENLIGHTENMENT: IBERIAN ECONOMICS

While France stood in awe of The Sun King (Louis XIV) and the splendor of Ver-
sailles, its neighbor to the south, Spain, was mired in down-at-the-heels decadence—
plagued with stagnation, lagging food production, and persistent internecine and
interregional struggles for political power. This sad state of affairs was in part the
consequence of mercantilist policies, which served the interests of the monarch, the
aristocracy, and the Church, and in part the consequence of other factors, such as
periodic plagues and the out-migration of human capital.1 Spanish mercantilism
established internal and external regulation that promoted monopolies, distorted
resource allocations, and retarded economic growth. An early and persistent exam-
ple of aristocratic rent seeking involved the Mesta organization—a cartel of sheep-
herders that protected the Merino wool export monopoly. This cartel (which was not
formally abandoned until 1836) obtained property rights to migratory sheep “roads”
and to tax revenues from shepherding, shifted resources away from sedentary agri-
culture, and established limits on urban growth in Spain for over 600 years. Bad eco-
nomic policy and ruinous expenditures on wars of conquest and other monarchical
adventures eventually bankrupted the Spanish state, forestalling the introduction of
the Industrial Revolution in Iberia, and limiting its economic growth.
Voices of protest and reform naturally arose. A “Spanish Enlightenment” grew
and flourished over the last half of the eighteenth century and the first decade of the

1
The Moors, who had occupied Spain for seven centuries, had made important contributions to
agriculture, architecture, and Spanish culture (see chapter 3). In 1492, prejudice and religious
intolerance led to the expulsion of the Jews and the Moors from Spain. Economically, the plan
backfired since many of both groups were commercial and financial entrepreneurs who supported
and enabled economic growth.
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90 Part I ■ Preclassical Economics

nineteenth.2 Much of the literature associated with this enlightenment movement

was understandably surreptitious because those who challenged established eco-
nomic interests were always in danger of imprisonment or harm. The Holy Inquisi-
tion, very much in action in Spain at this time, opposed any ideas and policies that
challenged the wealth or authority of the Catholic Church. Reform proposals had to
be introduced very carefully in order to avoid the harsh punishment of the Inquisi-
tion. Carefully crafted and sometimes anonymous pamphlets circulated under-
ground in the service of reform. Even these would not have been possible without
the support of Spain’s “enlightened despots,” Charles III (1759–1788) and Charles
IV (1788–1808), who wanted to make the state independent of the Church and who
supported the idea of state-directed reform.
A number of important social scientists and reformers bubbled up from this
dangerous intellectual stew,3 among them Manuel Rubin de Celis (1743–?), Gaspar
Melchor de Jovellanos (1744–1811), Francisco de Cabarrús (1752–1810), and Pablo
de Olavide (1725–1803). One of the greatest of these reformers was Count Pedro
Rodríguez de Campomanes (1723–1802), who allegedly wrote Discurso sobre el
fomento de la industria popular in 1774, two years before The Wealth of Nations
appeared.4 Widely read in Spain and Latin America, Campomanes’s book was one
of the most influential economic works within the Spanish-speaking world. Schum-
peter said in praise of its author that “in view of the date of Campomanes’ Discurso
(1774) it is not without interest to observe how little, if anything, he stood to learn
from the Wealth of Nations” (History, pp. 172–173). The contributions made by
Campomanes and his followers can be grouped into two interrelated areas of eco-
nomic theory and policy: (1) ideas related to liberalism and free trade, and (2) prac-
tical reforms relating to economic sociology and economic education.

Liberalism and Free Trade

Campomanes and his contemporaries were insistent that greater economic wel-
fare in Spain hinged on a thoroughgoing reform of the system of landholdings and
property rights. Spanish landed estates were “entailed,” meaning that they could
not be broken up for sale on the death of their owner. Land entails were upheld, and
large aristocratic family holdings were maintained by the practice of primogeniture,
which directed inherited landed property to the eldest son. A second factor contrib-
uting to intense concentration of landed property was the vast accumulation of land
holdings by the Catholic Church. Campomanes saw entails as an economic problem
because they prohibited widespread ownership of property and discouraged the
productivity that flows from individual ownership. (In England, Adam Smith railed

2 Indeed, Physiocracy itself made inroads into Spanish thought, but as Vicent Llombart (“Market
for Ideas”) has shown, its impact was selective and limited. Spain did not spawn a cadre of profes-
sional economists who were dedicated single-mindedly to theory or scientific rigor. Most eco-
nomic writers were lawyers, civil servants, merchants, or military officers who shared a common
enthusiasm for economics as a “useful science” and who professed an “enlightened faith” in polit-
ical economy as a basic instrument of economic progress.
3 The discussion in this section is based extensively on the research of D. R. Street (see references
and notes for further reading).
4
Campomanes was the author of many other works, a number of which contained ideas similar to
those presented in the Discurso. However, a lively debate arose on the authorship of the Discurso of
1774, with some evidence suggesting that the authorship should be assigned to Manuel Rubin de
Celis, a writer and translator during the Spanish Enlightenment and an admirer of Campomanes.
This debate is elaborated in Street (1986; 1991), and Llombart (1991) (see notes for further reading).
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Chapter 4 ■ The Dawn of Capitalism 91

against similar problems regarding the “enclosures” and problems associated with
the “commons.”) Economic efficiency—output of products and services—could not
be maximized when the economy was characterized by concentrated ownership in
the hands of a few.
Campomanes also used the Discurso to argue for self-interest and free trade in
input and product markets. Spanish mercantilism, like its other geographic vari-
ants, established an elaborate system of impediments to internal trade. The craft
guilds instigated laws that restricted movements of persons, products, and inputs.
Foreigners were prohibited from working in Spanish industries, thus limiting the
introduction of new technologies and foodstuffs. Campomanes advocated free
movement of all domestic inputs and outputs and supported free international trade
with the Americas as well. He also condemned the price controls—so popular dur-
ing food shortages throughout history—that had helped promote food riots during
the eighteenth century. His cohorts, Jovellanos, Cabarrús, and Olavide, promoted
similar ideas.
These writers also emphasized the twin villains in Spain’s stagnation—regulation
and high taxation. They roundly condemned the privileges of the Mesta and the high
taxes extracted by the king. Campomanes and his cohorts argued for lower taxes on
peasants and higher taxes on the aristocracy and the Church. Given the authoritarian
regime in Spain, they made such arguments at considerable peril to themselves.

Economic Societies and Economic Education

In order to give liberalism a practical face, Spanish Enlightenment economists
promoted economic societies and educational reforms. Among other things, slow
growth in the Spanish economy was attributed to the failure of Church-sponsored
education, most especially in the universities. As Don Street wrote: “The venture-
some reformers in Spain were searching for pragmatic means to develop the coun-
try, an education which entailed something other than vapid philosophizing by
undedicated and ignorant professors who required students to learn by rote and
who had no use for experimentation” (“Spanish Enlightenment Economics,” p. 33).
A major reform advanced by Spain’s liberal economists was to establish “economic
societies”—specialized extra-university institutions that were dedicated to specific
tasks that would foster economic growth.
The Spanish economic societies founded after 1775 were often based on foreign
models. Some examples include the royal Spanish Academy, the Academy of His-
tory, the Academy of Fine Arts of Saint Ferdinand, the School of Mines in Almadén,
and the Museum and Botany Garden at Madrid. Because Church-run universities
often exhibited a fear of the (practical and theoretical) sciences, many of the new
economic societies were scientifically oriented. The Basque Economic Society, for
example, established what might be called Spain’s first “land grant college,” the
Seminario Patriótico Vascongado in Vergara (see Street, “Spanish Antecedents”).
Courses commonly taught there included chemistry, mineralogy, metallurgy, public
architecture, agronomy, and political science. The societies also encouraged experi-
ments in agriculture, along with new crops and plant culture, which helped increase
the efficiency of Spanish farming.
The practical advantages of these new forms of education led to a belief among
economic reformers that human capital was as important in increasing the produc-
tivity of the Spanish economy as real fixed capital. In the same year that Smith pub-
lished The Wealth of Nations, Jovellanos argued that “the returns to labor, whatever
its object of application, will not be in simple proportion to the number of hands
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92 Part I ■ Preclassical Economics

employed in it, but in the combined proportion of this number and of the improve-
ment applied to labor” (“Economia civil,” p. 10, translated by Street, “Spanish
Enlightenment Economics,” p. 36). These ideas and technical advances swept
across the Atlantic to the colonies, where they were absorbed by Benjamin Franklin
and George Washington, to name a few.
Other reformers were even more radical. Cabarrús, who was indebted to the
French Enlightenment philosophers Rousseau and Voltaire, advocated closing the
Church-run educational system and replacing it with a scientifically based secular
system. He was particularly incensed by the abysmal conditions of public health
and burial practices in the Spanish economy, conditions that spread plague-borne
disease such as smallpox. (His interest in such reforms clearly anticipated those of
Edwin Chadwick in mid-nineteenth-century England—see chapter 10). Cabarrús
also struck a modern note by condemning Church regulation of “implicit” markets,
such as marriage and divorce. His “radical” beliefs, coupled with his staunch sup-
port of free speech, brought him into inevitable conflict with the Catholic Church
and its Holy Inquisition. (See the box, The Force of Ideas: Economic Sociology in
Enlightenment Spain).

The Force of Ideas: Economic Sociology in Enlightenment Spain

Nobel Prize (1992) winner Gary Becker pioneered the modern economic theories of
human capital and economic sociology. Economic sociology draws an analogy between mar-
kets for goods and services such as beets or shoes and markets for such “sociological” phe-
nomena as sex, marriage, polygamy, or psychological security. For example, marriage
obviously occurs for numerous reasons, but whatever the reasons, the decision to marry can
usually be expressed in terms of expected costs and benefits. When the net benefits of mar-
riage exceed those of remaining single, people marry.
Given the specialized nature of the traditional woman’s role, women have been particu-
larly vulnerable to economic disadvantage within the family “production unit.”* Thus, mar-
riage can be seen as an institutional response to minimize certain gender risk. As Becker
(Treatise, p. 38) puts the issue, “Marriage includes a contract that has protected specialized
women with limited alternatives against abandonment, neglect, and other ill treatment by
their husbands.” Marriage, in the traditional contract, provides protection for women who are
vulnerable because of (nonmarket) biological specialization. Hence, the Catholic Church’s
insistence on the indissolubility of marriage is particularly beneficial for women who want to
maximize the degree of certainty of the marriage contract. Divorce results if there are obsta-
cles to efficient pricing in the marriage market (leading to marriages of poorly matched
spouses), and/or if recontracting is not permitted after marriage bonds are established. If
divorce is not possible, a substitute for divorce will usually result. Utility of individuals is clearly
reduced if such mechanisms are not available.
Almost two centuries before Becker, such ideas were recognized by the radical Spanish lib-
eral Francisco de Cabarrús. Although “conservative” by profession (he was head of the Banco
de San Carlos, the first National Bank of Spain), Cabarrús’s writings were the most radical ideas
that floated free of direct Church control. In a carta (position paper) written in 1792 but not
published until 1808, Cabarrús defended civil dissolution of marriage on the intuitive ground
that divorce was the only solution to “utility” reductions of the individuals involved, and on
the practical basis that it would (indirectly) improve public health. Cabarrús argued that
divorce was tantamount to recontracting when “mistakes” are made, that even Jesus Christ
condoned divorce in instances of adultery, and that adultery was prevalent in Spain.
Cabarrús’s arguments are compatible with Becker’s modern views of utility maximization,
but he went further in introducing a public health issue as well. Divorce would limit venereal
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Chapter 4 ■ The Dawn of Capitalism 93

disease by reducing the tendency of disgruntled husbands to purchase the services of prosti-
tutes. (This assumes, of course, that prostitutes are at higher risk of venereal disease than the
female population at large.) He must have felt strongly about this issue because Cabarrús
argued that, as long as divorce was impossible, prostitution should be legalized as a means of
disease control!
Cabarrús proposed that houses of prostitution in large population centers should be run
under the direction of an elected official. Patrol squads with officers would be assigned to
major streets to keep order and avoid problems. Any sign of disease would cause immediate
removal of the prostitute to a hospital for treatment. Brothels should be scrupulously policed
for cleanliness, and sanitation measures should be required to reduce the risk of contracting
diseases. Prostitutes would be identified by a yellow feather worn on the head and would be
required to remain in their own districts. In addition to identifying house numbers, brothels
would be required to display a sign giving the names, ages, and hometowns of the trades-
women in order to settle any complaints and put down any disorder. In sum, Cabarrús recog-
nized that legalized divorce and prostitution would have two important social effects. First,
the happiness of the individuals (if not their families) would be increased. Second, whether or
not divorce was an option, husbands’ flight to prostitutes would be made safer.
Whatever the merits of Cabarrús’s arguments, they did not carry the day. Rather, his views
got him (and his liberal cohorts) into deep trouble with the Spanish religious establishment
and with the Holy Inquisition. Although the power of the Inquisition had weakened some-
what when his cartas were officially published in 1808, Cabarrús nevertheless had to be on
constant guard for his life. He had already been thrown in prison briefly in 1790 as a “danger-
ous subject.” After his death in 1810 his writings were officially “prohibited” by the Inquisition.
Cabarrús’s “conceptions of morality” (interpreted through the modern prism of Becker’s
ideas) remind us of certain similarities between markets for economic goods and markets for
social goods. Specifically, in the face of technological change and utility-maximizing behavior,
artificial controls on marriage, divorce, and prostitution are likely to be as self-defeating in
their sphere of behavior as quotas and price controls are in the market for traditional goods.
*This discussion is based on R. B. Ekelund, D. R. Street, and A. B. Davidson, “Marriage, Divorce, and Prostitution.”

Beset on all sides by opportunists, power brokers, and privileged classes, and at
great personal risk, the Spanish Enlightenment economists made important contri-
butions to what might be called a “practical” theory of markets that operated on the
principle of self-interest. Some of their contributions anticipated The Wealth of
Nations of the same era. Like Smith, these Spaniards set forth practical remedies
aimed at removing impediments to economic development and combating eco-
nomic stagnation. Their most durable insights consisted of recognizing the impor-
tance and economic vitality of human capital acquisitions and the urgent need to
reform the educational system in order to equip Spain for industrial development in
the nineteenth century.

■ CAPITALISM AT THE JUNCTION OF IDEAS AND HISTORY

Even a cursory survey of the antecedents of economic liberalism makes it clear
that ideas pertaining to the nature and operation of markets were around long
before Adam Smith ever codified them. In various countries and within a number of
alternative institutional settings, the framework of market exchange was gradually
and persistently yielding to closer examination by writers in Britain and Western
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94 Part I ■ Preclassical Economics

Europe. The writers whose ideas comprise the subject of this chapter paved the way
toward the full-scale avowal of free markets as a leading force of economic develop-
ment. These ideas clearly had consequences for the course of history. Without ques-
tion the various “enlightenment” movements of England, Scotland, France, and
Spain were central moving forces of historical events. But we must not overlook the
possibility of feedback—that historical events played a part, perhaps even a large
part, in the formation of ideas—much as the way in which self-interested parties in
mercantilist England helped create a set of institutions that made domestic regula-
tions harder to establish and enforce. Before examining Adam Smith’s seminal
work on free trade in part II (chapter 5), we pause to collect some of the historical
elements that contributed to the acceptance of free trade and the tenets of capital-
ism, knowing full well that (1) it is difficult to untangle ideas from history and his-
tory from ideas, and (2) it is quite possible that all of the factors mentioned in the
preceding and ensuing chapters are intertwined and mutually dependent.

■ THE DECLINE OF CATHOLICISM AND THE RISE OF PROTESTANTISM

We have already alluded to the prominent role played by the medieval Catholic
Church over the early and later Middle Ages (see chapter 2). The Church’s attempts
to forestall entry into the market for religion took the form of punishments (such as
excommunication and the Crusades) on the one hand and doctrinal innovations
aimed at retaining membership on the other. By the early part of the sixteenth cen-
tury, however, events conspired to permit successful and sustained entry into the
market for Christian religion. After being excommunicated by the Catholic Church
in 1521, Martin Luther (1483–1546), a former Augustinian monk and theologian,
established Lutheranism (through the Augsburg Confession) in 1530. Luther was
followed by John Calvin and a number of other Protestants who gave life to new
forms of Christianity in the ensuing years. Details of this breakaway are complex,
but the introduction of Protestantism and the sixteenth-century religious movement
known as the Reformation had an enormous impact on the way social scientists
view the emergence of capitalism.

Weber’s Thesis
First published in German in 1904–05, Max Weber’s The Protestant Ethic and
the Spirit of Capitalism (1930) inaugurated an ongoing debate about how capitalism
took hold in the Western world. Weber’s analysis of the relationship between religion
and economic development placed more emphasis on broad religious imperatives
than on the specific injunctions that each religion imposes on economic behavior. He
formulated the concept of a “Protestant ethic,” suggesting uniformity among Protes-
tant religions that are, in fact, fragmented in terms of moral codes, beliefs, doctrines,
and practices. He suggested a link between this Protestant ethic and the “spirit” of
capitalism, a connection posited to explain why Western civilization proved such fer-
tile ground for the Industrial Revolution and the development of capitalism.
Although the Protestant ethic is derived from fundamental religious principles,
in Weber’s treatment it is both “secular” and “worldly.” It includes, or perhaps
spawns, an economic ethic: “the summum bonum of this ethic [is] the earning of
more and more money combined with the strict avoidance of all spontaneous enjoy-
ment of life” (Protestant Ethic, p. 53). For Weber, the spirit of capitalism is anteced-
ent to the emergence of capitalism, and both derive from the Protestant ethic.
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Chapter 4 ■ The Dawn of Capitalism 95

Nowhere in his study does Weber define “the spirit of capitalism,” but he conveys its
meaning in terms of Benjamin Franklin’s homespun philosophy on the utility of vir-
tue. Weber wrote:
Honesty is useful because it assures credit; so are punctuality, industry, frugality,
and that is the reason they are virtues. . . . According to Franklin, those virtues,
like all others, are only in so far virtues as they are actually useful to the individual,
and the surrogate of mere appearance is always sufficient when it accomplishes
the end in view. (Protestant Ethic, p. 52)

Within this ethic, making money is not only the highest good, it is a duty, one
that is closely connected to the religious idea of a calling: “The earning of money
within the modern economic order is, so long as it is done legally, the result and the
expression of virtue and proficiency in a calling” (Protestant Ethic, pp. 53–54). By
Weber’s reasoning economic success is a measure of individual virtue. It is this idea
that sets his analysis apart. Yet, he limits his thesis to Western Europe and America,
for he is well aware that “capitalism existed in China, India, Babylon, in the Classic
World and in the Middle Ages. But in all these cases . . . this particular ethos was
lacking” (Protestant Ethic, p. 52).
Popular and naive perversions of Weber’s thesis notwithstanding, he did not
claim that the Protestant ethic alone was sufficient to bring about the capitalist sys-
tem—in other words, he did not assert that religion causes capitalism. Nor did he
champion the extreme position that modern capitalism would not have come into
existence without the Protestant ethic. Instead he maintained the intermediate posi-
tion that the Protestant ethic significantly fostered and accelerated the development
of Western capitalism. He was well aware that forms of capitalism existed prior to
the Reformation; and he was equally aware that only in Western Europe and Amer-
ica did capitalism “develop in a way and on a scale sufficient to bring about an
Industrial Revolution and an industrial civilization” (Lessnoff, Spirit of Capitalism).
For Weber, therefore, there was something special about the development of West-
ern capitalism after the Reformation. He found that special factor in the Protestant
work ethic and its strong element of asceticism.
Protestant theology tells us that salvation is attained by faith alone, but it also
advocates forms of human behavior that are pleasing to God, such as good works.
Luther, in particular, decisively altered the (pre-Reformation) Christian conception
of good works by prescribing the fulfillment of duties in worldly affairs as the high-
est form of moral activity that an individual can perform (Weber, Protestant Ethic).
Calvin complicated matters by adding the doctrine of predestination. Under Calvin’s
influence, good works became a reliable, objective sign of grace, so that those who
practiced good works could have their doubts assuaged and their fears allayed.
After Calvin, good works became not so much a toll on the highway to heaven but
rather a way of lessening or banishing the fear of eternal damnation. It is easy to see
how the combination of Lutheran virtue and Calvinist asceticism yielded an ethos
that stimulated entrepreneurs and artisans alike to achieve economic success in
their respective spheres. This ethic constituted a dramatic shift from the Christian
ethic of the pre-Reformation era.
Weber’s thesis suggests that the emergence of the Protestant ethic redirected
societal tastes and preferences from consumption to saving—thereby augmenting
funds for investment and economic growth. Protestantism also may have affected
economic growth in Western Europe in other ways. Generally, for example, Protes-
tant rituals were simpler, with less pomp and pageantry, and churches were less
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96 Part I ■ Preclassical Economics

elaborate in construction and ritual. Compared to the great Roman Catholic cathe-
drals of Europe far fewer resources were devoted to Protestant churches. It is quite
possible, moreover, that Protestantism’s rejection of the numerous feast days on the
Catholic calendar generated an increase in the number of work days, thereby
increasing labor inputs under Protestant regimes. Additionally, the new religion
expunged the Roman Catholic system of “indulgences for pilgrimages” to churches
and holy places, a factor that also might have contributed to economic growth.
Not surprisingly Weber’s thesis has provoked numerous challenges. Some crit-
ics emphasize that a nascent “capitalism” and an extensive use of markets in inter-
national trade existed in the Italian city-states long before Luther’s entry.
Furthermore, the Catholic Church’s doctrine of usury, selectively enforced, may
have made less impact on economic growth than commonly claimed. The possibility
also exists that by eliminating cruder forms of heresy in the pre-Enlightenment
period the Catholic Church facilitated the introduction of the “age of reason” and its
encouraging effect on the development of markets and investments. On the other
hand, the medieval Roman Catholic Church sometimes impeded the advance of sci-
ence, which became a lodestone of capitalism.

Medieval Science and the Emergence of Capitalism

Science and technology were leading edges of capitalism in Western Europe.
Low-level science and a spirit of open inquiry, especially in the form of agricultural
technology, was fostered first in Spain and then spread throughout Europe. The
influx of Arabian Muslim tribes into the Iberian Peninsula in the eighth century ush-
ered in a period of high prosperity that continued through the monarchy of Ferdi-
nand and Isabella. The Moors husbanded and developed natural and human
resources, including those in agriculture, manufacturing, and commerce. New
plants and trees were introduced, irrigation systems were developed, herding was
carried on in a manner consistent with agriculture, mining flourished, and the
weaving of silk and wool was celebrated all over the Western world. Relatively free
trade reigned and customs duties were held to moderate levels. Moorish propaga-
tion, maintenance, and defense of learning, especially pertaining to mathematics,
science, and architecture, also encouraged the development of Western Europe.5
Inasmuch as established religion is concerned, the role of Christianity was curi-
ously ambivalent. Christian missionaries helped fuel the development of capitalist
organizations in parts of Europe, particularly in the North. Monasteries became
agricultural estates that contributed to our knowledge of crop rotation and ranch
technology. Hard science, a product of Enlightenment, advanced steadily, if not
always spectacularly, in the fifteenth, sixteenth, and seventeenth centuries. And just
as meteorology reduced the demand for rain dance or rituals, medieval science
began to offer better explanations for events, especially by adopting empiricism and
the newly evolving “scientific method.” But the Catholic Church sometimes sacri-
ficed medieval science on the altar of doctrinal orthodoxy. Antagonistic actions
against late medieval scientists, including John Hus (burned at the stake in 1415),
Copernicus, Bruno Hildebrand (burned at the stake in 1600) and, most famously,
Galileo, cropped up repeatedly. Galileo’s most important and notable contribution
was his Dialogue Concerning the Two Chief World Systems—Ptolemaic & Coperni-

5
General religious tolerance of both Christians and Jews was practiced by the Moors also, a favor
that was not repaid them by the later Christian monarchs who banished both Muslims and Jews
from Spain in 1492.
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Chapter 4 ■ The Dawn of Capitalism 97

can (1632) in which he demonstrated the superiority of the Copernican theory that
the earth revolved around the sun. Aged and infirm, Galileo could not withstand the
rigors of the Inquisition, which found his defense of the Copernican system “gravely
suspect of heresy” and insisted on his repudiation of certain scientific views. Rather
than face torture, Galileo capitulated, thus becoming for all time an icon of the ten-
sion between science and religion.6
Knowledge is a powerful economic force, most effective when widely dissemi-
nated. Therefore, the invention of the printing press by Johann Gutenberg (in the
fifteenth century) was a major catalyst to the development of capitalism. The rapid
dissemination of printing had earthshaking implications for the course of civiliza-
tion, establishing the foundation for widespread literacy; aiding the development of
a “permanent Renaissance” in science, philosophy, and literature and establishing
the basis of the modern world. Less than seven decades after Gutenberg, the new
science of printing also facilitated the spread of Luther’s and Calvin’s “new” Chris-
tian religion, ultimately conjoined with other sects as Protestantism. Despite early
heresies that the Church managed to deflect, once the printing press became avail-
able as a mass medium to publicize Church abuses it was more difficult for it to
repel market intruders.
Gutenberg’s brilliant invention also transformed communications in the secular
world. Treatises on trade and the dissemination of accounting principles in printed
form helped propel ideas about trade. The whole debate regarding the pros and
cons of controls under mercantilism by pamphleteers in England and on the Conti-
nent (see chapter 3) would not have been possible without the printing press. By
expanding literacy across medieval Europe, the printing press helped to launch the
“first” information revolution (equaling and perhaps exceeding the modern revolu-
tion in digital technology). The ability to establish and build on ideas concerning
trade and commerce was a powerful force leading to the (ultimate) demise of abso-
lute monarchies and regulations over domestic and international commerce.

Preconditions of Market Exchange

The decline of mercantilism in England and Holland and its staying power in
France and Spain meant that capitalism evolved at different rates throughout
Europe. The full flowering of capitalism, and the Industrial Revolution that pro-
pelled it, could only occur after legal codes had firmly established sound credit
practices and secure property rights. Despite the checks to monarchical power
introduced by Parliament and the establishment of common law after the Glorious
Revolution of 1680, England did not reach the desired state of stability for another
forty years. Instability reigned as long as the Catholic “Pretender” (Prince Charles
Edward Stuart) to the English throne was given sanctuary by the French monarch.
From time to time, rumors of his return (with an army) created bank runs and
financial panics in England. Thus, the credible commitments required to establish a
stable capitalist economy had to wait until the House of Hanover ascended to the
English throne in 1720. Along the way, mercantilism declined bit by bit, paving the
way for new investment and expanded markets.7

6
Although the Inquisition was formally abolished in 1908, its function was folded into a Catholic
institution called the Congregation of the Holy Office, which was renamed in 1965, the Sacred
Congregation for the Doctrine of the Faith. Its role is to censor and issue pronouncements on cer-
tain contemporary books, other forms of communications, and elements of culture.
7
For details of this process, see Wells and Wills, “Revolution, Restoration, and Debt Repudiation.”
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98 Part I ■ Preclassical Economics

Another major transformation in European economies was triggered by the

Black Death (i.e., bubonic plague) that ravaged Europe and Asia in the fourteenth
century, killing millions of inhabitants. By some estimates, the plague reduced the
population of Europe to somewhere between one-half to two-thirds of former levels.
The surprising impact of this disastrous event was to change the relative prices of
labor, land, and capital used in production. Wages rose as labor became scarce rela-
tive to land. The consequences were manifold. Land tenure systems developed in a
manner that gave the laboring peasantry more secure rights in the land they
worked. Greater security of property rights in turn stimulated increased productiv-
ity; in their own self-interest, land owners and producers “economized” on the
scarce factor (labor) by making larger investments in capital, which brought about
high returns to innovation and invention in agriculture and other areas. The hand-
maiden of invention was new forms of power—from animal and human to water,
steam, and eventually electric power, which fueled the Industrial Revolution
throughout Europe and ushered in the modern age.

■ CONCLUSION
Up to this point we have taken a necessarily brief look at the intellectual move-
ments and historical changes that signaled the end of authoritarianism and highly
controlled markets. The breakdown of old habits and traditions was slow in coming,
but the pace quickened as the eighteenth century unfolded. Nevertheless, Adam Smith
did not arrive, as Venus, on a shell from the sea. He was, in a real sense, the repository
of the accumulated wisdom that preceded him. Previous ideas regarding demand,
exchange, and production were central to the advent of capitalism. The replacement
of centralized control in the hands of absolute monarchs by decentralized market
exchange and secure individual property rights established incentives that spurred
invention and efficiency like never before. All of these so-called “preconditions” for
economic growth were recognized and expounded by individuals who rose above
mundane observations, laying groundwork for the market theory that was to come.
Historical events obviously propel evolutionary change, but less obviously they
are themselves shaped by ideas that vie for acceptance over time. Institutions criti-
cal to the emergence of capitalism evolved throughout the long expanse of history
leading to today. Economic theory often assigns such forces to intellectual limbo as
“exogenous” factors, thereby avoiding messy consequences that do not bend easily
to empirical treatment. But analysts neglect such matters at their peril.
Christian religion and its changing forms undoubtedly played a critical role in
the transformations that were to come in economic organization, first throughout
northern Europe and then in the United States of America. Whether the arguments
of Max Weber have merit, it seems clear that religious regime changes were at least
associated with the capitalist spirit (causation is of course another matter). Prob-
lems of cause and effect, such as those presented by the nexus of religion and eco-
nomics, are notoriously difficult to solve. We must not hasten to make “definitive”
pronouncements about the cause of major historical and economic transformations,
but we are on solid ground by recognizing that many factors—intellectual, histori-
cal, and institutional—combined to produce the Industrial Revolution and the new
world it ushered in. One conclusion that can be drawn from this chapter is that all of
the intellectual and historical elements of market operation were in place at the
opening of the eighteenth century. Nevertheless, it was Adam Smith, a Scottish phi-
losopher, who crystallized for all time the case for free markets and capitalism.
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Chapter 4 ■ The Dawn of Capitalism 99

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NOTES FOR FURTHER READING

Sir William Petty’s writings were collected and published together for the first time
in 1899 by Charles Henry Hull (see references, Petty, Economic Writings). Hull prefaced
the whole collection with a lengthy introduction on Petty’s life and writings, including
the issue of John Graunt’s role in the development of statistics and his probable influ-
ence on Petty. A brief but able study of Petty’s economics has been produced by Alessan-
dro Roncaglia, Petty: The Origins of Political Economy (Armonk, NY: M. E. Sharpe,
1985). Tony Aspromourgos offers his retrospective on Petty in “The Life of William Petty
in Relation to His Economics: A Tercentenary Interpretation,” History of Political Econ-
omy, vol. 20 (Fall 1988), pp. 337–356. A. M. Endres examines Political Arithmetick in gen-
eral and Petty’s use of numbers in “The Functions of Numerical Data in the Writings of
Graunt, Petty, and Davenant,” History of Political Economy, vol. 17 (Summer 1985), pp.
245–264. On Petty and Cantillon together, see A. Brewer, “Petty and Cantillon,” History of
Political Economy, vol. 24 (Fall 1992), pp. 711–728. Marx drew inspiration from Petty’s
concept of surplus, but the idea has a more extensive pedigree. For a historical treatment
of how early economists looked at the problem of producing enough agricultural product
to sustain the population, and how to get that surplus to consumers, see Anthony Brewer,
“The Concept of an Agricultural Surplus from Smith to Petty.” Journal of the History of
Economic Thought, vol. 33 (December 2011), pp. 487–505. Among others, Brewer consid-
ers the ideas of Petty, Cantillon, Hutcheson, Hume, Steuart, Mirabeau, and Smith.
The standard reference on Boisguilbert is Hazel Roberts’s Boisguilbert, Economist of
the Reign of Louis XIV (New York: Columbia University Press, 1935), but it is now dated
somewhat. For a more recent assessment, see Gilbert Faccarello, The Foundations of
Laissez-Faire: The Economics of Pierre de Boisguilbert (London: Routledge, 1999). See
also J. J. Spengler, “Boisguilbert’s Economic Views vis-à-vis Those of Contemporary
Reformateurs,” History of Political Economy, vol. 16 (Spring 1984), pp. 69–88. C. W. Cole
(see references) devotes part of his work to Boisguilbert (pp. 231–267) as, in even larger
measure, does J. H. Bast, Vauban and Boisguilbert (Groningen: P. Noordhoff, 1935).
Boisguilbert’s role as an early precursor of Keynes is discussed by S. L. McDonald,
“Boisguilbert: Neglected Precursor of Aggregate Demand Theorists,” Quarterly Journal
of Economics, vol. 68 (August 1954), pp. 401–414.
The mystery surrounding Richard Cantillon does not stop with the man but extends
to his Essai as well. Until at least the 1750s, a number of drafts survived of Richard Can-
tillon’s Essay on the Nature of Trade in General, in different stages of completion. This is
suggested by a paragraph-by-paragraph comparison between three versions of Cantil-
lon's writings, namely the French Essai of 1755, fragments of Postlethwayt’s Universal
Dictionary (1752–1754), and Philip Cantillon’s Analysis of Trade (1759). Richard van den
Berg, “‘Something Wonderful and Incomprehensible in Their Œconomy’: The English
Versions of Richard Cantillon’s Essay on the Nature of Trade in General,” The European
Journal of the History of Economic Thought, vol. 19 (2012), pp. 868–907, claims that
while numerous variations between the texts may be attributed to free translation prac-
tice or to interventions by later editors, others cannot; he suggests a comparative study
of variations may provide us with insights into the development of the ideas of this mas-
terful economic theorist.
The standard translation of Cantillon’s Essai sur la nature du commerce en général
by Henry Higgs (1931), though useful for several generations, has become less service-
able over time. A new English translation by Chantal Saucier, edited by Mark Thornton,
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Chapter 4 ■ The Dawn of Capitalism 101

has been published by the Ludwig Von Mises Institute with the title An Essay on Eco-
nomic Theory (2010). Jevons hailed his rediscovery of Cantillon in “Richard Cantillon and
the Nationality of Political Economy,” Contemporary Review (January 1881), reprinted in
Higgs (see references, Cantillon, Essai). An overview of Cantillon’s work and his role in
the history of economics is provided by J. J. Spengler, “Richard Cantillon: First of the Mod-
erns,” Journal of Political Economy, vol. 62 (August, October, 1954), pp. 281–295, 406–424.
Cantillon’s originality is also the theme of Mark Thornton, “Richard Cantillon and the
Origins of Economic Theory,” Journal des Economistes et des Etudes Humaine, vol. 8
(March 1998), pp. 61–74.
The Irish economist Joseph Hone, “Richard Cantillon, Economist-Biographical Note,”
Economic Journal, vol. 54 (April 1944), pp. 96–100, sought to establish 1697 as the date of
Cantillon’s birth, but this claim has been discredited by more recent research. The details
of Richard Cantillon’s life have long been shrouded in mystery, but a provocative biogra-
phy by Antoin Murphy, Richard Cantillon: Entrepreneur and Economist (Oxford: Claren-
don Press, 1986), sheds much light on this “mystery man” of economics. A major episode
in Cantillon’s banking career was his association with John Law’s paper money scheme
and his connection with the “Mississippi Bubble.” For illuminating background on this
period, see Earl J. Hamilton, “The Political Economy of France at the Time of John Law,”
History of Political Economy, vol. 1 (1969), pp. 123–149. Also, see Antoin Murphy, John
Law: Economic Theorist and Policymaker (Oxford: Oxford University Press, 1997).
Cantillon’s monetary theory is discussed briefly in relation to other preclassical the-
orists in Joseph Ascheim and C. Y. Hsieh, Macroeconomics: Income and Monetary The-
ory (Columbus: Merrill, 1969), pp. 144–146. A. M. Huq, “Richard Cantillon and the
Multiplier Analysis,” Indian Journal of Economics, vol. 39 (April 1959), pp. 423–425,
emphasizes another macroeconomic theme in Cantillon’s Essai. Antoin Murphy, “John
Law and Richard Cantillon on the Circular Flow of Income,” European Journal of the
History of Economic Thought, vol. 1 (Autumn 1993), pp. 47–62, seeks to show that John
Law had a prior claim to both Cantillon and Quesnay as the originator of the circular
flow of income and expenditure.
The special role of land and its utilization in Cantillon’s work is the subject of Hans
Brems, “Cantillon versus Marx: The Land Theory and the Labor Theory of Value,” His-
tory of Political Economy, vol. 10 (Winter 1978), pp. 669–678; Anthony Brewer, “Cantillon
and the Land Theory of Value,” History of Political Economy, vol. 20 (Spring 1988), pp. 1–
14; and Tony Aspromourgos, “Cantillon on Real Wages and Employment: A Rational
Reconstruction of the Significance of Land Utilization,” The European Journal of the His-
tory of Economic Thought, vol. 4 (Autumn 1997), pp. 417–443. Other specific aspects of
Cantillon’s economics are treated in R. F. Hébert, “Richard Cantillon’s Early Contribu-
tions to Spatial Economics,” Economica, vol. 48 (February 1981), pp. 71–77; Renee Pren-
dergast, “Cantillon and the Emergence of the Theory of Profit,” History of Political
Economy, vol. 23 (Fall 1991), pp. 419–430; Mark Thornton, “Cantillon on the Cause of the
Business Cycle,” Quarterly Journal of Austrian Economics, vol. 9 (Fall 2006), pp. 45–60;
and same author, “Richard Cantillon and the Discovery of Opportunity Cost,” History of
Political Economy, vol. 39 (Spring 2007), pp. 97–120.
A divergence of opinion exists on whether Cantillon was a mercantilist. See
Anthony Brewer, “Cantillon and Mercantilism,” History of Political Economy, vol. 20 (Fall
1988), pp. 447–460; and two papers by Mark Thornton, “Was Richard Cantillon a Mer-
cantilist?” Journal of the History of Economic Thought, vol. 29 (December 2007), pp. 417–
435; and “Cantillon, Hume and the Rise of Anti-Mercantilism,” History of Political Econ-
omy, vol. 39 (Fall 2007), pp. 453–480.
The Physiocrats helped pioneer the deductive method in economics while emerging
as the first group of economic model builders. The logico-deductive background of eigh-
teenth-century French thought is explored by Daniel Klein, “Deductive Economic Meth-
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102 Part I ■ Preclassical Economics

odology in the French Enlightenment: Condillac and Destutt de Tracy,” History of

Political Economy, vol. 17 (Spring 1985), pp. 51–72; and Martin S. Staum, “The Institute
Economists: From Physiocracy to Entrepreneurial Capitalism,” History of Political Econ-
omy, vol. 19 (Winter 1987), pp. 525–550.
A penetrating study of the origins of Physiocracy, including the interaction between
Quesnay and Mirabeau, can be found in E. Fox-Genovese, The Origins of Physiocracy
(Ithaca, NY: Cornell University Press, 1976). Christine Théré and Loïc Charles, “The
Writing Workshop of François Quesnay and the Making of Physiocracy,” History of Polit-
ical Economy, vol. 40 (Spring, 2008), pp. 1–42, provide a glimpse of the early days of the
Physiocrats (before 1764), when Quesnay carefully controlled the research agenda of the
group and it functioned more like a workshop than a distinct “school” of thought.
On Quesnay’s liberal leanings versus his reliance on authority, see R. F. Hébert,
“Authority Versus Freedom in Quesnay’s Thought,” European Journal of the History of
Economic Thought, vol. 3 (Summer 1996), pp. 18–42. The standard general guide to Phys-
iocracy for many years has been Henry Higgs, The Physiocrats (London: Macmillan,
1897), but it is now considered somewhat outdated. Also dated, but still accessible, is the
treatment given the Physiocrats by Charles Gide and Charles Rist in their textbook A His-
tory of Economic Doctrines from the Time of the Physiocrats to the Present Day, R. Rich-
ards (trans.), 2d ed. (Boston: Heath, 1948). Much of the physiocratic literature is now
available in English, thanks to Meek (see references). Stephan Baur (see references)
examines the role of economic thought prior to the Physiocrats, as well as the influence of
the Physiocrats on Adam Smith. As noted in the text, conflicting interpretations of Phys-
iocracy exist between Beer (see references) and Ware (see references). D. C. Carbaugh
attempted a reconciliation between the two opposing views in “The Nature of Physio-
cratic Society: An Attempted Synthesis of the Beer–Ware Interpretations,” American Jour-
nal of Economics and Sociology, vol. 33 (April 1972), pp. 199–207. For a more recent
review of the debate, see G. Schacter, “François Quesnay: Interpreters and Critics Revis-
ited,” American Journal of Economics and Sociology, vol. 50 (July 1991), pp. 313–322.
Some notable attempts to trace the origins of physiocratic thought are to be found in
R. S. Franklin, “The French Socioeconomic Environment in the Eighteenth Century and Its
Relation to the Physiocrats,” American Journal of Economics and Sociology, vol. 21 (July
1962), pp. 299–307; O. H. Taylor, “Economics and the Idea of ‘Jus Naturale,’” Quarterly
Journal of Economics, vol. 44 (February 1930), pp. 205–241; and L. A. Maverick, “Chinese
Influences upon the Physiocrats,” Economic History, vol. 3 (February 1938), pp. 54–67.
Along the same lines, see Bert Hoselitz, “Agrarian Capitalism, the Natural Order of Things:
François Quesnay,” Kyklos, vol. 21 (1968), pp. 637–662; and José Benitez-Rochel and Luis
Roblels-Teigeiro, “The Foundations of the Tableau Économique in Boisguilbert and Cantil-
lon,” The European Journal of the History of Economic Thought, vol. 10 (Summer 2003),
pp. 231–248. See also, Loïc Charles, “The Visual History of the Tableau Économique,” The
European Journal of the History of Economic Thought, vol. 10 (Winter 2003), pp. 527–550.
An attempt to explain Quesnay’s nettlesome premise about the exclusive productiv-
ity of agriculture has been mounted by H. Spencer Banzhaf, “Productive Nature and the
Net Product,” History of Political Economy, vol. 32 (Fall 2000), pp. 517–551. Articles that
explore the relationship of Quesnay to his contemporaries include W. Eltis, “L’Abbé Con-
dillac and the Physiocrats,” History of Political Economy, vol. 27 (Summer 1995), pp.
217–236; T. P. Neill, “The Physiocrats’ Concept of Economics,” Quarterly Journal of Eco-
nomics, vol. 63 (November 1949), pp. 532–553; and same author, “Quesnay and Physioc-
racy,” Journal of the History of Ideas, vol. 9, no. 2 (1948), pp. 153–173.
Mary Jean Bowman, “The Consumer in the History of Economic Doctrine,” Ameri-
can Economic Review, vol. 41 (May 1951), pp. 1–18, discusses, among other things, the
views of the Physiocrats. Their doctrines of foreign trade in relation to mercantilist and
classical ideas are investigated by A. I. Bloomfield in “The Foreign Trade Doctrines of
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Chapter 4 ■ The Dawn of Capitalism 103

the Physiocrats,” American Economic Review, vol. 28 (December 1938), pp. 716–735. P.
Steiner, “Demand, Price and Net Product in the Early Writings of F. Quesnay,” European
Journal of the History of Economic Thought, vol. 1 (Spring 1994), pp. 231–251, explores
the neglected role of demand in Quesnay’s thought.
For different treatments of physiocratic tax proposals, see L. Einaudi, “The Physio-
cratic Theory of Taxation,” in Economic Essays in Honor of Gustav Cassel (London: G.
Allen, 1933); and G. B. Buurman, “A Comparison of the Single Tax Proposals of Henry
George and the Physiocrats,” History of Political Economy, vol. 23 (Fall 1991), pp. 481–
496. W. J. Samuels looks at policy and institutions in physiocratic writings in two arti-
cles: “The Physiocratic Theory of Property and State,” Quarterly Journal of Economics,
vol. 75 (February 1961), pp. 96–111; and “The Physiocratic Theory of Economic Policy,”
Quarterly Journal of Economics, vol. 76 (February 1962), pp. 145–162.
The tableau as an analytical device has attracted the attention of several writers; see
Almarin Phillips, “The Tableau Economique as a Simple Leontief Model,” Quarterly
Journal of Economics, vol. 69 (February 1955), pp. 137–144; I. Hishiyama, “The Tableau
Économique of Quesnay,” Kyoto University Economic Review (April 1960), pp. 1–46; T.
Barna, “Quesnay’s Tableau in Modern Guise,” Economic Journal, vol. 85 (September
1975), pp. 485–496; and Lars Herlitz, “The Tableau Économique and the Doctrine of Ste-
rility,” Scandinavian Economic History Review, vol. 9 (1961), pp. 3–55; same author,
“From Spending and Reproduction to Circuit Flow and Equilibrium: The Two Concep-
tions of the Tableau Économique,” The European Journal of the History of Economic
Thought, vol. 3 (Spring 1996), pp. 1–20; and in same journal and issue, Walter Eltis, “The
Grand Tableau of François Quesnay’s Economics,” pp. 21–43.
J. J. Spengler offers some important insights as to how the physiocratic theory of con-
sumption may have contributed to one of the cornerstones of classical economic theory in
“The Physiocrats and Say’s Law of Markets.” Journal of Political Economy, vol. 53 (Sep-
tember 1945), pp. 193–211; and J. Johnson treads similar ground in “The Role of Spending
in Physiocratic Theory,” Quarterly Journal of Economics, vol. 80 (November 1966), pp.
612–632. A major reinterpretation of Quesnay and his system has been undertaken by W.
A. Eltis, in two parts, “François Quesnay: A Reinterpretation,” Oxford Economic Papers,
vol. 27 (July and November, 1975), pp. 167–200, 327–351. See also A. C. Muller, “Quesnay’s
Theory of Growth: A Comment,” Oxford Economic Papers, vol. 30 (March 1978), pp. 150–
156; and the further comment by Eltis immediately following Muller’s remarks.
In a series of papers spanning several years, Gianni Vaggi systematically explored
key aspects of physiocratic thought. See, for example, “The Physiocratic Theory of
Prices,” Contributions to Political Economy, vol. 2 (March 1983), pp. 1–22; “A Physio-
cratic Model of Relative Prices and Income Distribution,” Economic Journal, vol. 95
(December 1985), pp. 928–947; “The Role of Profits in Physiocratic Economics,” History
of Political Economy, vol. 17 (Fall 1985), pp. 367–384; and The Economics of François
Quesnay (London: Macmillan, 1987).
Quesnay’s Tableau Économique, Marguerite Kuczynski and Ronald L. Meek (eds.),
London: Macmillan, 1972), reveals the extraordinary story of the disappearance and
reappearance of successive editions of the Tableau. Joseph Schumpeter’s History of Eco-
nomic Analysis (New York: Oxford University Press, 1954), part II, chap. 4, deals with
Petty and Cantillon as well as with the Physiocrats. Jean Cartelier, “Productive Activities
and the Wealth of Nations: Some Reasons for Quesnay’s Failure and Smith’s Success,”
The European Journal of the History of Economic Thought, vol. 10 (Autumn 2003), pp.
409–427, highlights important differences between two writers whose production theo-
ries were very close to each other.
The writings of individual Physiocrats tend to be scattered and inaccessible. A nota-
ble exception concerns the most able of Quesnay’s followers, Turgot. Most of Turgot’s
economic writings have been collected and translated by R. L. Meek, Turgot on Progress,
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104 Part I ■ Preclassical Economics

Economics and Sociology (London: Cambridge University Press, 1973); and by P. D.

Groenewegen, The Economics of A. R. J. Turgot (The Hague: Martinus Nijhoff, 1977).
See also, same author, “A Reappraisal of Turgot’s Theory of Value, Exchange and Price
Determination,” History of Political Economy, vol. 2 (Spring 1970), pp. 177–196; and “A
Reinterpretation of Turgot’s Theory of Capital and Interest,” Economic Journal, vol. 81
(June 1971), pp. 327–340. For a broader sweep of Turgot’s ideas on progress and the
emergence of institutions, see Philippe Fontaine, “Social Progress and Economic Behav-
iour in Turgot,” Perspectives on the History of Economic Thought, vol. 7, S. T. Lowry, ed.
(Aldershot, UK: Edward Elgar, 1992); and same author, “Turgot’s ‘Institutional Individu-
alism,’” History of Political Economy, vol. 29 (Spring 1997), pp. 1–20. Anthony Brewer,
“Turgot, Founder of Classical Economics,” Economica, vol. 54 (November 1987), pp.
417–428, makes the case for Turgot as a classical economist rather than a Physiocrat.
For a summary of the economic writings of a Physiocrat who later expatriated to
America, see J. J. McLain, The Economic Writings of DuPont de Nemours (Newark: Uni-
versity of Delaware Press, 1977). José Luis Cardoso, “Economic Thought in Late-Eigh-
teenth Century Portugal: Physiocratic and Smithian Influence,” History of Political
Economy, vol. 22 (Fall 1990), pp. 429–441, establishes the reach of Physiocracy beyond
France. Finally, for a broad sweep of French economic thought (including Cantillon) in
the century prior to Adam Smith, see R. F. Hébert, “In Search of Economic Order: French
Predecessors of Adam Smith,” in S. Todd Lowry (ed.), Pre-Classical Economic Thought
(Boston: Kluwer, 1987), pp. 185–210.
Comparatively little work has been done on the important contributions of Spanish
Enlightenment economists in English. But see Louis Baeck, “Spanish Economic
Thought: The School of Salamanca and the Arbitristas,” History of Political Economy,
vol. 20 (Fall 1988), pp. 381–408. For those who read Spanish, see Pedro Rodriguez de
Campomanes, Discurso sobre el fomento de la industria popular (1774), Facsimile,
Oviedo (1979); Francisco de Cabarrús, “Cartas” (1808), in J. A. Maravall (ed.), Conde de
Cabarrús (1973). Authorship of the former is evaluated by D. R. Street, “The Authorship
of Campomanes’ Discurso sobre el fomento de la industria popular: A Note,” History of
Political Economy, vol. 18 (1986), pp. 655–660, and debated by Vicent Llombart, “The
Discurso sobre el modo de fomentar la industria popular and the Discurso sobre el
fomento de la industria popular, two editions of the same work by Campomanes: A Reply
to D. R. Street,” History of Political Economy, vol. 23 (1991), pp. 527–531, and Street’s
“Reply” (same issue), pp. 533–536. The Spanish Enlightenment and issues relating to
retarded Spanish economic growth and its causes is treated in R. Herr, The Eighteenth
Century Revolution in Spain (Princeton, NJ: Princeton University Press, 1958); and, by
the same author, Rural Change and Royal Finances in Spain (Berkeley: University of
California Press, 1989). An excellent overview is given by J. Vicens-Vives, An Economic
History of Spain (Princeton, NJ: Princeton University Press, 1969). The particular and
peculiar role of the Mesta guild of sheepherders in the Spanish economy is treated in J.
Klein, The Mesta: Study in Spanish Economic History 1273–1836 (Port Washington, NY:
Kennikat Press, 1964 [reprint of 1920 edition]), and R. B. Ekelund, Jr., D. R. Street, and
R. D. Tollison, “Rent Seeking and Property Rights Assignments as a Process: The Mesta
Cartel of Mercantile Spain,” The European Journal of Economic History vol. 26 (1997),
pp. 9–35. In addition to works already mentioned by D. R. Street, see “The Human Capi-
tal Movement in the Spanish Enlightenment,” Midsouth Journal of Economics and
Finance, vol. 13 (1989), pp. 43–50, and “Jovellanos, An Antecedent to Modern Human
Capital Theory,” History of Political Economy, vol. 20 (1988), pp. 191–206.
Two excellent books on Spanish Enlightenment economics are Vicent Llombart,
Compomanes, economista y politica de Carlos III (Madrid: Alionza Editorial, 1992); and
L. Perdices, Pablo de Olavide, El Ilustrado (Madrid: Editorial Complutense, 1992).
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Part II
THE CLASSICAL PERIOD

After 1776 the field of economics gathered steam, much like the Industrial Revolu-
tion that nurtured it. By giving organization to economics, Adam Smith focused the
world’s attention on the subject, and inspired a number of subsequent thinkers to
turn their talents to this new field. Nowhere was this direction of effort more fever-
ish than in England, where, in relatively rapid succession, David Ricardo, Robert
Malthus, and John Stuart Mill laid important bricks in the mounting edifice of eco-
nomic theory. So fertile was this age of economic analysis that the interval from
1776 to 1870 is now called the classical period.
Adam Smith was a key figure. His efforts to systematize economics and to con-
struct a theory of economic development are presented in chapter 5. His ideas had a
twofold effect: They discredited mercantilism as an economic creed and they set the
pattern of future inquiry. Although there is a unifying thread running through clas-
sical macroeconomics, especially the British variant, there were also dissenting
voices. Jeremy Bentham, a lawyer by training, developed a utilitarian creed that
rejected Smith’s theme of “natural harmony” and sought to promote an “artificial
harmony” of interests in its place. Bentham’s ideas are presented in chapter 6, and
his influence, traced through Mill and his contemporary, Edwin Chadwick, is
explored in Part III. Robert Malthus, whose population theory became an integral
component of mainstream classical economics, nevertheless remained a maverick
on several key points of macroeconomic theory, especially on the nature of aggre-
gate demand (where he foreshadowed John Maynard Keynes). Malthus and his
position on key issues are discussed in chapters 6 and 7. Departing slightly from
Smith, Ricardo (chapter 7) sought to refocus economics on the issue of income dis-
tribution—but he did so within the analytical framework and macroeconomic focus
established by Smith. Absorbing the intricacies of Ricardo’s economics from an
early age, Mill (chapter 8) attempted to synthesize and improve economic thought
from Smith to his day.

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Adam Smith
System Builder

That new dawn of capitalism that the Physiocrats so eagerly looked forward to had
not yet arrived in 1776—when many Europeans were focused on the New World
and the struggles of an emerging nation—but it was certainly on its way. And it was
helped along, intellectually, by the publication in that year of a book that is still read
and still published (not just by and for graduate students, incidentally): Adam
Smith’s Inquiry into the Nature and Causes of the Wealth of Nations. The promi-
nence of this book in the development of economics gave its author the consensual
title, “father of economics.”
Adam Smith was born in Kircaldy, Scotland, in 1723. He was the only son of a
father who died a few months before his birth and a mother who lived to the ripe
old age of ninety. From his youth, Smith exhibited traits that we often attribute to
“professorial” types. His biographers describe him as an apt pupil, although given to
“fits of abstraction,” which later in his academic life turned to fits of reverie that fre-
quently unsettled his colleagues (when they observed him smiling to himself at reli-
gious services, for example). In one of his early morning reveries, clad in his
nightgown, Smith walked fifteen miles before the church bells from a neighboring
village “awakened” him. Absentmindedness seems to have been a feature of his
character. On one occasion, engaged in a lively discourse while walking with a
friend, and unaware of his whereabouts, he fell into a tanning pit! On another he is
said to have absentmindedly dropped his bread and butter into boiling water.
Moments later when he drank the concoction he declared it the worst cup of tea he
had ever tasted.
A cameo portrait of Smith reveals an unhandsome visage marked by a protrud-
ing lower lip, a large nose, and bulging eyes. He was troubled all his life with a ner-
vous affliction; his head shook, and he had a speech impediment. Yet, none of these
flaws impaired his intellectual abilities, and his other charms endeared him to his
friends and students. He described himself as “a beau in nothing but my books.” To
be sure, he was well versed in a wide array of subjects: He lectured not only on eco-
nomics but also on broad philosophical issues and on literature. Students traveled
from Russia and the Continent to attend his lectures. He was thoroughly acquainted
with the writers of Greek and Roman antiquity as well as with the authors of his
own day, especially his teacher Frances Hutcheson, his friend David Hume, and the
eminent French philosopher, Montesquieu. During his travels in France he was
introduced to Quesnay and his band of followers.

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108 Part II ■ The Classical Period

Smith cemented his reputation as a philosopher on the basis of his important

work, The Theory of Moral Sentiments, first published in 1759. In this treatise Smith
attempted to identify the origins of moral judgments, or moral approval and disap-
proval. Smith represented man as a creature of self-interest who nevertheless is
capable of making moral judgments on the basis of considerations other than self-
ishness. This apparent paradox is resolved, Smith asserted, through the faculty of
sympathy. That is, moral judgments are typically made by holding self-interest in
abeyance and putting oneself in the position of a third-person, impartial observer. In
this way, one reaches a sympathetic notion of morality rather than a selfish one, and
morality actually transcends selfishness.
The Theory of Moral Sentiments and its problems attracted immediate interest
and fame for its author. But some scholars regard its basic tenet as inconsistent with
the importance Smith later placed on self-interest as a driving force in The Wealth of
Nations. Informed opinion tends to view The Wealth of Nations as a logical extension
of The Theory of Moral Sentiments, although that is not a unanimous judgment. Nine-
teenth-century German philosophers, who could not resolve the seeming contradic-
tion between self-interest and sympathy, referred to it as Das Adam Smith Problem.
Whether or not resolved to everyone’s satisfaction, it is noteworthy that the progres-
sion in Smith’s thought from an inquiry into justice (The Theory of Moral Sentiments)
to an investigation of political economy (The Wealth of Nations) is fully consistent
with the evolution of ideas exhibited by the Christian and Arabic Scholastics.

■ THE NATURE OF SMITH’S ECONOMIC SYSTEM

Adam Smith’s prominent place in the history of economics owes much to the
fact that he was a system builder. His system combined a theory of human nature
and a theory of history with a peculiar form of natural theology and some hard-
headed observations of economic life. In the narrow confines of the economic
sphere, his system featured agriculture, manufacturing, and commerce. Exchange
in this system is facilitated by the use of money, and production is characterized by
the division of labor. The three main features of his central analysis are the division
of labor, price and allocation, and the nature of economic growth.
Smith’s focus on economics as an issue of moral philosophy gave the subject
legitimacy and marked the beginning of what is called the classical period in eco-
nomic thought. This period extends roughly from the appearance of The Wealth of
Nations in 1776 to the death of John Stuart Mill in 1873. Although individual differ-
ences in ideas persisted among members of the classical school, commonly held
principles included belief in natural liberty (laissez-faire) and the importance of
economic growth as a means of bettering the condition of human existence.1 Phys-
iocracy, which is also based on these two premises, was rejected by Smith because it
was too narrowly focused on agriculture as the source of wealth.

Natural Law and Property Rights

Unlike Cantillon, Smith made no attempt to segregate politics from economics,
and as a result the subject that he pioneered in the eighteenth century came to be
known as “political economy.” The chief political and economic problems that Smith
sought to define and resolve were the relation of the individual to the state and the
1
Although he falls within the classical period, John Stuart Mill was somewhat of an exception on
both these points (see chap. 8).
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Chapter 5 ■ Adam Smith 109

proper functions of the state in relation to its members. Smith’s views on these mat-
ters were grounded in his system of natural theology, which he expounded at consid-
erable length in The Theory of Moral Sentiments and carried forward, with some
modifications, to The Wealth of Nations. That theology was none other than the
Greek-Scholastic doctrine of natural law, albeit infused with Scottish common sense.
We have seen that the Physiocrats extolled a natural order based on natural law
as opposed to positive law. For them, natural law reflected the mind of the creator,
as inferred by human reason. It existed on a higher plane than positive law, which
consisted of the mere proclamations of a legislative assembly. Because positive law
was inferior to natural law, the less of it the better. This is one intellectual justifica-
tion for laissez-faire. Both the Physiocrats and Adam Smith argued essentially in
this vein.
In an attempt to illuminate the nature of natural law Sir Alexander Gray has
pointed out that
natural law is easier to talk about than to codify. But we come pretty near the core
of things when we regard natural law as concerned with the personal property
each individual has in himself, and as a groping effort to emphasize that there is a
body of “Rights of Man” existing anterior to, and if need be against, the State. To
express it in terms nearer our subject, “Natural Law” implies a restriction of the
functions of government, in the interests of the liberty of the individual. (“Adam
Smith,” p. 155)

All through The Wealth of Nations and its predecessor, The Theory of Moral Senti-
ments, Smith explained how the divine government of the universe reacts on our
immediate economic and political problems. The famous metaphor he used to drive
home this point has come to known as the “invisible hand”:
Every individual necessarily labours to render the annual revenue of the society as
great as he can. He generally, indeed, neither intends to promote the public inter-
est, nor knows how much he is promoting it. By preferring the support of domestic
to that of foreign industry, he intends only his own security; and by directing that
industry in such a manner as its produce may be of the greatest value, he intends
only his own gain, and he is in this, as in many other cases, led by an invisible hand
to promote an end which was no part of his intention. Nor is it always the worse
for the society that it was no part of it. By pursuing his own interest he frequently
promotes that of the society more effectively than when he really intends to pro-
mote it. I have never known much good done by those who affected to trade for the
public good. It is an affectation, indeed, not very common among merchants, and
very few words need be employed in dissuading them from it. (The Wealth of
Nations, p. 423)

This was both revolutionary and counter-intuitive to the ordinary eighteenth-

century mind. If individuals are guided “naturally” by self-interest to promote the
greater good of society, then there is no need for the kind of central planning that
authoritative governments engage in. But Smith had already underscored the futil-
ity of central planning caused by the ineptness of bureaucrats and politicians in the
Theory of Moral Sentiments:
The man of system . . . is apt to be very wise in his own conceit; and is often so
enamored with the supposed beauty of his own ideal plan of government, that he
cannot suffer the smallest deviation from any part of it. He goes on to establish it
completely, and in all its parts, without any regard either to the great interests, or
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110 Part II ■ The Classical Period

to the strong prejudices which may oppose it. He seems to imagine that he can
arrange the different members of a great society with as much ease as the hand
arranges the different pieces upon a chess-board. He does not consider that the
pieces upon the chess-board have no other principle of motion besides that which
the hand impresses upon them; but that, in the great chess-board of human soci-
ety, every single piece has a principle of motion of its own, altogether different
from that which the legislature might choose to impress upon it. (pp. 380–381)

These passages underscore Smith’s conviction that a natural harmony exists in

the economic world that makes government interference in most matters both
unnecessary and undesirable. The invisible hand, the doctrine of natural liberty, and
the wisdom of God (seen even in the folly of men) are all part of the argument. But
there is more than mere metaphysics at work here. Smith also advanced the empiri-
cal argument that government is in fact incompetent, and he emphasized the brazen
impertinence of the bureaucrat who tells us what to do in areas where we clearly
know our own interests much better than anyone else ever can. (Paradoxically,
however, when Smith was presented the opportunity to become a regulator, he
accepted—see the box, The Force of Ideas: Adam Smith as Regulator.)

The Force of Ideas: Adam Smith as Regulator

In The Wealth of Nations Adam Smith repeatedly attacked mercantilism and the intricate
system of government regulations it spawned. It is therefore curious that two years after the
appearance of his economic magnum opus Smith accepted an appointment as commissioner
of Scottish Customs and the Salt Duties, a position he held until his death in 1790. In the eigh-
teenth century, customs commissioners had broad enforcement powers: They were basically
“import police,” even maintaining their own small navy. The commission prosecuted smug-
glers and authorized the seizure and burning of their vessels, the breaking up of illegal liquor
stills, and searches of private property. Chiefly, however, it functioned as a tax-collecting
agency of British mercantilism, providing a major source of revenue for the royal government.
In 1781, customs duties contributed almost one-fourth of total revenues collected in the
United Kingdom.
How did the apostle of free trade spend his time as a regulator? Did he use the opportunity
to reform customs administration, to deregulate a mercantilist agency, or did he behave as a
hard-nosed regulator? The evidence is that Smith took his job seriously; that he worked dili-
gently as a government regulator; and that he was more concerned with bureaucratic effi-
ciency than philosophical principle during his tenure on the customs commission.* He
expressed neither outrage nor boredom with his duties; nor did he seek to reform the agency
or undermine its functions.
One would expect that the mundane job of collecting customs duties and enforcing cus-
toms law would be less intellectually stimulating than teaching at university or writing major
philosophical tracts. Yet, Smith seemed to enjoy his role as an applied economist, even if it
seems incongruous with his reputation as the prophet of economic liberalism. Does this epi-
sode tell us anything about the compelling force of self-interest that Smith put at the base of
individual behavior?
When Smith took office as customs commissioner in 1788 he was fifty-five years old. His
academic reputation was secure. He may have felt that his academic career had peaked. The
job of customs commissioner paid £600 per year, a tidy sum in its day, but not much more
than Smith could realize from alternative sources. Chances are he embraced the job of civil
servant because (1) his family had a long history of employment as customs officials, and (2)
he found the work interesting and challenging. Was he any less an economist for working on
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Chapter 5 ■ Adam Smith 111

the side of the economic system he had railed against? Not unless one believes that the
power of ideas is less than the power of individual action. Personal actions notwithstanding,
published ideas are subject to large economies of scale. One clear and forceful idea in pub-
lished form can reach and influence a large number of people at a relatively small cost. More-
over, ideas take time to form in people’s minds and are influential only after a considerable lag.
It is therefore far more likely that Smith would influence history by his written words than by
his example in one small agency of a vast bureaucratic system. Adam Smith the deregulator—
if he had chosen to exercise such a role—could never have been as much a force for economic
liberalism as Adam Smith the teacher and author.
*See G. M. Anderson, W. F. Shughart, and R. D. Tollison, “Adam Smith in the Customhouse.”

Human Nature
Smith’s advocacy of natural liberty rested on, and was impelled by, human psy-
chology. He was a hardheaded realist who took people as he found them and based
his analysis of society on an unchanging human character. Smith attributed two
innate features to the human psyche. The first is that as humans we are interested
primarily in things nearest us, and much less so in things at a distance (in either
time or space); thus, we are all of considerable importance to ourselves:
Every man . . . is first and principally recommended to his own care; and every
man is certainly, in every respect fitter and abler to take care of himself than of any
other person. (Theory of Moral Sentiments, p. 359)

The second feature of human psychology, actually a corollary of the first, is the
overwhelming desire of all individuals to better their condition:
The desire of bettering our condition [is] a desire which, though generally calm
and dispassionate, comes with us from the womb, and never leaves us till we go to
the grave. In the whole interval which separates those two moments, there is
scarce perhaps a single instant in which any man is so perfectly and completely
satisfied with his situation, as to be without any wish of alteration or improvement
of any kind. (The Wealth of Nations, pp. 324–325)

It is easy to confound self-interest (or Smith’s preferred term “self-love”) with

unbridled selfishness, although Smith was careful to distinguish the two. A society
that allows selfishness to run amuck is one that degenerates into chaos. Smith’s
“economic” man in The Wealth of Nations is not unlike his “moral” man in The The-
ory of Moral Sentiments. Both are creatures of self-interest, but their baser instincts
are held in check by twin forces. In the moral sphere, sympathy is the faculty that
holds self-interest in check; whereas in the economic sphere, competition is the fac-
ulty that restrains self-interest. Competition is the invisible hand that we identified
earlier. In this way Smith was proposing a natural solution to “the Hobbesian
dilemma,” the belief expressed by Thomas Hobbes that a society without extensive
government controls would devolve into chaos, making human life “nasty, poor,
brutish and short.” The key to understanding Smith’s liberal philosophy is that an
effective regulatory force (i.e., competition) exists in the nature of markets, making
artificial (i.e., legislative) regulations unnecessary—and due to inherent govern-
mental inefficiency—undesirable.
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112 Part II ■ The Classical Period

Monopoly, however, is the antithesis of competition and provides an avenue by

which unbridled self-interest can destroy the economic welfare of society. Although
all sellers of goods and services would like to charge the highest possible prices for
their wares or skills, they generally cannot, unless they have some monopoly privi-
lege, and in Smith’s day, the source of monopoly privileges was (mercantilist) gov-
ernment. Some of Smith’s most memorable passages contain invectives against
monopoly privileges. (All of the excerpts from this point on are from Smith’s The
Wealth of Nations, unless otherwise noted.) In one place he wrote: “People of the
same trade seldom meet together, even for merriment and diversion, but the conver-
sation ends in a conspiracy against the public, or in some contrivance to raise
prices” (p. 128). Elsewhere, he said: “Monopoly . . . is a great enemy to good man-
agement, which can never be universally established but in the consequence of that
free and universal competition which forces everybody to have recourse to it for the
sake of self-defense” (p. 147).

A Theory of History: Self-Interest and Economic Growth

In Adam Smith’s view, the historical process of economic growth is driven by
the interaction of self-interest, property rights, and the division of labor. The inter-
play of these forces in the proper institutional framework contributed to the coming
of the “commercial age” and comprised the foundation of Smith’s macroeconomics.
To Smith the history of civilization was characterized by four evolutionary
stages. The first is characterized by hunting tribes; the second by pastoral pursuits;
the third by sedentary farming; and the fourth by commerce. Each stage entails a
different structure of property rights. A hunting culture does not recognize exclu-
sive rights to property. All members of society stand on a relatively equal footing,
both economically and socially, and there is little demand for a formal structure of
civil government because the population is small and mobile. Leadership in such a
culture is customarily provided by the old and the wise, whose direction is accepted
by the rest of society in deference to their experience and superior intellect.
Over time, however, self-interest stimulates important sociopolitical evolution
and economic growth. Civil society is a consequence of changing relations of pri-
vate property and wealth. Speaking of an early transition in civil society, for exam-
ple, Smith observed:
Among nations of hunters, as there is scarce any property, or at least none that
exceeds the value of two or three days labour; so there is seldom any established mag-
istrate or any regular administration of justice . . . civil government is not so necessary.
It is in the age of shepherds, in the second period of society, that the inequality
of fortune first begins to take place, and introduces among men a degree of author-
ity and subordination which could not possibly exist before. It thereby introduces
some degree of that civil government which is indispensably necessary for its own
preservation. . . . Civil government, so far as it is instituted for the security of prop-
erty, is in reality instituted for the defense of the rich against the poor, or of those
who have some property against those who have none at all. (p. 674)

In other words, in civil society a wealth hierarchy leads to a power hierarchy that
establishes the rules of hereditary transfers of power, administration of justice, and
so forth. In this way, security of property rights is assured and the stability that
comes with secure property rights encourages production of more wealth.
Eventually, nomadic cultures tend to be replaced by stationary, agricultural
communities. This settled life brings more stable food supplies, increased special-
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Chapter 5 ■ Adam Smith 113

ization, and larger population. In the Middle Ages, agricultural interests functioned
within an institutional structure known as feudalism. Civil government under feu-
dalism was greatly decentralized insofar as each of the manorial barons adminis-
tered justice in his local domain. In Europe, this system lasted from the fall of the
Roman Empire to about the end of the fifteenth century. Its structure is still approx-
imated in some third-world nations today.
Just as self-interest explains the transition from nomadic to agricultural societ-
ies, so it explained for Smith the development of commercial society with its conse-
quent growth of cities as trading centers. In the immediate period after the fall of
Rome, urban tradesmen and mechanics were given equal tax treatment with their
rural counterparts, the farmers. As city dwellers became more independent, how-
ever, merchants succeeded in getting a general exemption from certain “trading
taxes.” They therefore emerged as an early class of “free traders,” and indeed, as
the first capitalists. Townspeople, moreover, were usually allied with the monarch
against their common foe, the land barons. The king often granted concessions to
the cities in return for their allegiance against the feudal lords, and eventually fiscal
independence could be obtained by the cities in return for a lump-sum tax paid to
the king. These developments led to self-governance in the towns and the eventual
establishment of a rule of law, which in turn provided a firm base for the expansion
of trade, particularly in the coastal cities. Flourishing trade, in turn, made the cities
even more independent of the manors. Ultimately towns became the haven of fledg-
ling capitalists because city law protected runaway serfs, provided they had evaded
capture for one year. Smith recognized this as a step in the accumulation of capital
by the lower classes:
If in the hands of a poor cultivator, oppressed with the servitude of villeinage, some
little stock should be accumulated, he would naturally conceal it with great care
from his master, to whom it would otherwise have belonged, and take the first
opportunity of running away to a town. (p. 379)

Serfdom/villeinage/feudalism all describe the same thing: an institution in which

peasants worked the land and were tied to it but did not own it. Serfs owed a certain
amount of labor to the landlord, but once they accumulated small surpluses, they
found that they could “buy back” this obligation by paying money rents to the land-
lords in lieu of labor services. First the surpluses were exchanged for money at the
local grain markets; then the money was used to “commute” their labor obligation.
This often resulted in a situation in which the peasant became very nearly an inde-
pendent, small businessperson. He or she could rent from the lord, sell the produce
to cover his rent, and keep the difference. The cumulative effect of this behavior was
to erode the traditional ties of the manor and to substitute the market and the search
for profits as the organizing principle of production. By the middle of the fourteenth
century money rents exceeded the value of labor services in many parts of Europe.
The lords seemed willing to cooperate with the new institutional arrangements,
in part because as their consumption patterns changed they required increasing
amounts of cash to buy “trinkets” and luxuries from the town merchants. Before
long, the lord of the manor was a mere landlord in the modern sense; soon a “mar-
ket” in land emerged, based on an individual’s right to own property, and was sup-
ported by the law of contract. From this point it was a short step to specialization
and the division of labor—the hallmarks of the industrial age.
In sum, economic growth up to the appearance of the “commercial system” was
a consequence of the interaction of self-interest, the evolution of property rights,
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114 Part II ■ The Classical Period

and institutional change in the wider sense. By 1776, signs of the arrival of the com-
mercial system were evident. Having observed this, Smith declared economic
growth to depend in a critical way on the extension of specialization and division of
labor. After reviewing the microeconomic foundations of Smith’s growth theory we
shall return to the central role of these twin principles.
The Wealth of Nations is a formidable book, and it is doubtful if even many econ-
omists have read it cover to cover. But it is a task that every serious student of eco-
nomics should attempt (at least once). For the book contains much more than
Smith’s celebrated attack on mercantilism (monopolies) and his justification of natu-
ral liberty (laissez-faire), for which it is best known. Even by contemporary stan-
dards it is a marvelous work. And it was not a late-blooming classic, as were so many
other economic treatises. It was widely read and quoted during Smith’s lifetime.
A brief review of the contents of The Wealth of Nations reveals its breadth of
treatment. Book I discusses the division of labor, the origin and use of money, and
the determination of price, wages, profits, and rent, with a lively digression thrown
in on variations in the value of silver. Book II contains Smith’s oft-maligned theory of
capital and interest. In Book III the reader is treated to a lengthy review of the eco-
nomic development of Europe from ancient times to the eighteenth century. Book IV
discusses different systems of political economy, including a scathing criticism of
mercantilism and barriers to free trade. Book V concludes with a lengthy treatise on
taxation and fiscal policy in eighteenth-century Britain. The final pages offer Smith’s
assessment of Britain’s colonial policy and the wisdom of empire building.
In many ways the least-read parts of the book are the most delightful, as when
Smith digresses on the history of education in the Middle Ages or the method of
selecting bishops in the ancient Church. In fact, Smith’s discussions of education
and religion form points of departure for two related subfields of contemporary eco-
nomic inquiry: the economics of education and the economics of religion. By a sim-
ilar token, the field of public finance owes much to Smith’s ample treatment in
Book V. We cannot do justice to the full scope of Smith’s contribution to the devel-
opment of economics here; consequently we focus on the cornerstones of microeco-
nomic and macroeconomic analysis presented in Books I–III.

■ MICROECONOMIC FOUNDATIONS OF THE WEALTH OF NATIONS

For all its diverse coverage of numerous economic topics, the central theme of
The Wealth of Nations is economic development. Whereas the Physiocrats focused
on growth of net product, Smith emphasized growth in national wealth (by which he
meant, in today’s terminology, national income). In one important respect, Smith
succeeded where the Physiocrats did not. Smith established his macroeconomic the-
ory of economic development on microeconomics, most notably the theory of value.

The Theory of Value

The chapter on value in The Wealth of Nations is preceded by a discussion of the
advantages of division of labor and the use of money in advanced societies. Smith
argued that the division of labor arises from a propensity in human nature to
exchange, which requires that each trader have more goods than necessary to sat-
isfy immediate needs (i.e., exchange requires a tradable surplus). Money enters the
picture because it makes trade more flexible and convenient. Value then is deter-
mined by the rules that people naturally observe in exchanging goods for money or
for one another. Smith posed the problem of value in terms of the following paradox:
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Chapter 5 ■ Adam Smith 115

The word value . . . has two different meanings, and sometimes expresses the utility
of some particular object, and sometimes the power of purchasing other goods
which the possession of that object conveys. The one may be called “value in use”;
the other, “value in exchange.” The things which have the greatest value in use have
frequently little or no value in exchange; and on the contrary, those which have the
greatest value in exchange have frequently little or no value in use. Nothing is more
useful than water: but it will purchase scarce anything; scarce anything can be had
in exchange for it. A diamond, on the contrary, has scarce any value in use, but a
very great quantity of other goods may frequently be had in exchange for it. (p. 28)

Smith did not resolve this riddle; he merely focused on the issue of value-in-
exchange as central to his inquiry. So long as the significance of incremental valua-
tions was overlooked this riddle was never adequately solved. Eventually the para-
dox yielded when the distinction was made and widely understood between total
utility and marginal utility. Because water is plentiful, its value at the margin is low
(reflecting low-priority uses); whereas because diamonds are scarce, their value at
the margin is high (reflecting high-priority uses). Somehow this distinction (and its
consequences) never quite crystallized in the minds of most classical economists as
long as they remained preoccupied with the distinction between value-in-use and
value-in-exchange. Smith set out to explain only exchange value, or relative price,
and its changes over time.
Labor as a Measure of Value. Book I, chapters 5 to 7, of The Wealth of Nations
contains the core of Smith’s discussion of exchange value. It is a discussion that is
marred by his tendency to treat simultaneously both the measure of value (price)
and the cause of value. In chapter 5, for example, Smith writes that labor is the mea-
sure of value:
The value of any commodity . . . to the person who possesses it, and who means
not to use or consume it himself, but to exchange it for other commodities, is equal
to the quantity of labour which it enables him to purchase or command. Labour,
therefore, is the real measure of the exchangeable value of all commodities. (p. 30)

Smith seems to have acquired this idea, that what is bought with money (or with
goods) is purchased by labor, from his friend David Hume, although the same idea
was expressed earlier by Sir William Petty (see chapter 4). There are, however, cer-
tain practical and theoretical difficulties in a labor theory of value that Petty was
unable to surmount. Smith revealed his awareness of these problems:
It is often difficult to ascertain the proportion between two different quantities of
labour. The time spent in two different sorts of work will not always alone deter-
mine this proportion. The different degrees of hardship endured, and of ingenuity
exercised, must likewise be taken into account. There may be more labour in an
hour’s hard work than in two hours easy business; or in an hour’s application to a
trade which it cost ten years labour to learn, than in a month’s industry at an ordi-
nary and obvious employment. But it is not easy to find any accurate measure
either of hardship or ingenuity. In exchanging indeed the different productions of
different sorts of labour for one another, some allowance is commonly made for
both. It is adjusted, however, not by any accurate measure, but by the higgling and
bargaining of the market, according to that sort of rough equality which, though
not exact, is sufficient for carrying on the business of common life. (p. 31)

Prices. Money is, of course, the most common measure of value, but Smith
wanted to substitute labor in its place because he recognized that the value of
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116 Part II ■ The Classical Period

money itself changes over time. He observed that everything has a real and a nomi-
nal price—the former unaffected by changes in the purchasing power of money. On
this important distinction Smith wrote:
Labour, like commodities, may be said to have a real and nominal price. Its real
price may be said to consist in the quantity of the necessaries and conveniences of
life which are given for it; its nominal price, in the quantity of money. The labourer
is rich or poor, is ill or well rewarded, in proportion to the real, not the nominal,
price of his labor. (p. 33)

It turns out that labor is an adequate measure of price only in a primitive econ-
omy ruled by barter. In Chapter 6, Smith finally makes it clear that when one leaves
“that early and rude state of society which precedes both the accumulation of stock
and the appropriation of land,” labor alone cannot adequately explain market price.
Capitalist economies are marked by capital accumulation and individual property
rights in land and other resources. Thus, Smith asserts that in the more advanced
societies market value is resolved into three component parts:
Wages, profit, and rent are the three original sources of all revenue as well as of all
exchangeable value. All other revenue [interest income, taxes, etc.] is ultimately
derived from some one or other of these. (p. 52)

By this point in his exegesis, we can see that Smith is talking about the source of
value and not merely its measure. By including profit as one of the necessary com-
ponents of price, Smith demonstrated an understanding of the concept of opportu-
nity costs, an idea also grasped by Cantillon. He observed:
Though in common language what is called the prime cost of any commodity does
not comprehend the profit of the person who is to sell it again, yet if he sells it at a
price which does not allow him the ordinary rate of profit in his neighborhood, he
is evidently a loser by the trade; since by employing his stock in some other way he
might have made that profit. (p. 55)

Notice the natural development of ideas in these two chapters of The Wealth of
Nations. Many writers before Smith had a labor-cost theory of value, and many
writers after him attributed the same theory to Smith. But his explanation is really
something else. It is one thing to charge that the true measure of value, in real
terms, is labor time, and another to avow that the source of value is the necessary
costs of production for each commodity. In short, Smith felt that labor theories of
value were valid only for primitive societies where labor represents the main (if not
the only) factor of production.
Market Price versus Natural Price. Chapter 7 of Book I is filled with what
Mark Blaug called “the kind of ‘partial equilibrium analysis’ that has always been
the bread and butter of economists” (Economic Theory, p. 39). In it, Smith discusses
the natural and market price of commodities. Essentially, he set up a dichotomy
between actual (i.e., market) price and natural (i.e., equilibrium) price. The former
is determined by the interaction of supply and demand in the short run; the latter,
by long-run costs of production. He wrote:
The market price of every particular commodity is regulated by the proportion
between the quantity which is actually brought to market, and the demand of those
who are willing to pay the natural price of the commodity, or the whole value of the
rent, labour, and profit, which must be paid in order to bring it thither. Such people
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Chapter 5 ■ Adam Smith 117

may be called the effectual demanders, and their demand the effectual demand;
since it may be sufficient to effectuate the bringing of the commodity to market. It
is different from the absolute demand. A very poor man may be said in some sense
to have a demand for a coach and six; he might like to have it; but his demand is
not an effectual demand, as the commodity can never be brought to market in
order to satisfy it. (p. 56)

More than a century later, Alfred Marshall (see chapter 16) presented a graphi-
cally explicit explanation of price that clarified Smith’s distinction between natural
and market price. Marshall’s explanation is based on the now familiar concepts of
supply and demand schedules, concepts that proved remarkably difficult for earlier
writers to conceive and explain. It is not at all clear whether Smith thought of price
and quantity adjustments in terms of shifting schedules of demand and supply or
simply as movements along a given curve (or curves)—if, indeed, he thought of
adjustments in this way at all. But we can use Marshall’s analysis to interpret Smith
and clarify his meaning.
Thus, in figure 5-1 (on the following page) assume some price—say, p0—is
equivalent to Smith’s natural price. Furthermore, assume this price to be equal to
the sum of the “natural rates of wages, rent, and profit,” and to remain unchanged
over time. Smith’s concept of effectual demand suggests the existence of a down-
ward-sloping demand curve. The poor beggar who would like to have a coach and
six but cannot afford it would eventually purchase one, perhaps, if the price were
low enough. Others of varying degrees of wealth might find their demands becom-
ing “effective” at lower prices. Thus, in figure 5-1 assume the existence of demand
curve D0. Smith’s effectual demand (i.e., quantity demanded at the natural price) is
Q0. Barring changes in tastes, incomes, prices of other goods, numbers of demand-
ers and suppliers, and expectations about the future, p0 and Q0 would be the long-
run equilibrium price and output in the industry under investigation. Let us now
juxtapose Smith’s commentary and figure 5-1:
When the quantity of any commodity which is brought to market falls short of the
effectual demand [Q1], all those who are willing to pay the whole value of the rent,
wages, and profit which must be paid in order to bring it thither, cannot be sup-
plied with the quantity which they want [Q0]. Rather than want it altogether, some
of them will be willing to give more. A competition will immediately begin among
them, and the market price will rise more or less above the natural price [to p1, for
example], according as either the greatness of the deficiency or the wealth and
wanton luxury of the competitors, happen to animate more or less the eagerness of
the competition. Among competitors of equal wealth and luxury the same defi-
ciency will generally occasion more or less eager competition, according as the
acquisition of the commodity happens to be of more or less importance to them.
Hence the exorbitant price of the necessaries of life during the blockade of a town
or in a famine. (p. 56)

The last sentence above is a clear reference to the importance of demand elasticity in
the short run. Continuing in Smith’s language, consider the reverse market situation:
When the quantity brought to market exceeds the effectual demand [Q2], it cannot
be all sold to those who are willing to pay the whole value of the rent, wages, and
profit, which must be paid in order to bring it thither. Some part must be sold to
those who are willing to pay less, and the low price which they give for it must
reduce the price of the whole. The market price will sink more or less below the
natural price [to p2, for example], according as the greatness of the excess
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118 Part II ■ The Classical Period

increases more or less the competition of the sellers, or according as it happens to

be more or less important to them to get immediately rid of the commodity. The
same excess in the importation of perishable, will occasion a much greater compe-
tition in that of durable commodities. (p. 57)

The last sentence in the above passage is likewise a clear reference to the impor-
tance of supply elasticity in the short run.
Finally, Smith describes the conditions necessary to achieve balance in the mar-
ketplace:
When the quantity brought to market is just sufficient to supply the effectual
demand and no more, the market price naturally comes to be either exactly, or as
nearly as can be judged of, the same with the natural price [p0]. The whole quan-
tity on hand can be disposed of for this price, and cannot be disposed of for more.
The competition of the different dealers obliges them to accept of this price, but
does not oblige them to accept of less. (p. 57)

One can see in these

passages the fundamental
Market line of argument advanced
price
by the medieval Scholas-
tics (chapter 2). But Smith
improved the earlier expo-
p1
sition by explaining how
competitive forces work
as a natural mechanism to
p0 p‫׳‬0 (LRS) drive buyers and sellers
toward an equilibrium. He
recognized that the eco-
p2 nomic realities of emer-
gent capitalism made the
doctrine of just price su-
perfluous. In the “medi-
D0 eval” world markets were
stunted and most trade did
O Q1 Q0 Q2 Quantity not take place under com-
petitive conditions. Power
was concentrated in the
Figure 5-1 If Q1 represents the quantity brought to the hands of few sellers. By
market, then the market price will rise above the natural contrast, Smith’s “mod-
price, from p0 to p1. A similar adjustment would occur if Q2 ern” world was one in
were brought to market. which atomistic competi-
tion flourished, and eco-
nomic power was thereby
diffused. This diffusion of power, Smith argued, provided an automatic check to the
individual abuse of power, which was a matter of great concern to the Scholastics.
Smith’s theory of natural price fulfilled the conditions for economic justice set forth
by the Church doctors, but it did so not by appealing to moral codes but rather the
natural forces of the competitive marketplace.
There is reason to believe, however, that Smith was not entirely comfortable
with the abstract notions of price and equilibrium. Recall that in Scholastic econom-
ics (chapter 2) there were two competing “theories” vying for dominance: the sup-
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Chapter 5 ■ Adam Smith 119

ply side and the demand side. Each made its own claim to preeminence. The supply
side argument maintained that since market price must cover costs of production
over the long haul, value must be a function of the resources used in production.
The demand side makes its own claim to being a determinant of value because peo-
ple are willing to pay for something in proportion to the intensity of their desire.
Smith noted that value can be influenced by utility (demand), but for reasons
unknown he did not advance this side of the analysis. His contribution to demand
theory is pretty much limited to a distinction between absolute demand (aggregate
desire) and effectual demand (desire + purchasing power). Effectual demand is the
demand of buyers who are willing to pay the “natural price,” which is the price suf-
ficient to cover production costs. Smith evidently felt that the “cost theory” of value
needed further analysis, and he seemed to want to choose labor as the common
denominator underlying the supply-side elements of value. He appeared, moreover,
to be groping for an absolute and universal measure of value, but it was beyond his
grasp. Smith’s attempt to resolve the two sets of claims, supply and demand, led to
the description of equilibrium outlined above.
There are two points that need to be emphasized regarding Smith’s value theory.
The first is that Smith represented the natural price as an equilibrium value (i.e.,
“the central price to which the prices of all commodities are continually gravitating”)
and as an invariant quantum over the long run. In modern parlance, he envisioned
the long-run supply curve as horizontal (represented by the dashed line, p0 p0 in fig-
ure 5-1). Since this type of long-run supply curve exists only in industries character-
ized by constant (unit) costs of production, Smith’s theory of value fits only a special
case. Today economists recognize that many industries produce under conditions of
increasing costs, and a few actually produce under conditions of decreasing costs.
The second point is that Smith was aware of the abstract nature of his model.
He explained how real markets often deviate from the ideal:
Though the market price of every particular commodity is in this manner continu-
ally gravitating, if one may say so, towards the natural price, yet sometimes partic-
ular accidents, sometimes natural causes, and sometimes particular regulations of
police, may, in many commodities keep up the market price, for a long time
together, a good deal above the natural price. (p. 59)

Smith’s terminology needs to be appreciated for what it is. By “accidents” he meant

events that cause information to be withheld from either sellers or buyers, such as
trade secrets or clandestine production techniques. Examples of “natural causes”
that push prices above the “natural” level include limited acreage of certain peculiar
soils. Wine lovers know, for example, that all the land fit for producing Mouton-
Rothschild clarets cannot supply the effectual demand, so that the price of this wine
is many times its cost of production. Adam Smith felt that little could be done about
the capriciousness of nature, and that trade and manufacturing secrets could not be
kept for very long. But government intervention (i.e., “particular regulations of
police”) could keep actual prices above natural prices permanently. The British
economy in Smith’s day, rife with the institutional remnants of mercantilism,
imposed restrictive practices that prevented many markets from reaching equilib-
rium, thereby limiting the volume of trade, internal and external, hindering the divi-
sion of labor, and retarding economic development.
In a mercantilist economy, government is the source of monopoly privileges.
Smith was quick to point out the parallel between government grants of monopoly
privileges and trade secrets:
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120 Part II ■ The Classical Period

A monopoly granted either to an individual or to a trading company has the same

effect as a secret in trade or manufacturers. The monopolists, by keeping the mar-
ket constantly understocked, by never fully supplying the effectual demand, sell
their commodities much above the natural price, and raise their emoluments,
whether they consist in wages or profits, greatly above the natural rate. (p. 61)

In the final analysis, Smith’s model of market equilibrium was based on cause
and effect, but he was careful to explain its abstract nature. Economic reality is dif-
ferent from theory because it entails conditions that slow or prevent smooth and
certain adjustments to long-run equilibrium. On this score, it is instructive to com-
pare Smith to the Physiocrats (see chapter 4), who viewed the Tableau économique
as a rigid form of cause and effect. In their model, a given change in the primary
income flows among the three socioeconomic classes of society created exact and
continuing changes in national income. Despite his admiration for these “French
men of system,” Smith felt that the Physiocrats became unwitting captives of their
own abstractions. Ever the Scottish realist, Smith regarded economic life as neither
simple nor precise.
We must not overlook the fact that Smith had an enlightened view of the inter-
dependence between product markets and factor markets, and that this interdepen-
dence is basic to his concept of long-run price adjustments. He noted, for instance,
that if at any time the quantity of a good supplied exceeded the effectual demand:
Some of the component parts of its price must be paid below their natural rate. If it
is rent, the interest of the landlords will immediately prompt them to withdraw a
part of their land; and if it is wages or profit, the interest of the labourers in the one
case, and of their employers in the other, will prompt them to withdraw a part of
their labour or stock from their employment. The quantity brought to market will
soon be no more than sufficient to supply the effectual demand. All the different
parts of its price will rise to their natural rate, and the whole price to its natural
price. (p. 57)

In other words, according to Smith, product prices cannot be in long-run equilib-

rium unless factor prices are also in long-run equilibrium. The operation of all inter-
dependent markets achieving simultaneous equilibrium constitutes what we now
call general-equilibrium analysis, the formal mathematics of which were developed
in the following century by the French economist Léon Walras (see chapter 17).
Smith’s concept of natural value was an important clarification of advances
made by earlier writers, but nevertheless it remains tautological. The theory of nat-
ural value explains price in terms of cost of production. But costs are themselves
prices. They are payments made to purchase (or hire) the various factors of produc-
tion. In essence, then, the theory of natural value explains prices by prices. A com-
plete theory of value cannot stop here but must also explain the cause and
determination of the payments to each factor of production.

Factors and Their Shares

Actually, Smith did not develop a satisfactory theory of the determination of
wages, profit, and rent, but he did offer numerous important insights and contribu-
tions that were later expanded by his followers. It can be said that Smith offered as
many as three explanations of wages, three explanations of rent, and perhaps two
explanations of profit. In the discussion that follows we don’t emphasize the analyt-
ical elegance of Smith’s ideas so much as the wide range of penetrating insights
that he entertained on the subject of income distribution.
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Chapter 5 ■ Adam Smith 121

Wages. Smith begins his discussion of wages as he did his discussion of value,
by harking back to “that original state of things which precedes both the appropria-
tion of land and the accumulation of stock.” In a primitive society, wages are deter-
mined by productivity: “In that original state of things . . . the whole produce of
labour belongs to the labourer. He has neither landlord nor master to share with
him” (p. 64). But things change as institutions change. As soon as land becomes pri-
vate property, the landlord demands his or her share of the annual produce, and as
soon as capital accumulation occurs, the capitalist does likewise. Thus, the landlord
and the capitalist share in the produce of labor, and Smith says that once this hap-
pens it becomes purposeless to trace further the possible effects of increased labor
productivity on wages. Unfortunately this view retarded subsequent developments
in the theory of income distribution, but nevertheless, it set the stage for Smith’s
development of the classical wages-fund concept, which played a prominent part in
the refinement of Smith’s theories by Ricardo, Malthus, and others. Smith’s more
refined theory of wages, such as it was, is contained in the wages-fund doctrine.
From an analytical standpoint the difficulty that confronts us so many years
later is that the wages-fund was, simultaneously, a theory of wages and a theory of
capital. The predominant view of wage payments throughout most of the eighteenth
and nineteenth centuries can be summarized as follows: Accumulated capital makes
it possible to employ labor and thus constitutes a fund for the maintenance of a
working population. This fund consists of advances to workers for which the owner
of the fund (i.e., the capitalist) expects, and is entitled to, a return. Although the
notion of the wages-fund was not original with Smith, he gave the idea popular form:
It seldom happens that the person who tills the ground has wherewithal to main-
tain himself till he reaps the harvest. His maintenance is generally advanced to him
from the stock of a master, the farmer who employs him, and who would have no
interest to employ him, unless he was to share in the produce of his labour, or
unless his stock was to be replaced to him with a profit. (p. 65)

In this idea of a wages-fund, Smith brings together the essential ingredients of the
economic growth process. The existence of a wages-fund is, simultaneously, a ratio-
nale for saving (i.e., accumulation), an explanation of wages and profit, and a deter-
minant of population growth. The doctrine maintains that workers are dependent on
capitalists to provide them with tools to work with and with food, clothing, and shelter
(i.e., “wage goods of subsistence”) in order to survive. The only way to increase the
stock of wage goods is to induce capitalists to save, and the only way to do that is to
increase profits, which, in Smith’s view, constitutes the sole source of saving. In other
words, savings must find an outlet in the production process—if used to hire more
workers, the wages-fund grows, and so do the (average) payments to workers. Work-
ers therefore spend more on wage goods, aggregate demand increases, and more is
produced in the next period of production. In this system it is important to note that
money is viewed as a medium of exchange only, not as a store of value. Hoarding
appears irrational (i.e., costly), and therefore all savings are invested. That is, saving
goes into the wages-fund. A particular variant of this view later came to be known as
“Say’s law,” after the French economist and disciple of Smith, Jean-Baptiste Say.
In effect, the wages-fund represents capital earmarked for the hire of labor. In
another place, however, Smith underscores the contractual nature of wages. Thus,
he argues:
What are the common wages of labour depends every where upon the contract
usually made between those two parties, whose interests are by no means the
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122 Part II ■ The Classical Period

same. The workmen desire to get as much, the masters to give as little as possible.
The former are disposed to combine in order to raise, the latter in order to lower
the wages of labour. (p. 66)

Thus, an individual wage, or wage level, is the result of a bargaining process. There
is clearly a lower limit to wages, Smith continues, or to the combined activity of
employers, since
a man must always live by his work, and his wages must at least be sufficient to
maintain him. They must even upon most occasions be somewhat more; otherwise
it would be impossible for him to bring up a family, and the race of such workmen
could not last beyond the first generation. (pp. 67–68)

As the wages-fund grows, then, it can support a larger population, so that as

average wages rise sufficiently above subsistence, workers will propagate more
and increase in number. Population growth cannot continue unrestrained, how-
ever, because larger populations place increasing burdens on the wages-fund.
Thus, the long-run tendency may be toward subsistence levels of average wage
rates. This constitutes yet a third theory, in which the long-run average wage is
determined by subsistence.
Which one of these explanations represents Smith’s theory of wages? The
wages-fund, the contract theory, and the subsistence theory are not inconsistent
with each other, and indeed, they may be collapsed into one. The size of the wages-
fund explains the size of total wage payments, whereas individual or average wage
rates are explained by supply-and-demand conditions. In the long run, Smith views
wage rates as determined by costs of workers’ maintenance and reproduction. The
natural wage is a subsistence one, but “subsistence” simply means the minimum
payment that workers insist on before they are willing to have children. In other
words, labor, too, is produced at constant costs, so that the long-run supply curve of
labor is horizontal at whatever wage is consistent with Smith’s notion of subsis-
tence. In the short run, however, wage rates may be above or below the long-run
equilibrium wage, since short-run supply and demand may be affected by contrac-
tual arrangements, accidents of nature, legislation, and so on. On close examina-
tion, therefore, Smith subjects the price of labor to the same forces that determine
the value of any good or service.
Whereas the distinction between short run and long run is a useful one in eco-
nomic analysis, Smith’s explanation allows that even in the long run, the trend in
wages may be upward, since an increased demand for labor causes higher average
wages and induces an increase in population, but with a sufficient time lag in the
latter. In other words, in a growing economy, increases in labor supply may continu-
ally lag behind increases in labor demand. The practical limits to this process are
something that concerned writers who succeeded Smith.
Aside from the question of the aggregate level of wages, Smith extended the
discussion of “equilibrium wage differences,” by which is meant the wage premi-
ums occasioned by certain conditions of employment. Whereas the aggregate level
of wages is an important macroeconomic variable, the notion of equilibrium wage
differences is an important microeconomic consideration. Cantillon (chapter 4) was
the first writer to broach this subject in a systematic way. Workers similarly trained
and similarly situated in every other respect will nevertheless earn more or less
according to the degree of time and expense in acquiring skills, the degree of risk
and danger in employment, and the extent of trust required of employees. Cantillon
opened this discussion with characteristic brevity:
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Chapter 5 ■ Adam Smith 123

The crafts which require the most time in training or most ingenuity and industry
must necessarily be the best paid. A skilful cabinet-maker must receive a higher
price for his work than an ordinary carpenter, and a good clock and watchmaker
more than a blacksmith.
The arts and occupations, which are accompanied by risks and dangers, like
those of foundry workers, sailors, silver miners, etc. ought to be paid in proportion
to the risks. When skill is needed, over and above the dangers, they ought to be
paid even more, such as ship pilots, divers, engineers, etc. When capacity and
trustworthiness are needed the labor is paid still more highly, as in the case of jew-
elers, bookkeepers, cashiers and others. (Essay, p. 45)

In The Wealth of Nations (Book I, chap. 10, part 1), Smith elaborated these issues
and broadened the discussion of “the inequalities of wages and profits arising from
the nature of the employments themselves.” A short summary of his main points fol-
lows. According to Smith:
1. Wages vary in inverse proportion to the agreeableness of the employment. (“The
most detestable of all employments, that of public executioner, is, in proportion
to the quantity of work done, better paid than any common trade whatever.”)
2. Wages vary in direct proportion to the cost of learning the business. (“Education
in the ingenious arts and in the liberal professions, is . . . tedious and expensive.
The pecuniary recompence, therefore . . . , of lawyers and physicians ought to be
much more liberal: and it is so accordingly.”)
3. Wages vary in inverse proportion to the constancy of employment. (“No species of
skilled labor . . . seems more easy to learn than that of masons and bricklayers. . . .
The high wages of those workmen, therefore, are not so much the recompence of
their skill, as the compensation for the inconstancy of their employment.”)
4. Wages vary in direct proportion to the trust that must be placed in the employee.
(“The wages of goldsmiths and jewelers are everywhere superior to those of
many other workmen, not only of equal, but of much superior ingenuity; on
account of the precious metals with which they are intrusted.”)
5. Wages vary in inverse proportion to the probability of success. (“The counselor at
law who, perhaps at near forty years of age, begins to make something by his
profession, ought to receive the retribution, not only of his own so tedious and
expensive education, but of that of more than twenty others who are never likely
to make any thing by it.”)
Profit and Interest. Smith declared that of the five factors affecting equilib-
rium wage differences only the first and the last affect equilibrium profit differ-
ences—namely “the agreeableness or disagreeableness of the business and the risk
or security with which it is attended.” Smith treated profit as a return to capital
rather than a return to entrepreneurship, so his theory of profits is lacking by con-
temporary standards. In fact, it is overgenerous to attribute a theory of profit at all
to Smith. Nevertheless, he offered useful insights into the profit-making process.
The chief characteristic of profits, according to Smith, is their uncertainty:
Profit is so very fluctuating that the person who carries on a particular trade can-
not always tell you himself what is the average of his annual profit. It is affected,
not only by every variation of price in the commodities which he deals in, but by
the good or bad fortune both of his rivals and of his customers, and by a thousand
other accidents to which goods when carried either by sea or land, or even when
stored in a warehouse, are liable. It varies, therefore, not only from year to year,
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124 Part II ■ The Classical Period

but from day to day, and almost from hour to hour. To ascertain what is the average
profit of all the different trades carried on in a great kingdom, must be much more
difficult; and to judge of what it may have been formerly, or in remote periods of
time, with any degree of precision, must be altogether impossible. (p. 87)

What Smith suggested, therefore, is that whereas aggregate profits are not easily
measured, interest may be viewed as a proxy for profit. He defined profit as “reve-
nue derived from stock [i.e., capital] by the person who manages or employs it.” He
defined interest as revenue derived from stock “by the person who does not employ
it himself, but lends it to another.” Smith’s conception of profit therefore emerges as
the sum of two payments: (1) a return on capital advanced, and (2) a compensation
for bearing risk. Interest alone cannot explain all profit, although it is a good indica-
tion of profit. Pushing this idea further, Smith wrote:
According . . . as the usual market rate of interest varies in any country, we may be
assured that the ordinary profits of stock must vary with it, must sink as it sinks,
and rise as it rises. The progress of interest, therefore, may lead us to form some
notion of the progress of profit. (p. 88)

Alert to the idea of opportunity costs, Smith added certain obiter dicta to the con-
cepts of profit and interest. “The lowest ordinary rate of profit,” he charged, “must
always be something more than what is sufficient to compensate the occasional
losses to which every employment of stock is exposed. It is the surplus only which is
neat or clear profit.” By the same token, Smith declared that: “The lowest ordinary
rate of interest must . . . be something more than sufficient to compensate the occa-
sional losses to which lending, even with tolerable prudence, is exposed. Were it not
more, charity or friendship could be the only motives for lending” (p. 96). He also
made it clear what effect competition would likely have on profits:
The increase of stock, which raises wages, tends to lower profit. When the stocks
of many rich merchants are turned into the same trade, their mutual competition
naturally tends to lower its profit; and when there is an increase in stock in all the
different trades carried on in the same society, the competition must produce the
same effect in all. (p. 87)

It is generally accepted that Smith viewed profit as a residual, or surplus, perhaps

because this was the view taken by Smith’s leading British disciple, David Ricardo
(see Chapter 7). However, the following excerpt from Smith’s chapter on profit
challenges this conventional wisdom:
In reality high profits tend much more to raise the price of work than high
wages. . . . Our merchants and master manufacturers complain much of the bad
effects of high wages in raising the price, and thereby lessening the sale of their
goods both at home and abroad. They say nothing concerning the bad effects of
high profits. (pp. 97–98)

If, indeed, profit is a residual, it seems unlikely that it could be price determining, as
the above passage suggests. But we shall leave it up to the reader to determine what
Smith really meant on the matter of profit, a subject to which we shall return when
we examine Smith’s blueprint for macroeconomic growth.
Rent. Smith’s discussion of rent hinges on three factors: (1) monopoly ele-
ments, (2) the residual surplus idea, and (3) alternative costs. Smith defined rent
simply as “the price paid for the use of land,” but he was emphatic that land rent “is
naturally a monopoly price. It is not at all proportioned to what the landlord may
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Chapter 5 ■ Adam Smith 125

have laid out upon the improvement of land, or to what he can afford to take; but to
what the farmer can afford to give” (p. 145). Rent, like wages, is usually determined
by contractual arrangement between landlord and tenant, but Smith clearly thought
the bargain was uneven. He considered rent a monopoly return in part because the
landlord had the upper hand:
In adjusting the terms of the lease, the landlord endeavors to leave him [the ten-
ant] no greater share of the produce than what is sufficient to keep up the stock
from which he furnishes the seed, pays the labour, and purchases and maintains
the cattle and other instruments of husbandry, together with the ordinary profits of
farming stock in the neighborhood. This is evidently the smallest share with which
the tenant can content himself without being a loser, and the landlord seldom
means to leave him any more. (p. 144)

Other monopoly elements involved in the determination of rent include fertility and
location. Thus, land fitted for a particular product may have a monopoly, such as the
great wine-producing regions of the French Côte d’Or or the Champagne districts.
In this case, Smith noted that the quantity of land devoted to wine production was
too small to satisfy the effectual demand, so that the market price of French wines
was higher than their natural price. He maintained that “the surplus of this price in
this case, and in this case only, bears no regular proportion to the like surplus in
corn or pasture, but may exceed it in almost any degree; and the greater part of this
excess naturally goes to the rent of the landlord” (p. 155).
Smith also described rent as a residual payment. It is the part of annual produce
remaining after all other costs of production, including ordinary profit, are realized.
As such, rent is price determined rather than price determining. In Smith’s own
words, rent “enters into the composition of the price of commodities in a different
way from wages and profit. High or low wages and profit are the causes of high or
low price; high or low rent is the effect of it” (pp. 145–146).
Finally, Smith maintained that differential rents can be explained on the basis
of alternative costs.
In Europe corn2 is the principal produce of land which serves immediately for
human food. Except in particular situations, therefore, the rent of corn land regu-
lates in Europe that of all other cultivated land. If in any country the common and
favourite vegetable food of the people should be drawn from a plant of which the
most common land, with the same or nearly the same culture, produced a much
greater quantity than the most fertile does of corn, the rent of the landlord . . .
would necessarily be much greater. (p. 159)

In other words, the rent of land in a particular use will depend greatly on the pro-
ductivity of land in its next-best alternative use.

The Critical Role of the Entrepreneur

Some find it curious that Smith’s theory of economic development allows a meager
role to the entrepreneur. In this regard Smith’s economics stands in stark contrast
to Cantillon, who assigned the entrepreneur a pivotal role in the operation of a mar-
ket economy. Perhaps the difference is explained in part by their backgrounds and
objectives. Cantillon was a banker/businessman, who seemed more intent on writ-
ing a manual for businessmen/financiers. Smith was a philosopher/academic, who
2
The term “corn” was at this time often used in the generic sense to mean virtually all edible grains,
such as wheat, barley, oats, etc.
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126 Part II ■ The Classical Period

seemed more intent on writing a manual for statesmen/policy makers. Cantillon

tried to exclude overt political considerations from his analysis, declaring them “no
part of my subject.” Smith may be fairly said to have integrated economics into pol-
itics to give birth to the subject henceforth known as “political economy.”
Although Smith did not emphasize the role of the entrepreneur in The Wealth of
Nations, he discussed entrepreneur-types earlier in The Theory of Moral Sentiments
(1759). In Wealth, the entrepreneur is encountered in three different forms: the
adventurer, the projector, and the undertaker. Smith speaks disparagingly of the
first two and with unqualified approbation only of the undertaker, who he identified
with “the prudent man”—a concept developed at length in Moral Sentiments.
According to Smith, adventurers are those who hazard their capital on the most
difficult of enterprises, spurred on by unbounded confidence in their success,
despite extraordinary risks. Smith attributed a measure of irrationality to this kind
of behavior because although “the ordinary rate of profit always rises more or less
with the risk, it does not . . . seem to rise in proportion to it, or so as to compensate
it completely” (Wealth, p. 111). Adventurers, therefore, are not stable agents in a
theory of economic development, because although a “bold adventurer may some-
times acquire a considerable fortune by two or three successful speculations,” he “is
just as likely to lose one by two or three unsuccessful ones” (Wealth, p. 114).
In Smith’s day, the term “projectors” had a dual connotation. One type is cun-
ning, lawless, scheming, and cheating; the other possesses ingenuity and integrity
and engages in honest invention. Owing, perhaps, to the inconsiderable number of
honest projectors, Smith was critical of the first class of projectors who devise
“expensive and uncertain projects . . . which bring bankruptcy upon the greater part
of the people who engage in them,” like the “search after new silver and gold mines”
(Wealth, p. 529). These projectors are injurious to society, Smith said, because
“every injudicious and unsuccessful project in agriculture, mines, fisheries, trade, or
manufactures, tends . . . to diminish the funds destined for the maintenance of pro-
ductive labor” (Wealth, p. 324). Smith allowed, however, that some projectors are
prudent businesspeople. Of the “prudent man” Smith said that “if he enters into any
new projects or enterprises, they are likely to be well concerted and well prepared.
He can never be hurried or drove into them by any necessity, but has always time
and leisure to deliberate soberly and coolly concerning what are likely to be their
consequences” (Moral Sentiments, p. 352). The prudent man, according to Smith, is
frugal: He accumulates capital and is an agent of slow but steady progress.
By treating the entrepreneur as menace on the one hand and benefactor on the
other, Smith left the concept of entrepreneurship muddled, for which he was
derided by later scholars. Joseph Spengler characterized Smith’s entrepreneur as
essentially passive: “a prudent, cautious, not overly imaginative fellow, who adjusts
to circumstances rather than brings about their modification” (“Adam Smith’s The-
ory,” pp. 8–9). Joseph Schumpeter, a leading analyst of the role of the entrepreneur
in economic development (see chapter 23), was unsympathetic to Smith in many
ways, not least of which was his treatment of the entrepreneur. According to Schum-
peter, if pressed, Smith would have affirmed that no business runs by itself, yet
this is exactly the over-all impression his readers get. The merchant or master
accumulates “capital”—this is really his essential function—and with this “capital”
he hires “industrious people,” that is, workmen, who do the rest. In doing so he
exposes these means of production to risk of loss; but beyond this, all he does is to
supervise his concern in order to make sure that the profits find their way to his
pocket. (History, p. 555)
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Chapter 5 ■ Adam Smith 127

Enzo Pesciarelli admits that Smith’s works have to be mined carefully to find
the few useful gems that comprise his contribution to the subject of entrepreneur-
ship. Collecting the various hints sprinkled throughout the Wealth of Nations, and
supplementing them with Smith’s “prudent man” concept developed in The Theory
of Moral Sentiments, Pesciarelli offers the following composite picture of Smith’s
entrepreneur (“Smith, Bentham, and Development,” pp. 527–528):
• Smith’s undertaker faces risk and uncertainty.
• Smith’s undertaker formulates plans and projects in an effort to earn profit.
• Smith’s undertaker seeks out the necessary capital for implementation of his
planned undertaking.
• Smith’s undertaker combines and organizes the productive factors.
• Smith’s undertaker inspects and directs production.
What is missing from Pesciarelli’s list of elemental characteristics is any explicit
connection between entrepreneur and innovation. We know that Smith was very
sensitive to the effects of innovation in a capitalist society. In fact, he was one of the
first economic writers to recognize innovation as a professional activity. In a remark
on inventions made by workmen, Smith noted that many improvements in manu-
facturing are made by workmen, but that a more learned class of men—“who are
called philosophers or men of speculation”—also play a key role. Those who belong
to this learned class, “whose trade it is not to do anything, but to observe everything
. . . upon that account, are often capable of combining together the powers of the
most distant and dissimilar objects.” (Wealth, p. 10). Thomas Edison might easily fit
into this group of “philosopher-inventors.” This was a potentially fruitful line of
inquiry, which, unfortunately, Smith did not develop to any measurable extent.
The eighteenth-century inventor (i.e., Smith’s “philosopher” or “speculator”)
was an amateur by contemporary standards; yet, Smith’s view of innovation as pro-
fessional activity was ahead of its time. He held that innovation is the product of the
division of labor, which in turn depends on the extent of the market. Innovation
therefore appears first in markets that are enlarged by cheap transportation. Opu-
lence and progress thereafter accompany the division of labor, and with this prog-
ress the innovator or inventor “becomes more expert in his own peculiar branch,
more work is done upon the whole, and the quantity of science is considerably
increased by it” (Wealth, p. 10).

■ SMITH’S MACROECONOMICS:
BLUEPRINT FOR ECONOMIC DEVELOPMENT
Book I of The Wealth of Nations, devoted primarily to the microeconomic foun-
dations of value and distribution, is a prelude to Smith’s main objective: the nature
and causes of economic development. His theory of economic development has to
be pieced together because all of its essentials cannot be found in any one place in
The Wealth of Nations. The starting point for all of Smith’s macroeconomics is the
division of labor. Joseph Schumpeter said that for Adam Smith the division of labor
“is practically the only factor in economic progress” (History, p. 187).

Division of Labor
Despite some exaggeration Schumpeter’s statement is very close to the mark.
Smith’s discussion of the division of labor in Book I provides an exceptionally lucid
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128 Part II ■ The Classical Period

analysis of the gains from specialization and exchange—principles on which he

based the theory of markets. In an oft-quoted passage, Smith described the gains
from specialization and division of labor in a pin factory:
A workman not educated to . . . the trade of the pin-maker . . . nor acquainted with
the use of the machinery employed in it . . . could scarce, perhaps, with his utmost
industry, make one pin in a day, and certainly could not make twenty. But in the
way in which this business is now carried on, not only the whole work is a peculiar
trade, but it is divided into a number of branches, of which the greater part are like-
wise peculiar trades. One man draws out the wire, another straights it, a third cuts
it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the
head requires two or three distinct operations; to put it on, is a peculiar business, to
whiten the pins is another; it is even a trade by itself to put them into the paper;
and the important business of making a pin is, in this manner, divided into about
eighteen distinct operations, which, in some manufactories, are all performed by
distinct hands, though in others the same man will sometimes perform two or three
of them. I have seen a small manufactory of this kind where ten men only were
employed, and where . . . each person . . . [averaged] four thousand eight hundred
pins in a day. But if they had all wrought separately and independently, and without
any of them having been educated to this peculiar business, they certainly could
not each of them make twenty, perhaps not one pin in a day. (p. 5)

From his discussion Smith concluded that there are three advantages of division of
labor, each leading to greater economic wealth: (1) an increase in skill and dexterity
of every worker, (2) the saving of time, and (3) the invention of machinery. Inven-
tion is a consequence of the narrow focus of a worker’s attention on a particular
object or task occasioned by the division of labor. As Smith explained: “Men are
much more likely to discover easier and readier methods of attaining any object,
when the whole attention of their minds is directed toward that single object, than
when it is dissipated among a great variety of things” (p. 9).

Wealth, Income, and Productive and Unproductive Labor

We have already seen that Smith differed sharply with the mercantilists on the
nature of a country’s wealth. “High value of the precious metals,” he observed, “can be
no proof of the poverty or barbarism of any particular country. . . . It is a proof only of
the barrenness of the mines which happened at that time to supply the commercial
world” (p. 238). To Smith, national wealth was measured not by the value of precious
metals but by “the exchangeable value of the annual produce of the land and labour of
the country.” Smith meant by the term “national wealth” essentially the same thing
economists today mean by the term “national income” (or its common measure, GDP).
But Smith considered the essence of wealth to be the production of physical
goods only, and this led in Book II to his unfortunate distinction between productive
and unproductive labor. According to this distinction, productive labor is that which
produces a tangible good of some market value. Unproductive labor, on the other
hand, results in the production of intangibles, such as services performed by arti-
sans or professionals. Smith characterized his own output (as a teacher) as essen-
tially unproductive, since it did not result in tangible goods sold in the marketplace.
He also categorized the services of lawyers, physicians, and other service-oriented
workers in the same way.
This distinction between productive and unproductive labor has been much
maligned. It is, of course, absurd to characterize the service industries as unproduc-
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Chapter 5 ■ Adam Smith 129

tive simply because they do not produce tangible goods. Yet, what Smith was driv-
ing at was the distinction between those activities that increase aggregate net
investment, and thus serve the end of economic growth, and those activities that
serve merely the needs of households. This latter distinction is a perfectly valid one
in economic theory, although the terminology Smith chose is unfortunate. Despite
the negative connotation, Smith did not consider unproductive workers useless; he
simply did not regard their activities as furthering the goal of economic growth.

The Role of Capital

While division of labor—considered by Smith an inherent tendency in society—
starts the growth process, capital accumulation is what keeps it going. Key elements
in the growth process are the nature, accumulation, and employment of stock. By
“stock,” Smith meant wealth in modern terms, a part (or all) of which is reserved for
consumption and a part of which may be reserved for deriving further revenue,
through investment. The larger the last share, the greater the growth potential of
any nation. Recall that capital accumulation enlarges the wages-fund, which in turn
allows a larger number of workers to be engaged in productive activity, thereby
increasing the size of national output.
Workers exhaust the wages-fund over time as they draw down advances for
their subsistence during the production process. At the end of the production period,
however, the goods produced are sold, ordinarily at a profit, so that the stock of wage
goods (capital) is replenished, and even increased, by the amount of profit earned. In
this manner, through profit accumulation, the stock of capital grows over time, thus
supporting more workers and greater output in the next production period.
The complete chain of economic growth as represented by Smith is summa-
rized in figure 5-2, in which growth is viewed as an ongoing process as long as the
chain of causation remains unbroken. The line of causation proceeds in clockwise

Increased Greater
productivity output

Division of Higher
labor wages

Increased capital Increased per

accumulation capita income

Greater wealth Higher levels of

of a nation annual consumption

Figure 5-2 Smith’s theory of economic growth is an ongoing process, with division of
labor starting the growth process and proceeding in a clockwise fashion in the diagram.
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130 Part II ■ The Classical Period

fashion, starting at approximately the “ten-o’clock” position, with the division of

labor. The ultimate constraint on the growth process is the increased difficulty of
finding new and profitable investment outlets as the capital stock continues to grow
over time.

■ CONCLUSION
From the Middle Ages to the mid-eighteenth century, Europe and Great Britain’s
populations and national outputs increased significantly. The Industrial Revolution
was awakening when Adam Smith wrote The Wealth of Nations, causing a change
in people’s attitude toward trade and commerce. From a narrow concern with eco-
nomic justice and the status quo typical of the Middle Ages, the predominant focus
shifted to economic growth and change. This evolutionary shift, in turn, led to the
dismantling of feudalistic and mercantilistic restraints of trade and commerce.
The reasons for this turnabout are not very obscure. In a society characterized
by economic stagnation, such as medieval Europe, one person’s gain is another’s
loss—hence the concern of the Church fathers for economic justice and their ten-
dency to portray want minimization as the path to spiritual happiness and economic
well-being. In the vernacular of contemporary game theory the writers of the medi-
eval era tended to view economic activity as a “zero-sum game.” When national out-
put is expanding, however, economic activity becomes a “positive-sum game” where
everyone can benefit at the same time. In the “positive-sum” arena people are less
preoccupied with ethics and more intent on increasing economic wealth. Concerns
about economic justice tend to melt away when each individual can get a larger
slice of the (growing) economic pie without making someone else worse off. By
1776, the prospects of economic development made it possible, as well as desirable,
to reduce restraints against individual profit seeking in an expanding economy.
The idea of a self-regulating economy operating within a market system was a
new one in the mid-eighteenth century. Anticipations of the idea crept into early
Continental economic literature before then, but clearly Adam Smith gave the idea
its most timely and forceful expression. The perception of a natural social order,
existing in the absence of any form of central planning, was one of the most liberat-
ing ideas ever to emerge in the history of economic thought. It shunted economic
analysis onto a new path. Adam Smith led the way by providing a framework for
analyzing the economic questions of income growth, value, and distribution. For
practically the next century, economists worked largely within that framework to
investigate the questions raised by the quiet Scottish philosopher. In this manner,
Smith rightly came to be considered father of economics. He succeeded beyond
measure in weaving together his own contributions plus those of his predecessors—
who were many—into a systematic, comprehensive treatise that was greater than
the sum of its parts.
Soon after its publication, Smith’s book became many things to many people, a
fact that accounts in no small measure for its immediate success. Businesspeople
and workers alike could find passages in The Wealth of Nations to support their
interests. Government bureaucrats were treated less kindly, although Smith
reserved three important roles for the state: (1) to administer justice, (2) to provide
for the national defense, and (3) to maintain certain enterprises in the public inter-
est that could never be profitable if undertaken privately (i.e., the “public-goods”
question). Now that we are into the twenty-first century, it seems obvious that each
of these functions has weighed increasingly heavy on governments at every level.
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Chapter 5 ■ Adam Smith 131

REFERENCES
Anderson, G. M., W. F. Shughart, and R. D. Tollison. “Adam Smith in the Customhouse,”
Journal of Political Economy, vol. 93 (August 1985), pp. 740–759.
Blaug, Mark. Economic Theory in Retrospect, 4th ed. London: Cambridge University
Press, 1985.
Cantillon, Richard. An Essay on Economic Theory: An English translation of Richard
Cantillon’s Essai sur la nature du commerce en général. Chantal Saucier (trans.),
Mark Thornton (ed.). Auburn, AL: Ludwig von Mises Institute, 2010 [1755].
Gray, Alexander. “Adam Smith,” Scottish Journal of Political Economy, vol. 23 (June
1976), pp. 153–169.
Pesciarelli, Enzo. “Smith, Bentham and the Development of Contrasting Ideas on Entre-
preneurship,” History of Political Economy, vol. 21 (Fall 1989), pp. 521–536.
Schumpeter, Joseph A. History of Economic Analysis, E. B. Schumpeter (ed.). New York:
Oxford University Press, 1954.
Smith, Adam. An Inquiry into the Nature and Causes of the Wealth of Nations, Edwin
Cannan (ed.). New York: Modern Library, 1937 [1776].
———. The Theory of Moral Sentiments. Indianapolis: Liberty Classics, 1976 [1759].
Spengler, Joseph J. “Adam Smith’s Theory of Economic Growth—Part II,” Southern Eco-
nomic Journal, vol. 26 (July 1959), pp. 1–12.

NOTES FOR FURTHER READING

Inasmuch as the literature on Adam Smith is vast and varied, only a sampling can be
presented here. For a glimpse of the large store of Smithiana, see Burt Franklin and F.
Cordasco, Adam Smith: A Bibliographical Checklist (New York: Burt Franklin, 1950);
and Henry W. Speigel’s bibliography accompanying The Growth of Economic Thought,
3d ed. (Durham, NC: Duke University Press, 1991). The standard works on Smith’s life
and thought are John Rae, Life of Adam Smith (New York: A. M. Kelley, Publishers, 1965
[1895]); W. R. Scott, Adam Smith as Student and Professor (Glasgow: Jackson, Son &
Co., 1937); and C. R. Fay, The World of Adam Smith (Cambridge: Heffer, 1960). On the
first centenary of The Wealth of Nations, Walter Bagehot, an economist in his own right,
wrote an interesting characterization of Smith, “Adam Smith as a Person,” Fortnightly
Review, no. 115 (July 1, 1876), pp. 18–42, reprinted in Bagehot’s Biographical Studies, R.
H. Hutton (ed.) (London: Longmans, 1881). More recent evaluations of Smith and his
thought include E. G. West, Adam Smith: The Man and His Works (New Rochelle, NY:
Arlington House, 1969); and Sam Hollander, The Economics of Adam Smith (Toronto:
University of Toronto Press, 1973), a wholesale reinterpretation of Smith’s significance
as an economist.
A long-standing debate concerns the compatibility of intellectual arguments in
Smith’s Theory of Moral Sentiments and The Wealth of Nations. The preponderance of
evidence seems to support the consistency thesis—there is no real conflict between the
two works published almost twenty years apart. On this issue, see A. L. Macfie, “Adam
Smith’s Moral Sentiments as Foundation for His Wealth of Nations,” Oxford Economic
Papers, n.s., vol. 2 (October 1959), pp. 209–228; same author, “Adam Smith’s Theory of
Moral Sentiments,” Scottish Journal of Political Economy, vol. 8 (1960), pp. 12–27; W. F.
Campbell, “Adam Smith’s Theory of Justice, Prudence, and Beneficence,” American Eco-
nomic Review, vol. 57 (May 1967), pp. 571–577; Ralph Anspach, “The Implications of the
Theory of Moral Sentiments for Adam Smith’s Economic Thought,” History of Political
Economy, vol. 4 (Spring 1972), pp. 176–206; R. L. Heilbroner, “The Socialization of the
Individual in Adam Smith,” History of Political Economy, vol. 14 (Fall 1982), pp. 427–439;
J. T. Young, “The Impartial Spectator and Natural Jurisprudence: An Interpretation of
Adam Smith’s Theory of the Natural Price,” History of Political Economy, vol. 18 (Fall
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132 Part II ■ The Classical Period

1986), pp. 365–382; same author, “Natural Jurisprudence and the Theory of Value in
Adam Smith,” History of Political Economy, vol. 27 (Winter 1995), pp. 755–773; and J. M.
Evensky, “The Two Voices of Adam Smith: Moral Philosopher and Social Critic,” History
of Political Economy, vol. 19 (Fall 1987), pp. 447–468.
Some papers that explore the intersection between ethics and economics in Smith’s
work are as follows: R. E. Prasch, “The Ethics of Growth in Adam Smith’s Wealth of
Nations,” History of Political Economy, vol. 23 (Summer 1991), pp. 337–352; Jerry Even-
sky, “Ethics and the Classical Liberal Tradition in Economics,” History of Political Econ-
omy, vol. 24 (Summer 1992), pp. 61–77; same author, “Adam Smith on the Human
Foundation of a Successful Liberal Society,” History of Political Economy, vol. 25 (Fall
1993), pp. 395–412; and J. T. Young and Barry Gordon, “Distributive Justice as a Norma-
tive Criterion in Adam Smith’s Political Economy,” History of Political Economy, vol. 28
(Spring 1996), pp. 1–25.
The sesquicentennial of the publication of The Wealth of Nations in 1926 was fol-
lowed fifty years later by a full-scale celebration of the bicentennial event. On the former,
see J. M. Clark et al., Adam Smith, 1776–1926 (Chicago: University of Chicago Press,
1928). In connection with the latter, see T. W. Hutchison, “The Bicentenary of Adam
Smith,” Economic Journal, vol. 86 (September 1976), pp. 481–492; G. J. Stigler, “The Suc-
cesses and Failures of Professor Smith,” Journal of Political Economy, vol. 84 (December
1976), pp. 1199–1214; and the entire Winter 1976 issue of History of Political Economy,
which contains papers on Smith by Ronald Meek, H. W. Spiegel, E. G. West, and others.
A major part of the bicentennial was the publication by the University of Glasgow of
Smith’s complete works and correspondence, accompanied by a new biography by I. S.
Ross and two volumes of critical essays edited by A. S. Skinner and T. Wilson.
Smith’s theory of history and his development of systematic inquiry is examined by
Andrew S. Skinner in “Economics and History—the Scottish Enlightenment,” Scottish
Journal of Political Economy, vol. 12 (February 1956); “Adam Smith: The Development of
a System,” Scottish Journal of Political Economy, vol. 23 (June 1976), pp. 111–132; and
“Smith and Shackle: History and Epistemics,” Journal of Economic Studies, vol. 12 (1985),
pp. 13–20; by G. Bryson in Man and Society: The Scottish Inquiry of the Eighteenth Cen-
tury (New York: A. M. Kelley, 1968); and by Ronald L. Meek in “Smith, Turgot, and the
‘Four Stages’ Theory,” History of Political Economy, vol. 3 (Spring 1971), pp. 9–27. Smith’s
theory of property rights is the subject of a note by David E. R. Gay, “Adam Smith and
Property Rights Analysis,” Review of Social Economy, vol. 33 (October 1975), pp. 177–179.
The starting point of Smith’s theory of economic development is the division of
labor. Despite its catalytic role in his theory of economic development Smith seemed of
two minds on the subject. He recognized its benefits in Book I and its limitations in Book
V. For a discussion of the issues, see E. G. West, “Adam Smith’s Two Views on the Divi-
sion of Labor,” Economica, vol. 31 (February 1964), pp. 23–32; and Nathan Rosenberg,
“Adam Smith on the Division of Labor: Two Views or One?” Economica, vol. 32 (May
1965), pp. 127–140. For historical antecedents of the concept, see Vernard Foley, “The
Division of Labor in Plato and Smith,” History of Political Economy, vol. 6 (Summer
1974), pp. 171–191. Alienation, the favorite theme of Karl Marx, has also been proposed
as a specter for Adam Smith: see E. G. West, “The Political Economy of Alienation: Karl
Marx and Adam Smith,” Oxford Economic Papers, vol. 21 (March 1969), pp. 1–23; the
critique of West by R. Lamb, “Adam Smith’s Concept of Alienation,” Oxford Economic
Papers, vol. 25 (July 1973), pp. 275–285; and West’s rejoinder, “Adam Smith and Alien-
ation: A Rejoinder,” Oxford Economic Papers, vol. 27 (July 1975), pp. 295–301. See also
M. Fay, “The Influence of Adam Smith on Marx’s Theory of Alienation,” Science and
Society, vol. 47 (Summer 1983), pp. 129–151. The concept of alienation arises again in J.
P. Henderson, “Agency or Alienation? Smith, Mill and Marx on the Joint-Stock Com-
pany,” History of Political Economy, vol. 18 (Spring 1986), pp. 111–131.
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Chapter 5 ■ Adam Smith 133

Smith’s theory of economic development is explored by J. J. Spengler, “Adam

Smith’s Theory of Economic Development,” Science and Society, vol. 23 (1959), pp. 107–
132; by W. O. Thweatt, “A Diagrammatic Presentation of Adam Smith’s Growth Model,”
Social Research, vol. 24 (July 1957), pp. 227–230; by V. W. Bladen, “Adam Smith on Pro-
ductive and Unproductive Labor: A Theory of Full Development,” Canadian Journal of
Economics and Political Science, vol. 24 (1960), pp. 625–630; by Hla Myint, “Adam
Smith’s Theory of International Trade in the Perspective of Economic Development,”
Economica, vol. 44 (August 1977), pp. 231–248; by P. Bowles, “Adam Smith and the Natu-
ral Progress of Opulence,” Economica, vol. 53 (February 1986), pp. 109–118; and by
Gavin C. Reid, “Disequilibrium and Increasing Returns in Adam Smith’s Analysis of
Growth and Accumulation,” History of Political Economy, vol. 19 (Spring 1987), pp. 87–
106. Anthony Brewer, “The Concept of Growth in Eighteenth-Century Economics,” His-
tory of Political Economy, vol. 27 (Winter 1995), pp. 609–638, argues that only Turgot and
Hume anticipated Smith’s view that continuing economic growth was the normal state of
affairs. See also, Anthony Brewer, “Adam Ferguson, Adam Smith, and the Concept of
Economic Growth,” History of Political Economy, vol. 31 (Summer 1999), pp. 237–254,
which argues that many of the main themes of Adam Smith’s work were foreshadowed
by Adam Ferguson, a leading figure of the Scottish Enlightenment.
On the origins of the exchange economy in Smith, see Andrew Skinner, “Adam
Smith: The Origins of the Exchange Economy,” European Journal of the History of Eco-
nomic Thought, vol. 1 (Autumn 1993), pp. 21–46. James P. Henderson, “The Macro and
Micro aspects of The Wealth of Nations,” Southern Economic Journal, vol. 21 (July 1954),
pp. 25–35, presents a balanced overview of Smith’s economics. Smith’s theory of value is
explored by M. A. Stephenson, “The Paradox of Value: A Suggested Interpretation,” His-
tory of Political Economy, vol. 4 (Spring 1972), pp. 127–139; David Levy, “Diamonds,
Water and Z Goods: An Account of the Paradox of Value,” History of Political Economy,
vol. 14 (Fall 1982), pp. 312–322; Michael V. White, “Doctoring Adam Smith: The Fable of
the Diamonds and Water Paradox,” History of Political Economy, vol. 34 (Winter 2002),
pp. 659–683; H. M. Robertson and W. L. Taylor, “Adam Smith’s Approach to the Theory of
Value,” Economic Journal, vol. 67 (June 1957), pp. 181–198. Terry Peach, “Adam Smith
and the Labor Theory of (Real) Value: A Reconsideration,” History of Political Economy,
vol. 41 (Summer 2009), pp. 383–406, argues that Smith meant the labor theory to apply
to more than simple economies, and was more devoted to the principle than is com-
monly thought.
Almost all aspects of Smith’s economics have drawn attention at one time or
another. See, for example, Ronald L. Meek, “Adam Smith and the Classical Concept of
Profit,” Scottish Journal of Political Economy, vol. 1 (June 1954), pp. 138–153; Samuel
Hollander, “Some Implications of Adam Smith’s Analysis of Investment Priorities,” His-
tory of Political Economy, vol. 3 (Fall 1971), pp. 238–264; P. E. Mirowski, “Adam Smith,
Empiricism and the Rate of Profit in Eighteenth-Century England,” History of Political
Economy, vol. 14 (Summer 1982), pp. 178–198; R. F. Hébert and A. N. Link, “Adam Smith
on the Division of Labor and Relative Prices,” History of Economics Society Bulletin, vol.
9 (Fall 1987), pp. 80–84; David Levy, “Adam Smith’s Case of Usury Laws,” History of
Political Economy, vol. 19 (Fall 1987), pp. 387–400; and C. E. Staley, “A Note on Adam
Smith’s Version of the Vent for Surplus Model,” History of Political Economy, vol. 5 (Fall
1973), pp. 438–448. For more on the same issue, see H. D. Kurz, “Adam Smith on Foreign
Trade: A Note on the Vent-for-Surplus Argument,” Economica, vol. 59 (November 1992),
pp. 475–481.
Adam Smith is widely referred to as the apostle of laissez-faire, though the term is of
French, not British, origin. For a cross-section of Smith’s views on the role of govern-
ment and its policies, see Nathan Rosenberg, “Some Institutional Aspects of The Wealth
of Nations,” Journal of Political Economy, vol. 68 (1960), pp. 557–570; R. D. Freeman,
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134 Part II ■ The Classical Period

“Adam Smith, Education, and Laissez-Faire,” History of Political Economy, vol. 1 (Spring
1969), pp. 173–186; Warren J. Samuels, “The Classical Theory of Economic Policy: Non-
legal Social Control,” Southern Economic Journal, vol. 31 (October 1973), pp. 123–137;
G. J. Stigler, “Smith’s Travels on the Ship of State,” History of Political Economy, vol. 3
(Fall 1971), pp. 265–277; Donald Winch, “Science and the Legislator: Adam Smith and
After,” Economic Journal, vol. 93 (September 1983), pp. 501–520; H. H. Song, “Adam
Smith as an Early Pioneer of Institutional Individualism,” History of Political Economy,
vol. 27 (Fall 1995), pp. 425–448; Edward J. Harpham, “The Problem of Liberty in the
Thought of Adam Smith,” Journal of the History of Economic Thought, vol. 22 (June
2000), pp. 217–237; Warren J. Samuels and Steven G. Medema, “Freeing Smith from the
‘Free Market’: On the Misperception of Adam Smith on the Economic Role of Govern-
ment,” History of Political Economy, vol. 37 (Summer 2005), pp. 219–226.
The issue of the invisible hand and its role in Smith’s market system is explored by
Stefano Fiori, “Visible and Invisible Order: The Theoretical Duality of Smith’s Political
Economy,” The European Journal of the History of Economic Thought, vol. 8 (Winter
2001), pp. 429–448; S. Ahmad, “Adam Smith’s Four Invisible Hands,” History of Political
Economy, vol. 22 (Spring 1990), pp. 137–144; J. R. Davis, “Adam Smith on the Providen-
tial Reconciliation of Individual and Social Interests: Is Man Led by an Invisible Hand or
Misled by a Sleight of Hand?” History of Political Economy, vol. 22 (Summer 1990), pp.
341–352; Lisa Hill, “The Hidden Theology of Adam Smith,” The European Journal of the
History of Economic Thought, vol. 8 (Spring 2001), pp. 1–29; and Amos Witztum, “Inter-
dependence, the Invisible Hand, and Equilibrium in Adam Smith,” History of Political
Economy, vol. 42 (Spring 2010), pp. 155–192, who asserts that there is a type of general
equilibrium analysis in Smith, but it is different from that of contemporary economics.
Michael E. Bradley, “Adam Smith’s System of Natural Liberty: Competition, Contestabil-
ity, and Market Process,” Journal of the History of Economic Thought, vol. 32 (June 2010),
pp 237–262, explores whether Smith’s system of perfect liberty bears any traits of perfect
competition, arguing that it does, but that it differs respecting rivalry between firms and
the role of the entrepreneur. Bradley also contrasts Smith’s view to neoclassical perfect
competition, contestable markets theory, and the Austrian theory of competition.
It is possible that Galileo Galilei encountered and resolved the paradox of exchange
value in a key methodological passage in his famous book on astronomy. Although his
brush with this idea could not be termed “theoretical” or “economic” in any conventional
sense, he understood that real price changes were related to scarcity. This astonishing
point had been hitherto unrecognized. Adam Smith may have been influenced by Galileo
on scientific method as revealed in Smith’s History of Astronomy. Smith read and
digested Galileo’s famous works directly and through his careful study of his most
important influence, Isaac Newton. Smith’s failure to solve the paradox in the Wealth of
Nations and to seek a measurement of constant change may have been, at least deriva-
tively, an attempt to follow Galileo’s methodological lead. See Robert B. Ekelund, Jr. and
Mark Thornton, “Galileo, Smith and the Paradox of Value: The ‘Connection’ of Art and
Science,” History of Economic Ideas, vol. 19 (2011), pp. 85–101.
Here is a mélange of works on various aspects of Smith’s thought that defies easy
categorization: D. A. Redman, “Adam Smith and Isaac Newton,” Scottish Journal of Polit-
ical Economy, vol. 40 (May 1993), pp. 210–230; N. Rosenberg, “Adam Smith and the
Stock of Moral Capital,” History of Political Economy, vol. 22 (Spring 1990), pp. 1–18; J.
A. Gherity, “Adam Smith and the Glasgow Merchants,” History of Political Economy, vol.
24 (Summer 1992), pp. 357–368; Bruce Elmslie, “The Endogenous Nature of Technologi-
cal Progress and Transfer in Adam Smith’s Thought,” History of Political Economy, vol.
26 (Winter 1994), pp. 649–663; and C. Nyland, “Adam Smith, Stage Theory, and the Sta-
tus of Women,” History of Political Economy, vol. 25 (Winter 1995), pp. 617–640. Neil De
Marchi and Jonathan A. Greene, “Adam Smith and Private Provision of the Arts,” History
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Chapter 5 ■ Adam Smith 135

of Political Economy, vol. 37 (Fall 2005), pp. 431–454, provide reasons why Smith did not
favor government intervention in the arts.
For conflicting interpretations of Smith’s views on organized religion and economic
incentives, see C. G. Leathers and Patrick. Raines, “Adam Smith on Competitive Reli-
gious Markets,” History of Political Economy, vol. 24 (Summer 1992), pp. 499–514; and
R. B. Ekelund, Jr., R. F. Hébert, and R. T. Tollison, “Adam Smith on Religion and Market
Structure,” History of Political Economy, vol. 37 (Winter 2005), pp. 647–660. Jerry Even-
sky, “Adam Smith’s Moral Philosophy: The Role of Religion and Its Relationship to Phi-
losophy and Ethics in the Evolution of Society,” History of Political Economy, vol. 30
(Spring 1998), pp. 17–42, considers Smith’s views on religion in a different context.
Gavin Kennedy, “The Hidden Adam Smith in his Alleged Theology,” Journal of the His-
tory of Economic Thought, vol. 33 (September 2011), pp. 385–402, criticizes the view that
Smith was truly religious, arguing instead that his concessions to religion were simply
conventional, and pronounced as safeguards against persecution. Kennedy also alleges
that Smith was loathe to offend his mother’s religious sensibilities, but he altered his
works to make them less religiously oriented after her death.
Finally, on the relevance of Adam Smith’s thought for the modern age, see S. Moos,
“Is Adam Smith Out of Date?” Oxford Economic Papers, vol. 3 (June 1951), pp. 187–201;
K. E. Boulding, “After Samuelson, Who Needs Adam Smith?” History of Political Econ-
omy, vol. 3 (Fall 1971), pp. 225–237; and R. H. Coase, “The Wealth of Nations,” Economic
Inquiry, vol. 15 (July 1977), pp. 309–325.
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Classical Economics (I)

Utility, Population, and Money

Momentous change occurred during the era that produced classical economic liter-
ature. The quantifiable nature of this change is clouded today by the lack of reliable
records and the passage of time, but economic historians have been able to give it
an approximate face. In Great Britain income and population began to grow along-
side each other in the mid-eighteenth century. From 1700 to 1871, national income
in Britain increased eighteenfold. During the same time Britain’s population
increased almost fourfold. As one might expect, the volume of trade expanded, par-
ticularly after the liberalization of trade policy following the publication of The
Wealth of Nations. At the same time, there was a fundamental change in the balance
of the British economy. Agriculture, which accounted for 40–45 percent of national
output during most of the eighteenth century, declined to only 14 percent by 1871.
Manufacturing, which accounted for approximately 24 percent of national output in
1770, accounted for 38 percent a century later. The Industrial Revolution was
clearly underway.
Adam Smith did more to establish economics as a scientific discipline than any
writer before him. He established the foundations of classical value theory and pro-
vided a meaningful blueprint for economic growth. He also breathed into political
economy an underlying philosophy based on the doctrine of utility, or self-interest.
This philosophy maintains that the desire to improve one’s position manifests itself
in individual attempts to acquire benefits and avoid costs. The idea that self-interest
was, if not the exclusive, at least the dominant influence on human activity gained
ground very quickly in the eighteenth century. Smith was merely one in a long line
of philosophers who espoused the principle, including David Hume, Smith’s teacher
and friend. Together they forged a philosophical framework that served as a touch-
stone for the new field of political economy.
Before the close of the eighteenth century, several key themes intruded on, and
were embraced by, political economy. Although independently formulated, each of
these themes was integrated into the newly recognizable subject. The first theme,
utilitarianism, was implicit in Smith’s writings but was given a much more forceful
statement by Jeremy Bentham. The second theme, populationism, was embryonic
in Cantillon’s writing but was developed into a full-blown theory by Robert Malthus.
The third theme, money, was resolutely shaped—under the influence of evolving
banking theory and practice—into an axiom of classical macroeconomics.

136
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Chapter 6 ■ Classical Economics (I) 137

■ JEREMY BENTHAM AND UTILITARIANISM

Jeremy Bentham (1748–1832), a lawyer by training and a younger contempo-
rary of Smith, formalized the doctrine of self-interest in terms of the pleasure-pain
principle. In his Introduction to the Principles of Morals and Legislation (1789), Ben-
tham wrote with confidence:
Nature has placed mankind under the governance of two sovereign masters, pain
and pleasure. It is for them alone to point out what we ought to do as well as to
determine what we shall do. . . . The principle of utility recognizes this subjection.
(p. 17)

From a policy standpoint there are two distinct ways in which the principle of
utility (self-interest) has been interpreted. One rests on the belief in a natural iden-
tity of interests, the other on the belief in an artificial identity of interests. Adam
Smith championed the natural identity thesis, which emphasized spontaneous
order and harmony. He believed that in a free economy the individual self-interests
of human nature harmonize of their own accord; consequently he advocated essen-
tially a laissez-faire policy. Bentham, however, took a different tack, admitting that
individuals are chiefly self-interested but denying any natural harmony of egoisms.
Crime, for example, provides a case of self-interested behavior that violates the pub-
lic interest. The very fact that crime existed was for Bentham sufficient proof that
natural harmony did not. The central tenet of Bentham’s philosophy, therefore, was
that the interest of each individual must be identified with the general interest and
that it was the business of the legislator to bring about this identification through
direct intercession. Thus, it was in the form of the artificial identity of interests
framework that Bentham first adopted the utility principle. His doctrine came to be
known as utilitarianism.
Superficially, Bentham’s doctrine bears a resemblance to the ancient Greek phi-
losophy of hedonism, which also held that moral duty consists of the gratification of
pleasure-seeking interests. But hedonism is individualistic; it prescribes individual
actions without reference to the general happiness. Utilitarianism added to hedo-
nism the ethical doctrine that human conduct should be directed toward maximiz-
ing the happiness of the greatest number of people. “The greatest happiness for the
greatest number” became the watch phrase of the utilitarians—those who shared
Bentham’s philosophy. Among them were such personalities as the father–son com-
bination of James and John Stuart Mill (see chapter 8) and Edwin Chadwick (see
chapter 10). This group championed legislation plus social and religious sanctions
that punished individuals for harming others in the pursuit of their own happiness.
Bentham defined his principle in the following fashion:
By the principle of utility is meant that principle which approves or disapproves of
every action whatsoever, according to the tendency which it appears to have to
augment or diminish the happiness of the party whose interest is in question . . .
not only of every action of a private individual, but of every measure of govern-
ment. (Principles of Morals and Legislation, p. 17)

This passage implies a very minimal distinction between morals and legislation.
Bentham’s self-appointed mission was to make the theory of morals and legislation
scientific in the Newtonian sense. As Newton’s revolutionary physics hinged on the
universal principle of attraction (i.e., gravity), Bentham’s theory of morals rested on
the principle of utility. Newton’s roundabout influence on the social sciences was
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138 Part II ■ The Classical Period

widespread in the nineteenth century, which demonstrated a passion for measure-

ment. Bentham rode the crest of this new wave in the social sciences. If pleasure
and pain could be measured in some objective sense, then every legislative act
could be judged on welfare considerations. This achievement required a conception
of the general interest, which Bentham readily defined.
Bentham asserted that the general interest of the community is measured by
the sum of the individual interests in the community. His utilitarian approach chal-
lenged class distinctions; it was both democratic and egalitarian. It mattered not
whether one was a pauper or a king—each individual interest was to receive equal
weight in the measurement of the general welfare. Thus, if something adds more to
a peasant’s pleasure than it subtracts from the happiness of an aristocrat, it is desir-
able on utilitarian grounds. Likewise, if government action of a certain kind
enhances the happiness of the community more than it diminishes the happiness of
some segment of it, intervention is thereby justified by Bentham’s reasoning.
All of this presupposes a kind of “moral arithmetic,” which Bentham saw as
analogous to the mathematical operations required of Newtonian physics. The
operations of moral arithmetic are not all of the same kind, however. The values of
different pleasures are added for individuals, but the value of a given pleasure must
be multiplied by the number of people who experience it, and the various elements
that make up the value of each pleasure must also be multiplied by each other. This
requires a rather complicated summing up. Facing the difficulties as best he could,
Bentham chose money as an appropriate measure of pain and pleasure. Money, as
we know, is subject to diminishing marginal utility: the more of it acquired, the less
utility each additional unit conveys. Bentham recognized this fact, but he did not
explore its consequences so as to more firmly establish consumer demand theory. It
can be said fairly that Bentham was more of a utilitarian than a marginalist. Never-
theless, he exerted a major influence on one of the pioneers of neoclassical value
theory, William Stanley Jevons (see chapter 15).

The Felicific Calculus

Bentham’s attempt to measure economic welfare scientifically took the form of
the felicific calculus, or summing up, of collective pleasures and pains. As early as
1789, in his Introduction to the Principles of Morals and Legislation (p. 30), Ben-
tham described the circumstances by which the values of pleasure and pain were to
be measured. For the community, they consist of the following seven factors:
1. The intensity of pleasure or pain
2. Its duration
3. Its certainty or uncertainty
4. Its propinquity or remoteness
5. Its fecundity, or the chance it has of being followed by sensations of the same
kind (i.e., pleasure followed by more pleasure, or pain followed by more pain)
6. Its purity, or the chance it has of not being followed by sensations of the oppo-
site kind (e.g., childbirth has a low index of purity because it represents a mix-
ture of pain and pleasure)
7. Its extent, that is, the number of people who are affected by it

Bentham recognized that the fifth and sixth circumstances are not inherent proper-
ties of pain or pleasure itself but only of the act that produces pleasure or pain.
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Chapter 6 ■ Classical Economics (I) 139

Therefore they serve only as indicators of the tendency of any act or event to affect
the community.
After identifying the dimensions of pleasure/pain, Bentham spelled out the
mechanics by which welfare calculations were to be made. “To take an exact account,
then, of the general tendency of any act, by which the interests of the community are
affected,” he directed, “proceed as follows”: Begin with any one person of those
whose interests seem most immediately to be affected by it and take an account:
1. Of the value of each distinguishable pleasure which appears to be produced by
it in the first instance.
2. Of the value of each pain which appears to be produced by it in the first instance.
3. Of the value of each pleasure which appears to be produced by it after the first.
This constitutes the fecundity of the first pleasure and the impurity of the first pain.
4. Of the value of each pain which appears to be produced by it after the first. This
constitutes the fecundity of the first pain and the impurity of the first pleasure.
5. Sum up all the values of all the pleasures on the one side, and those of all the
pains on the other. The balance, if it be on the side of pleasure, will give the
good tendency of the act upon the whole, with respect to the interests of that
individual person; if on the side of pain, the bad tendency of it upon the whole.
6. Take an account of the number of persons whose interests appear to be con-
cerned; and repeat the above process with respect to each. Sum up the numbers
expressive of degrees of good tendency . . . in regard to . . . the whole: do this
again with respect to each individual, in regard to whom the tendency of it is
bad upon the whole. Take the balance; which, if on the side of pleasure, will give
the general good tendency of the act . . . if on the side of pain, the general evil
tendency with respect to the same community. (Principles of Morals and Legisla-
tion, pp. 30–31)

It is rather a tall order to follow this procedure for every act of public policy.
Bentham admitted that he did not expect the felicific calculus to be followed pursu-
ant to every moral judgment or legislative enactment, but he urged legislators and
administrators always to keep the theory in view, for as close as the actual process
of evaluation follows it, the nearer it will be to an exact measure.

An Evaluation of Utilitarianism
Bentham recognized some of the practical and analytical difficulties in his the-
ory of welfare measurement and ignored others. One of the many problems con-
fronting the theory is how to treat interpersonal comparisons of utility. To
paraphrase an old cliché, one man’s happiness may be another man’s poison. The
fact that different individuals have different tastes, different incomes, different goals
and ambitions, and so forth, makes comparisons of utility (gained or lost) between
individuals illegitimate by any objective criteria. Bentham admitted this obstacle,
but he felt that such comparisons must be made, or else social reform is impossible.
Hence his welfare theory is subjective (i.e., normative) rather than objective.
Another problem in Bentham’s welfare theory concerns the weighting, if any, of
qualitative pleasures. Should pleasures of the mind, for example, receive more or
less emphasis than pleasures of the body? Although he was aware of this problem,
Bentham was unable to resolve it. Like so many later economists, he settled on
money as the best available measure of utility, even though money measures do not
always register qualitative changes unambiguously.
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140 Part II ■ The Classical Period

Bentham was apparently unaware of the logical pitfall that economists call the
fallacy of composition. This fallacy asserts that because something is true of a part,
it is therefore true of the whole. Confident that the collective interest was a faithful
representation of the individual interests that comprised it, Bentham represented
the measure of collective interest as the sum of individual interests. While this
assertion may be true in some instances, it is not necessarily true in all. A simple
example may serve to illustrate this point. It is presumably in the general interest of
American society to have every automobile in the United States equipped with all
possible safety devices. However, a majority of individual car buyers may not be
willing to pay the cost of such equipment in the form of higher auto prices. In this
case, the collective interest does not coincide with the sum of the individual inter-
ests. The result is a legislative and economic dilemma. In other words, Bentham’s
basic assumption regarding welfare measurement may lead to inaccurate estimates
of the general welfare.
On purely philosophical grounds, Bentham’s view of human nature is essen-
tially passive: people are “pushed” about by the search for pleasure and the avoid-
ance of pain. Hence, in Bentham’s view, there are no “bad” motives or “moral”
deficiencies; there are only “bad” calculations regarding pleasure and pain. Ben-
tham did not think it wrong to make a bad calculation; it may be stupid, but presum-
ably stupidity can be corrected by education. Indeed, the utilitarians placed a great
deal of emphasis on education as a means of social reform.
Utilitarianism is regarded by many as overly narrow in its approach to human
behavior. Little or no room is given to behavioral motives other than the pursuit of
pleasure and the avoidance of pain. But despite its inherent difficulties, Bentham
felt that the felicific calculus was a useful, if unoriginal, theory. He believed that
individual pleasure-pain calculations are made frequently, even if unconsciously. “In
all this,” he charged, “there is nothing but what the practice of mankind, whereso-
ever they have a clear view of their own interest, is perfectly conformable to” (Prin-
ciples of Morals and Legislation, p. 32).
Bentham’s search for an exact, quantitative measure of utility was bound to
prove futile. Even to this day, welfare economists have never successfully solved the
problem of interpersonal utility comparisons in such a way as to derive truly objec-
tive criteria on which to base welfare decisions. Nevertheless, the influence of Ben-
tham’s philosophy was transmitted through James Mill, a fellow utilitarian, to his
son, John Stuart, particularly in the area of social reform. Moreover, the felicific cal-
culus provided a foundation for Jevons’s more profound insights into the marginal-
utility theory of consumer behavior (see chapter 15).
Bentham’s influence on economic policy was especially profound in the first
decades following his death, when Edwin Chadwick and John Stuart Mill champi-
oned reforms based on utilitarian premises (see chapter 10). Even today Bentham’s
approach to economics inspires contemporary extensions of neoclassical theory
into such areas as the economics of crime and the economics of franchise bidding
(see the notes for further reading at the end of the chapter). In a general sense, Ben-
tham was a master innovator of institutional and administrative reforms designed to
alter economic incentives in compliance with the general will.

■ THOMAS ROBERT MALTHUS AND POPULATION

A second cornerstone of classical economics was the population principle. The
writer who gave classical population theory its definitive statement was Thomas
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Chapter 6 ■ Classical Economics (I) 141

Robert Malthus (1766–1834). John Maynard Keynes, who later led a group of like-
minded academicians at Cambridge University, called Malthus the “first of the Cam-
bridge economists.” At Cambridge Malthus studied for the ministry. Despite a con-
genital cleft palate, he won prizes for his declamations in Greek, Latin, and English.
He graduated in 1788 and took holy orders the same year, but he remained at Cam-
bridge as a graduate fellow until 1804, at which time he married, and according to
the rules of the college, had to resign his fellowship.
Malthus’s father befriended Jean-Jacques Rousseau and David Hume, both of
whom are reputed to have been young Robert’s (he went by his middle name) first
visitors when he was an infant. Robert Malthus grew into an independent thinker, a
trait that he later put to good use in establishing his reputation. In 1798 Malthus
published, anonymously, An Essay on the Principle of Population as It Affects the
Future Improvement of Society, with Remarks on the Speculations of Mr. Godwin,
M. Condorcet, and Other Writers. Anonymity, however, quickly gave way to general
recognition, and in due course, Malthus’s name became a household word.
The full title of the Essay hints at its underlying motivation. Malthus reacted
against the extreme optimism of the philosophers Godwin and Condorcet, who,
inspired by the political euphoria of the French Revolution, forecast the elimination
of social evils. They envisioned a society devoid of war, crime, government, disease,
anguish, melancholy, and resentment, where every man unflinchingly sought the
good of all. Malthus’s answer to this utopian vision was deceptively simple: the per-
fectibility of human society is impossible, he stated, because the biological capacity of
man to reproduce will, if left unchecked, outstrip the physical means of subsistence.
Malthus wrote his first Essay on Population without much evidential support.
Afterward, and partly because of the furor it created, he began to add some empiri-
cal flesh to his bare-bones theory. Subsequent editions of the Essay appeared in
1803, 1806, 1807, 1817, and 1826. Finally, Malthus published A Summary View of the
Principle of Population in 1830. By then the population principle he made famous
had become a canon of classical economics. Despite numerous modifications
through its several editions, the core thesis of the first Essay remained unchanged.

An Outline of the Theory

Malthus based his population principle on two propositions. The first asserted
that “Population, when unchecked, increases in a geometrical progression of such a
nature as to double itself every twenty-five years” (A Summary View, p. 238). He
attempted to add precision to this principle by basing it on population experience in
the United States. Available statistics were unreliable, however, and provided little real
empirical support for Malthus’s first postulate. Consequently, he acknowledged that
this doubling of population every twenty-five years was neither the maximum growth
rate of population nor necessarily the actual rate. But he insisted throughout that the
potential growth rate of population always advanced in geometric progression.
The second postulate asserted that under even the most favorable circum-
stances, the means of subsistence (i.e., the food supply) cannot possibly increase
faster than in arithmetic progression. The precision that Malthus attributed to this
second assertion was unfortunate, since the arithmetic progression of the food sup-
ply could not be supported by fact, not even as loosely as the first assertion could
about the growth of population. Nevertheless, the juxtaposition of these two postu-
lates was jarring because it established an obvious discrepancy between the poten-
tial growth of population versus the food supply. In Malthus’s own words: “The
power of population being . . . so much superior, the increase of the human species
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142 Part II ■ The Classical Period

can only be kept down to the level of the means of subsistence by the constant oper-
ation of the strong law of necessity, acting as a check upon the greater power” (A
Summary View, p. 21).
This population dilemma posed theoretical and practical questions. The theo-
retical question centered on the identification of the actual checks to population
growth; the practical question concerned solutions to the problem, namely, which
checks should be encouraged over others. Malthus discussed both issues, beginning
with the identification problem.
Positive and Preventive Checks. The ultimate check on population growth is
limited food supply. But there are others, and Malthus classified various limiting
factors into positive checks and preventive checks. The former, such as disease,
increase the death rate; whereas the latter, such as contraception, lower the birth-
rate. A man of the cloth, Malthus held certain religious convictions. Hence, he
favored neither contraception nor abortion as practical means to circumscribe pop-
ulation growth. In a carefully measured condemnation of the latter, he described
abortion as “improper arts to conceal the consequences of irregular connection”!
Although his views in this regard may be considered quaint by contemporary stan-
dards, the important issue for our purposes is the separation of theory and policy.
From a theoretical perspective the significance of Malthus’s contribution lay in
his ability to mold the procreative tendency and the checks to it into an analytical
framework that focused attention on those forces tending to change the number of
people on earth. The following summary is uppermost in Malthus’s population theory:
Positive Checks on Population Growth: war, famine, pestilence
Preventive Checks on Population Growth: moral restraint, contraception, abortion
As theory, the population principle tells us that population will increase whenever
the cumulative effect of the various checks is less than that of procreation; that it
will decrease whenever the cumulative effect of the checks is greater than that of
procreation; and that it will remain unchanged whenever the combined effects of
the checks and of procreation are self-canceling. Viewed in this matter-of-fact way,
the theory is value-free, and the analyst’s job becomes that of determining the quan-
titative dimensions of the forces at play.
Theoretical Limitations. On the face of it, Malthus’s population theory is neu-
tral with respect to assumptions and conclusions. Given relevant empirical inputs as
described above, the theory is capable of explaining all manner of population
changes: growth, depopulation, or stagnation. But although the theory is quite gen-
eral, Malthus advanced a specific outcome of the population–food supply struggle:
he asserted that the inevitable result would be a subsistence economy. He believed
that the tendency to procreate would in fact dominate the cumulative effect of the
checks to population growth. This represents a departure from value-free science. It
is an unfortunate departure for two reasons: (1) as prophecy, it has frequently
proved wrong, and (2) the conclusion Malthus committed to is not at all inherent in
his purely theoretical structure.
Does this tendency to draw a false conclusion invalidate the theory on which it
rests? Not necessarily, for Malthus’ theoretical structure is quite capable of yielding
general conclusions regarding population and subsistence for different economies
at different historical periods. What is required to make the theory operational in a
predictive sense is reliable information about the magnitude of the tendencies
embodied in his theoretical apparatus.
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Chapter 6 ■ Classical Economics (I) 143

Malthus has been faulted for overlooking other checks that might forestall his
gloomy conclusion. For one thing, he did not conceptually separate sex and procre-
ation. Yet in a world of modern birth control techniques and other arts of family
planning, the distinction is especially relevant. Many families limit the number of
their offspring for reasons other than financial ones (e.g., a desire for personal free-
dom and mobility or a career). These additional checks overlooked by Malthus are
capable of reducing the disparity between multiplication of the species and growth
of the food supply.
A more serious shortcoming of Malthus’s population theory was his tendency,
shared by other classical writers, to underestimate the advance of agricultural tech-
nology. There was already the hint in the Essay that agriculture is subject to dimin-
ishing returns, a topic that Malthus later expanded in his theory of rent. As an
economic law, however, diminishing returns hold only for a constant state of tech-
nology. And in advanced economies, rapid progress in technology has so far suc-
ceeded in forestalling the Malthusian specter of overpopulation and starvation. This
does not, of course, deny the very real threat of subsistence in the developing world,
where the Malthusian specter appears to be a genuine obstacle to economic growth
and development. However, it is not at all clear that the problems of the developing
world derive from natural calamities rather than the failure of government. (See the
box, The Force of Ideas: Malthus, Birth Control, and Authoritarian Governments.)

The Force of Ideas: Malthus, Birth Control, and Authoritarian Governments

Malthus was somewhat ambivalent, but mostly pessimistic, concerning the relation
between food supply and population. However, his population principle establishes that if the
“checks” to population are sufficiently effective, it is possible to stave off population disasters
and food crises indefinitely. Today there is more optimism in this regard because technologi-
cal change has increased the effectiveness of Malthus’s checks and brought new checks into
existence. Persistent improvements in agricultural technology have raised the prospects of
greater food supply. New and improved methods of birth control appear from time to time,
reducing the prospects of excessive population growth. But in addition to factors overlooked
by Malthus, such as changes in technology, economic theory has also matured to the point of
offering additional explanations of population growth and decline.
In developed economies, income and wealth tend to grow as population expands. Con-
temporary economics tells us that income growth produces both income and substitution
effects. As real income rises, so does the demand for most goods; as prices rise (alongside
higher incomes), however, people tend to substitute relatively cheaper goods in place of rela-
tively expensive ones. Children may be viewed as investment goods or as consumption
goods. The tendency to treat children as investment goods is stronger in poor countries than
in rich countries, for reasons that will be explained below. Nobel laureate Gary Becker (see
chapter 26) and other economists have pointed out that when time costs are admitted, chil-
dren are relatively expensive consumption goods. So in rich countries people tend to substi-
tute relatively cheaper consumption goods—as measured by explicit and implicit costs—for
relatively more expensive children. In other words, people buy more “stuff” and have fewer
children. This phenomenon explains part of the reduction in population in the developed
world, where fertility rates (i.e., number of live births per female) have been declining for some
time, especially in Europe and North America. It also explains in part why population rates are
high in poorer countries, where children are most often regarded as investment goods
because on the one hand they provide labor resources to the family unit and on the other
they provide a kind of “social security” for parents in their old age.

(continued)
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144 Part II ■ The Classical Period

Periodically we hear tragic news of massive starvation and high child mortality rates in
poor countries, such as those in sub-Saharan Africa. Our first response is to invoke the ghost of
Malthus to explain such misery. But the causes of starvation may lie elsewhere. Although dif-
fering in degree, income and substitution effects are in play everywhere. People who have
limited means of accumulating wealth may regard children as a cheap means of “wealth”
accumulation, driving population higher even in the face of poverty. We must also recognize
that authoritarian governments may curtail economic growth by actions that reduce incen-
tives to invest or adopt new technology. In other words, not all imbalances between popula-
tion and food supply may be attributable to the factors that Malthus described.

■ EARLY MONETARY ISSUES

For a time at least, Malthus’s population theory seemed to settle an important
question in classical economics, the issue of labor supply. After Malthus, population
came to be the chief determinant of wages, and in subsequent explanations of
labor’s aggregate share of annual output, emphasis was placed on the wages-fund
concept, which drew additional support from Malthus’s population doctrine. An
issue that proved more difficult to settle was the monetary question, namely what
effect, if any, money has on economic activity.

Preclassical Monetary Theory

From roughly 1650 to 1776, monetary theory consisted primarily of two strands
of thought. One argument advanced by John Law, Jacob Vanderlint, and (Bishop)
George Berkeley was that “money stimulates trade.” This argument stressed the
effect of money on output and employment, largely ignoring the connection
between money and prices. The other argument, made most forcefully by John
Locke, Richard Cantillon, and David Hume, emphasized the connection between
money and prices.
Like many early theories, the money-stimulates-trade argument was a useful
first approximation. Underlying the theory was the idea that, given a volume of
trade, there is an appropriate amount of money required to carry out exchange
transactions. The element of truth in the money-stimulates-trade doctrine is that
money is an important determinant of aggregate spending, which in turn deter-
mines the levels of output and employment. But this theoretical progression does
not go far enough, especially in two critical respects. First, as previously noted, it
ignores the possible effects of money on the price level. And second, it overlooks
the role of expectations in the decision-making process. This last matter sharply
divides Keynes (see chapter 21) from the money-stimulates-trade theorists of the
seventeenth and eighteenth centuries. Unlike his forebears, Keynes did not assert
that money is the key to solving unemployment. However, like them, he saw money
as the key to explaining unemployment.
Although we have already discussed the mechanics of the quantity theory of
money in chapters 3 and 4, we take this occasion to mention once again the name of
David Hume (1711–1776), at whose hands the quantity theory of money took the
form of its commonly accepted version. It was Hume who attempted a reconcilia-
tion of the money-stimulates-trade theory with the quantity theory of money. More-
over, it is in Hume’s economic writings that the concept of neutral money emerges
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Chapter 6 ■ Classical Economics (I) 145

for the first time. As Keynes observed, “Hume had a foot and a half in the classical
world” (General Theory, p. 343n).
Eighteenth-century attitudes toward money cannot be understood in a histori-
cal vacuum. The century opened with the monetary experiments of John Law, “who
was inspired by the idea that an abundance of money is the royal road to wealth”
(Rist, History, p. 103). After the collapse of Law’s inflationary system in France,
most of the enlightened men of that epoch—from Cantillon to Hume, from Quesnay
and Turgot to Smith, and in the next century, from Thornton to Ricardo—deempha-
sized the importance of money, insisting instead that labor and natural resources
are the fundamentals of wealth. Paradoxically, the business community continued
to believe in a metallic currency even as the theorists argued against it.
Because Europe was ravaged by war throughout the eighteenth century, there
was a great deal of pressure on the economies of Europe to expand the money sup-
ply. Scarcely had forced paper currency been established in England at the close of
the century when everybody began to ponder ways and means of returning as
quickly as possible to metallic currency. There may be some lessons for the present
in this past experience. Adam Smith clearly taught that the only things that count in
the advancement of wealth are the resources nature provides for man’s activity and
the use he makes of them through his labor and inventions. But this is not enough.
It must be kept in mind that human beings live in society and that society is based
on a set of reciprocal exchanges. The greater part of these exchanges takes place
over extended periods of time, which introduces some uncertainty about the future.
The goods that offer the best possibility of guarding against the uncertainties of
time are precious, rare, durable, indestructible objects, such as gold.
In periods of increased uncertainty brought on by incipient inflation, controver-
sies over “hard money” versus paper currencies are resurrected. Control of money
supply is an important responsibility in every nation, and uncertainty waxes and
wanes with volatility in stocks of money. What has been more durable as a theoreti-
cal issue is the controversy over money’s “neutrality” or “nonneutrality.” The neu-
trality of money refers to the fact that changes in the money stock have no effect on
relative prices. In their zeal to discredit the mercantilist idea that money constitutes
wealth, early monetary theorists gave the impression that money is a veil that hides
the real forces of productivity, which alone account for genuine economic wealth.
All that monetary changes do is change the price level in proportion to the change in
money. Hume gave the classic exposition of this view:
If we consider any one kingdom by itself, it is evident, that the greater or less
plenty of money is of no consequence; since the prices of commodities are always
proportioned to the plenty of money. . . . It is a maxim almost self-evident, that the
prices of everything depend on the proportion between commodities and money,
and that any considerable alteration on either has the same effect, either of height-
ening or lowering the price. (Writings, pp. 33, 41)

It is one thing to isolate the effects of money changes on the price level while
ignoring the concomitant effects on relative prices, but it is quite another to deny
that monetary shocks have any effect whatsoever on relative prices. Not all early
monetary theorists were naive in this regard. Cantillon (see chapter 4) saw quite
clearly the relative price effects of money, and Hume also worked out a domestic
adjustment mechanism that described the short-run as well as the long-run effects
of a change in money. He observed that an increase or decrease in money supply
impacted not only prices but also employment, output, and productivity (Mayer,
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146 Part II ■ The Classical Period

“David Hume and Monetarism,” p. 573). Finally, Gary Becker and William Baumol
found virtually no support for the view that early monetary theorists unequivocally
endorsed the “neutral money thesis.” They thereby concluded that the whole idea
was basically a “straw man” constructed for the convenience of neoclassical mone-
tary theorists (“The Classical Monetary Theory,” p. 376).

Classical Monetary Theory

Insofar as pure theory is concerned, most of the ground in monetary economics
was broken in the eighteenth century. The nineteenth century had little more to do
than adopt the monetary theory of Cantillon and Hume, which it did, sometimes
adding more confusion than light.
The Bullion Report of 1810 provides the best summary statement of the period’s
monetary thought. As the eighteenth century came to a close England’s attempt to
check the imperialistic designs of Napoleon put a strain on the British banking sys-
tem. In 1797 England stopped paying out funds in gold. At first Britain’s switch to
an inconvertible paper currency produced only a slight increase in the circulation of
British bank notes and little change in exchange rates. But beginning in 1808 the
increase in note issue began to make itself felt as prices climbed steadily and
exchange rates fell. Certain sectors of the public expressed their concern, and early
in 1810 Francis Horner, a member of Parliament, proposed in the House of Com-
mons that a committee be appointed to investigate the high price of bullion. A num-
ber of witnesses were called to testify, after which a report drawn up largely by
Horner, William Huskisson, and Henry Thornton was delivered to the Commons in
June. It was not debated until the following year, however, when its conclusions
were rejected.
The Bullion Report was the first official argument against discretionary mone-
tary policy. It maintained that an excessive amount of note issue influenced the
value of paper money and it attributed the high price of bullion (inflation) to this
cause. Paradoxically, and contrary to prevailing evidence, the report maintained
that Britain’s monetary problems were not caused by a lack of public confidence in
paper money. The committee’s stance in this regard may have been staked by
Thornton, who took a similar position in his book, An Enquiry into the Nature and
Effects of the Paper Credit of Great Britain (1802). By the end of the report, however,
the committee had practically reversed itself, for it concluded that the return to con-
vertibility was the only way to “effectively restore general confidence in the value of
the circulating medium of the kingdom” (Cannan, Paper Pound, p. 70).
The Bullion Report served as a pretext for David Ricardo’s (see chapter 7) early
pamphlets on monetary matters, which were published as commentaries on the
report. In 1809, Ricardo issued his “Treatise on the Price of Bullion,” and in 1816,
his “Proposals for an Economical and Secure Currency.” In both works Ricardo
reaffirmed the quantity theory of money and advocated a return to convertibility.
The concept of quantity completely dominated Ricardo’s monetary theory. He main-
tained that both declines and rises in the price level are regulated by changes in the
quantity of money. The idea of money as a store of value seems not to have occurred
to him. He makes no mention of the demand for money. He defined money in the
narrowest terms as a mere regulator of value. Ricardo either rejected or ignored the
idea of money as a link between the present and the future by virtue of its imperish-
ability and scarcity. His view of credit was also overly restrictive. For example,
unlike Cantillon, he did not think of checks as instruments of circulation but as a
means of economizing on the use of money. Since he did not regard checks as cur-
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Chapter 6 ■ Classical Economics (I) 147

rency instruments, they could not affect prices. Taken together, Ricardo’s ideas on
money had the effect of changing the quantity theory of money into the Ricardian
theory of money. His formulation was so one-sided and restrictive that it led many
later economists to regard with suspicion any theory of money or prices in which
quantity plays a part.
Published in 1823 after his death, Ricardo’s Plan of a National Bank furthered
the notion that paper money is an efficient substitute for metallic money because it
requires fewer resources to maintain. All that is necessary is to fix the quantity of
paper money once and for all. Ricardo devised a plan for this whereby the state
would be granted the monopoly issue of paper money and would only be able to
issue new notes against a backing of new gold from abroad. He introduced an ele-
ment of currency elasticity, however, by allowing the central bank to engage in
open-market operations: It would buy government securities when it desired to
increase the quantity of money and sell them when it desired to decrease the quan-
tity of money. These purchases and sales were to be determined by changes in the
exchange rate, which would reflect the relation between the value of paper money
and its metallic counterpart. Thus, it can be seen that the idea of such operations,
while sometimes regarded as the height of modernism, is in fact very old. Moreover,
it seems but a brief step from recognizing the legitimacy of such operations under a
gold standard to the idea of a fully managed, fiat currency.
John Stuart Mill (see chapter 8), who represented classical economics at the
height of its influence, also accepted the quantity theory but added qualifications to
it, some of which served to correct Ricardo’s excesses. For one thing, Mill recog-
nized (as did Cantillon and Hume) that the rigid conclusions of the quantity theory
were based on the assumption of an equiproportionate distribution of new money
relative to initial money holdings. Any other distribution would upset the strict pro-
portionality between money and prices. Furthermore, he believed that the strict
quantity theory held only for metallic money. He said:
When credit comes into play as a means of purchasing, distinct from money in
hand, we shall hereafter find that the connection between prices and the amount of
circulating medium is much less direct and intimate, and that such connection as
does exist no longer admits of so simple a mode of expression. (Principles, p. 495)

Mill also recognized that an increase in bank credit under conditions of full employ-
ment could drive the interest rate down.
By far the brightest light among the classical monetary theorists was Henry
Thornton, the British banker and parliamentarian mentioned above in connection
with the Bullion Report of 1810. Thornton made two important contributions to
monetary theory: (1) the distinction between the natural rate of interest and the
bank (loan) rate of interest, and (2) the doctrine of “forced saving.”
Regarding the first principle, Thornton correctly pointed out that the rate of
return on invested capital (determined by thrift and productivity) regulates the bank
interest rate on loans. If the bank rate is below the return on invested capital, com-
petition for business loans will drive the bank rate up; if the bank rate is above the
return on invested capital, the demand for bank loans will dry up, forcing banks to
lower rates in order to make loans. Therefore, the question of determining the opti-
mum quantity of bank loans depends on a comparison of the rate of return on capi-
tal (Thornton called this the “natural” rate) and the interest rate on bank loans. If
investment and savings are determined by the real forces of thrift and productivity,
then only a change in one or the other of these forces will shift the schedules
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148 Part II ■ The Classical Period

depicted in figure 6-1. In this model, SS represents the supply of savings as a func-
tion of the interest rate. Likewise, II represents the demand for investable funds
also as a function of the interest rate. The intersection of SS and II determines the
natural rate (r). In monetary equilibrium, the loan rate (i) will be equal to the natu-
ral rate. But if monetary equilibrium is disturbed by an increase in paper money, the
interest rate on bank loans will be driven down, say to i (because of an increase in
loanable funds). At the same time, SS and II would remain unchanged unless there
was a change in the real factors of thrift and productivity, which would not be
induced by a purely monetary phenomenon such as an increase in paper money.
Thus, a gap would be created
between the natural rate and the loan
Loan I S‫׳‬ rate, and this gap would give rise to an
rate insatiable demand for loans. The ensu-
ing inflationary pressure would be
eliminated only when the loan rate was
again raised to its former level at r. In
the process, however, prices would
i=r have climbed to a higher level. In this
way, the quantity theory is vindicated:
An increase in money leads to higher
i‫ < ׳‬r prices but not to a (long-run) change in
the real interest rate.
Thornton’s second contribution—
the doctrine of forced saving—recog-
I‫׳‬ nized that an increase in money brings
S
about an increase in capital as well as an
increase in prices. This would be the
Amount loaned
case as long as part of the new money
went to entrepreneurs. If entrepreneurs
Figure 6-1 At monetary equilibrium, the converted this new money into capital,
loan rate is equal to the natural rate (i = r). then output effects (forced capital accu-
With a monetary disturbance, the loan rate mulation) would accompany the higher
will diverge from the natural rate (i  r). prices associated with the increase in
money; hence money would not be
strictly neutral, as Hume maintained. In
addition, Thornton suggested the possibility that an increase in bank notes under
conditions of general unemployment would lead to an increase in output and employ-
ment rather than an increase in prices. Clearly, Thornton affirmed the neutrality of
money only as a long-run proposition, and then only under certain circumstances.

■ CLASSICAL ECONOMICS AND THE

GENERATORS OF TRADE AND VALUE
Classical economists, at least those writers reviewed in this chapter, placed little
or no emphasis on entrepreneurism, with the exception of Jeremy Bentham, who
was drawn into a discussion of the topic by his disagreement with Adam Smith on
the subject of usury. Smith’s advocacy of usury laws to prevent excessive financial
resources from reaching prodigals and projectors struck a discordant note with
Bentham, who considered it odd (as did many later economists) that the apostle of
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Chapter 6 ■ Classical Economics (I) 149

laissez-faire would advocate government intervention in financial markets. Smith

established his position in a discussion of “sober people” (his offhand reference to
entrepreneurs) in the Wealth of Nations (pp. 339–340):
The legal rate [of interest] . . . , though it ought to be somewhat above, ought not to
be much above, the lowest market rate. If the legal rate of interest in Great Britain,
for example, was fixed so high as eight or ten per cent the greater part of the
money which was to be lent, would be lent to prodigals and projectors, who alone
would be willing to give this high interest. Sober people, who will give for the use
of money no more than a part of what they are likely to make by the use of it,
would not venture into the competition. A great part of the capital of the country
would thus be kept out of the hands which were most likely to make a profitable
and advantageous use of it, and thrown into those which were most likely to waste
and destroy it. Where the legal interest, on the contrary, is fixed but a very little
above the lowest market rate, sober people are universally preferred as borrowers,
to prodigals and projectors. The person who lends money, gets nearly as much
interest from the former, as he dares to take from the latter, and his money is much
safer in the hands of the one set of people than in those of the other. A great part of
the capital of the country is thus thrown into the hands in which it is most likely to
be employed with advantage.

Bentham responded in his Defence of Usury (1787) that laws against usury limit
the overall quantity of capital loaned and borrowed, and act to keep away foreign
money from domestic capital markets. Both these effects tend to throttle the activi-
ties of successful entrepreneurs and impede economic development. He argued that
interest rate ceilings discriminate against entrepreneurs of new projects, because,
by their sheer novelty, such projects are more risky than those already proven prof-
itable by experience. Moreover, legal restrictions such as usury laws are powerless
to pick out bad projects from good ones.
Bentham pressed his argument further. He criticized Smith for underestimating
the role of talented individuals whose imagination and inventiveness have been
responsible for the progress of nations. He regarded innovation as the driving force
behind the development of humanity, and viewed the projector as innovator. Hence,
he reprimanded Smith for lumping prodigals and projectors together. For Bentham,
the distinguishing feature of the latter is that they depart from routine patterns of
behavior, break away from the common herd, discover new markets, find new
sources of supply, and improve existing products or lower costs of production. Ben-
tham asserted that to be a projector requires courage and genius (“Defence,” p. 177),
qualities to which we attribute “all those successive enterprizes by which arts and
manufactures have been brought from their original nothing to their present splen-
dor.” Projectors create utility, Bentham argued, by bringing about improvements,
whether such improvements “consist in the production of any new article adapted to
man’s use, or in meliorating the quality, or diminishing the expence, of any of those
which are already known to us. It falls, in short, upon every application of the human
powers, in which ingenuity stands in need of wealth for its assistant” (“Defence,” p.
170). The affinity of this view to Schumpeter’s (see chapter 23) is unmistakable.1
According to Pesciarelli (“Smith, Bentham”), Smith and Bentham each had a
different view of human progress and consequently a different conception of the

1
Pesciarelli (“Smith, Bentham,” p. 531) points out that four of the five new combinations that com-
prise innovation emphasized by Schumpeter in his Theory of Economic Development were previ-
ously identified by Bentham.
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150 Part II ■ The Classical Period

entrepreneur. Bentham’s entrepreneur is an exceptional individual, one above the

common herd—a minority in society. Smith’s entrepreneur is a common type—
widespread in society, one who exercises self-control in the exercise of economic
activity in order to receive the approbation of others. According to Pesciarelli, “The
prudent man unconsciously promotes the interest of society because he consciously
sets limits on the pursuit of his own interests. He is the visible promoter of the invis-
ible hand; he is the fulcrum but also the limit of Smith’s belief in the working of a
self-adjusting mechanism” (“Smith, Bentham,” pp. 534–535). Their divergent views
led to different conceptions of economic development. For Bentham economic
development is generated by discontinuous changes involving improvements (in the
broadest sense) and resulting in a nonlinear path of progress. Smith’s notion of eco-
nomic progress is slow, gradual, uniform, and not subject to sudden variations.
By supporting the cause of projectors, Bentham was to some extent pleading
his own case. He was a proponent of the Panopticon, the name he gave to his model
prison, an architectural and institutional innovation. His brother, Samuel, devised
the architectural idea behind the Panopticon, and it was first applied in Russia. This
new prison consisted of a circular design in which all the cells were arranged con-
centrically facing a central pavilion, which contained an inspector, or at most a
small number of inspectors. From his central vantage point the inspector could eas-
ily observe all the prisoners without being seen himself. Hidden by a system of
blinds, prison administrators, even outside visitors, could inspect the prisoners
while rendered invisible. Bentham thought that this would reform prisoners,
because under constant scrutiny they would lose the will and the power to do evil.
The idea was somewhat fanciful, and Bentham was never able to attract enough
backers to make his model prison a reality. The site that he proposed for his novel
construction was subsequently taken by the Tate Gallery in London.
Bentham’s innovation on his brother’s design was an administrative arrange-
ment that established management by contract. The success of this arrangement
was made to depend on the dynamic activities of the entrepreneur and the proper
structuring of economic incentives. Bentham believed that true reform would occur
in prisons only if the administrative plan simultaneously protected convicts against
the harshness of their warders, on the one hand, and society against the wasteful-
ness of administrators on the other. The choice, as he saw it, was between contract
management and trust management. Elie Halévy explained the differences between
these two administrative arrangements:
Contract-management is management by a man who treats with the government,
and takes charge of the convicts at so much a head and applies their time and
industry to his personal profit, as does a master with his apprentices. Trust-man-
agement is management by a single individual or by a committee, who keep up the
establishment at the public expense, and pay into the treasury the products of the
convicts’ work. (Growth, p. 84)

Bentham did not believe that trust management could establish the proper junc-
tion of interest and duty on the part of the entrepreneur because its success
depended on “public interest” as a motivating factor. Like Smith, Bentham had
much more confidence in individual self-interest as the spur to human action. But
he had no confidence in spontaneous order. The beauty of contract management
was that it brought about an artificial identity of interests between the public on the
one hand and the entrepreneur on the other. In Bentham’s scheme the entrepreneur
is an independent contractor who “purchases,” through competitive bid, the right to
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Chapter 6 ■ Classical Economics (I) 151

run the prison, thereby also acquiring title to whatever profits might be earned by
the application of convict labor. Such an entrepreneur-manager could maximize his
long-term gains by preserving the health and productivity of his worker-convicts. In
this manner public interest became entwined with private interest.
In 1787, Bentham completed the idea of contract management by an additional
administrative arrangement. He thought that life insurance offered an excellent
means of joining the interest of one man to the preservation of a number of men. He
therefore proposed that after consulting the appropriate mortality tables, the entre-
preneur (prison manager) should be given a fixed sum of money for each convict
due to die that year in prison, on condition that at the end of the year he must pay
back the same sum for each convict who had actually died in prison. The entrepre-
neur would keep the difference as profit, thus providing economic incentive to
lower the average mortality rate in his prison (Works, p. 53).
Bentham was virtually alone among British classical economists in his repeated
emphasis on the entrepreneur as an agent of economic progress. Through contract
management he recast the entrepreneur as government contractor, a franchisee
who undertakes financial risk in order to obtain an uncertain profit. He also explic-
itly linked entrepreneurship to invention. He promoted contract management as a
progressive (administrative) innovation that should therefore be rewarded accord-
ingly, no less than an inventor is rewarded for a successful (product) invention
(Works, p. 47).

■ CONCLUSION
The issues and concerns raised in this chapter combined to form the general
backdrop against which classical economic analysis was staged in the nineteenth
century. Self-interest became the dominant explanation of economic activity. Mal-
thus’s population theory entered economic analysis as an endogenous variable and
became an integral part of the theory of aggregate income distribution. Finally, the
quantity theory of money provided the analytical structure for understanding and
explaining changes in the aggregate price level. With the exception of population
theory, each of these propositions has remained within the corpus of mainstream
economics. Neoclassical economics reclassified population changes as exogenous
variables, that is, “outside” influences beyond the direct concern of the theorist.
Smith recognized the role of the entrepreneur in society, but did not take full advan-
tage of Cantillon's thoroughgoing insights regarding the centrality of the entrepre-
neur in the market economy. Whereupon, Bentham seized the opportunity to recast
the entrepreneur as government contractor, but his idea remained fallow: the next
generation of economists focused on other aspects of Smith's vision.

REFERENCES
Becker, Gary, and William Baumol. “The Classical Monetary Theory: The Outcome of the
Discussion,” Economica, n.s., vol. 19 (November 1952), pp. 355–376.
Bentham, Jeremy. “Defence of Usury,” in Jeremy Bentham’s Economic Writings, vol. 1.
W. Stark (ed.). London: George Allen & Unwin, 1952 [1787].
———. An Introduction to the Principles of Morals and Legislation. Oxford: The Claren-
don Press, 1879 [1789].
———. The Works of Jeremy Bentham, vol. 4. J. Bowring (ed.). New York: Russell & Rus-
sell, 1962 [1838–1843].
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Cannan, Edwin. The Paper Pound of 1797–1821. London: King, 1921.

Halévy, Elie. The Growth of Philosophic Radicalism, Mary Morris (trans.). London:
Faber, 1928.
Hume, David. David Hume: Writings on Economics, E. Rotwein (ed.). Madison: Univer-
sity of Wisconsin Press, 1970.
Keynes, J. M. The General Theory of Employment, Interest and Money. London: Macmil-
lan, 1936.
Malthus, T. R. An Essay on the Principle of Population and a Summary View of the Princi-
ple of Population, A. Flew (ed.). Baltimore: Penguin, 1970.
Mayer, Thomas. “David Hume and Monetarism,” Quarterly Journal of Economics, vol. 95
(August 1980), pp. 89–101.
Mill, J. S. Principles of Political Economy, W. J. Ashley (ed.). New York: A. M. Kelley,
1965 [1848].
Pesciarelli, Enzo. “Smith, Bentham and the Development of Contrasting Ideas on Entre-
preneurship,” History of Political Economy, vol. 21 (Fall 1989), pp. 521–536.
Rist, Charles. History of Monetary and Credit Theory, Jane Degras (trans.). New York:
Macmillan, 1940.
Smith, Adam. An Inquiry into the Nature and Causes of the Wealth of Nations, Edwin
Cannan (ed.). New York: Modern Library, 1937 [1776].

NOTES FOR FURTHER READING

General references to Bentham and his ideas include J. L. Stocks, Jeremy Bentham
(Manchester, England: Manchester University Press, 1933); C. W. Everett, Jeremy Ben-
tham (New York: Dell, 1966); D. J. Manning, The Mind of Jeremy Bentham (London:
Longmans, 1900); and Elie Halévy (see references). From the standpoint of economics,
perhaps the best original source on Bentham is his Economic Writings, 3 vols., W. Stark
(ed.) (London: George Allen & Unwin, 1952–1954). The Works of Jeremy Bentham, 11
vols., J. Bowring (ed.) (New York: Russell & Russell, 1962), is more complete but ranges
far beyond economics to morals, philosophy, and jurisprudence.
Two opposing views of Bentham’s felicific calculus are presented by Lionel Robbins,
Bentham in the Twentieth Century (London: University of London, Athlone Press, 1965);
and John Plamenatz, The English Utilitarians, 2d ed. (Oxford: Blackwell, 1958). On the
same subject, see W. C. Mitchell, “Bentham’s Felicific Calculus,” Political Science Quar-
terly, vol. 33 (June 1918), pp. 161–183, reprinted in The Backward Art of Spending Money
(New York: McGraw-Hill, 1937). Bentham’s welfare theory is examined by Antoinette
Baujard, “A Return to Bentham’s Felicific Calculus: From Moral Welfarism to Technical
Non-welfarism,” European Journal of the History of Economic Thought, vol. 16, (Sum-
mer 2009), pp. 431–453; and same author, “Collective Interest versus Individual Interest
in Bentham’s Felicific Calculus: Questioning Welfarism and Fairness,” European Journal
of the History of Economic Thought, vol. 17 (Fall 2010), pp. 607–634. Francophones
should consult Nathalie Sigot, Bentham et l’économique. Une histoire d’utilité (Paris:
Economica, 2001). On the impact of Bentham on the French Revolution and vice versa,
see two articles by Marco Guidi, “The French Revolution and the Creation of Ben-
thamism,” European Journal of the History of Economic Thought, vol. 16 (Summer 2009),
pp. 375–380; and same author, “Jeremy Bentham, the French Revolution and the Political
Economy of Representation (1788–1789),” European Journal of the History of Economic
Thought, vol. 17 (Fall 2010), pp. 579–605.
Other treatments include W. Stark, “Liberty and Equality, or: Jeremy Bentham as an
Economist,” Economic Journal, vol. 51 (April 1941), pp. 56–79, and vol. 56 (December
1946), pp. 583–608; Jacob Viner, “Bentham and J. S. Mill: The Utilitarian Background,”
American Economic Review, vol. 39 (March 1949), pp. 360–382; and T. W. Hutchison,
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Chapter 6 ■ Classical Economics (I) 153

“Bentham as an Economist,” Economic Journal, vol. 66 (June 1956), pp. 288–306. Also
interesting is P. A. Palmer’s “Benthamism in England and America,” American Political
Science Review, vol. 35 (October 1941), pp. 855–871; and E. G. West, “The Benthamites
as Educational Engineers: The Reputation and the Record,” History of Political Economy,
vol. 24 (Fall 1992), pp. 595–622.
The standard reference on Malthus is James Bonar, Malthus and His Work, 2d ed.
(New York: Macmillan, 1924). Another useful work is G. F. McCleary, The Malthusian
Population Theory (London: Faber, 1953). See also, W. Petersen, Malthus (Cambridge,
MA: Harvard University Press, 1979). James Bonar, C. R. Fay, and J. M. Keynes com-
bined efforts to write “A Commemoration of Thomas Robert Malthus,” Economic Jour-
nal, vol. 45 (June 1935), pp. 221–234, on the occasion of the centenary of Malthus’s
death. Keynes was also lavish in his praise of Malthus in his Essays in Biography (New
York: Norton, 1963). For other appraisals, see Lionel Robbins, “Malthus as an Econo-
mist,” Economic Journal, vol. 77 (June 1967), pp. 256–261; and R. L. Meek, “Malthus:
Yesterday and Today,” Science and Society, vol. 18 (Winter 1954), pp. 21–51.
Noteworthy treatments of Malthus’s population theory include S. M. Levin, “Mal-
thus’s Conception of the Checks to Population,” Human Biology, vol. 10 (1938), pp. 214–
234; same author, “Malthus and the Idea of Progress,” Journal of the History of Ideas, vol.
27 (January–March 1966), pp. 92–108; Kingsley Davis, “Malthus and the Theory of Popu-
lation,” in P. F. Lazarsfeld and M. Rosenberg (eds.), The Language of Social Research
(New York: Free Press, 1955); J. P. Hubel, “The Demographic Impact of the Old Poor
Law: More Reflections on Malthus,” Economic History Review, vol. 33 (August 1980), pp.
367–381; David Collard, “Malthus, Population, and the Generational Bargain,” History of
Political Economy, vol. 33 (Winter 2001), pp. 697–716; J. M. Pullen, “Malthus on the Doc-
trine of Proportion and the Concept of the Optimum,” Australian Economic Papers, vol.
21 (December 1982), pp. 270–285; same author, “Some New Information on the Rev. T. R.
Malthus,” History of Political Economy, vol. 19 (Spring 1987), pp. 127–140; P. Laslett,
“Gregory King, Robert Malthus and the Origins of English Social Realism,” Population
Studies, vol. 39 (November 1985), pp. 351–362; and two articles by Samuel Hollander:
“On Malthus’s Population Principle and Social Reform,” History of Political Economy,
vol. 18 (Summer 1986), pp. 187–235; and same author, “Malthus’s Vision of the Popula-
tion Problem in the Essay on Population,” Journal of the History of Economic Thought,
vol. 12 (Spring 1990), pp. 1–26. Elise S. Brezis and Warren Young, “The New Views on
Demographic Transition: A Reassessment of Malthus’s and Marx’s Approach to Popula-
tion,” The European Journal of the History of Economic Thought, vol. 10 (Spring 2003),
pp. 25–45, explore the divergence of views regarding the family and labor market caused
by different concepts of demographic transition. For an interesting account of where
Malthus’s population data came from, see Dean Peterson, “The Origins of Malthus’s
Data on Population: The Political and Religious Biases in the American Sources,” Jour-
nal of the History of Economic Thought, vol. 19 (Spring 1997), pp. 114–126.
Correspondence between Senior and Malthus on the subject of population can be
found in Nassau Senior’s Selected Writings on Economics (New York: Augustus Kelley,
1966). Russell Dean, “Owenism and the Malthusian Population Question, 1815–35,” His-
tory of Political Economy, vol. 27 (Fall 1995), pp. 579–597, draws a connection between
Malthus and the Utopian Socialist, Robert Owen (see chapter 11). To celebrate the bicen-
tennial of the first (anonymous) edition of Malthus’s Essay on the Principle of Popula-
tion, a mini-symposium was held that involved a number of Malthus scholars; see the
papers and commentary by A. M. C. Waterman, Samuel Hollander, J. M. Pullen, and
Donald Winch in History of Political Economy, vol. 30 (Summer 1998), pp. 289–363.
Monetary theory has an old and extensive history. On the preclassical period, see
Douglas Vickers, Studies in the Theory of Money: 1690–1776 (Philadelphia: Chilton,
1959); A. E. Monroe, Monetary Theory before Adam Smith (Cambridge, MA: Harvard
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154 Part II ■ The Classical Period

University Press, 1923); William Letwin, The Origins of Scientific Economics (Garden
City, NY: Doubleday, 1964), which contains a reprint of Locke’s early Manuscript on
Interest; and Jacob Viner, Studies in the Theory of International Trade (New York:
Harper & Row, 1937). F. Cesarano, “Monetary Theory in Ferdinando Galiani’s Della
Moneta,” History of Political Economy, vol. 8 (Autumn 1976), pp. 380–399, provides
insights into the early Italian contribution; Locke and Hume are the subjects of A. H.
Leigh, “John Locke and the Quantity Theory of Money,” History of Political Economy, vol.
6 (Summer 1974), pp. 200–219; J. A. Weymark, “Money and Locke’s Theory of Property,”
History of Political Economy, vol. 12 (Summer 1980), pp. 282–292; M. I. Duke, “David
Hume and Monetary Adjustment,” History of Political Economy, vol. 11 (Winter 1979),
pp. 572–587; and T. Mayer, “David Hume and Monetarism” (see references).
John Law (1671–1729), famous for his association with financial “bubbles,” was one
of the most controversial monetary theorists of all times. Economic historian Antoin
Murphy has demonstrated how Law understood that monetary expansion could increase
output and employment in an economy that is characterized by widespread unemploy-
ment. Moreover, Law was in full control of an understanding of the quantity theory, the
circular flow of income, and a staple of microeconomic theory—the law of one price. See
A. E. Murphy, ed., John Law’s Essay on a Land Bank (Dublin: Aeon Publishing, 1994).
Adam Smith’s ideas on money and monetary theory, which have not been aired in
this chapter, are the subject of David Laidler’s “Adam Smith as a Monetary Economist,”
Canadian Journal of Economics, vol. 14 (May 1981), pp. 185–200. C. N. Chen, “Bimetal-
lism: Theory and Controversy in Perspective,” History of Political Economy, vol. 4
(Spring 1972), pp. 89–112, discusses bimetallism within a general-equilibrium frame-
work. An important nineteenth-century monetary economist was Thomas Tooke, whose
ideas on the subject are explored by Carlo Panico, “Thomas Tooke and the Monetary
Thought of Classical Economics,” European Journal of the History of Economic Thought,
vol. 19 (Fall 2012), pp. 679–683; Matthew Smith, “Thomas Tooke on the Bullionist Con-
troversies,” European Journal of the History of Economic Thought, vol. 15 (Winter 2008),
pp. 49–84; and Arie Arnon, “The Transformation of Thomas Tooke’s Monetary Theory
Reconsidered,” History of Political Economy, vol. 16 (Summer 1984), pp. 311–326.
For an examination of classical monetary theory in light of contemporary debate
over the desirability of reinstituting the gold standard, see David Glasner, “A Reinterpre-
tation of Classical Monetary Theory,” Southern Economic Journal, vol. 52 (July 1985),
pp. 46–67. See also, same author, “The Real-Bills Doctrine in Light of the Law of Reflux,”
History of Political Economy, vol. 24 (Winter 1992), pp. 867–894; and again same author,
“Classical Monetary Theory and the Quantity Theory,” History of Political Economy, vol.
32 (Spring 2000), pp. 39–59. Daniel Besomi, “Paper Money and National Distress: Wil-
liam Huskisson and the Early Theories of Credit, Speculation and Crises,” The European
Journal of the History of Economic Thought, vol. 17 (Winter 2010), pp. 49–85, explores
the ideas of the third author of the Bullion Report of 1810.
For general surveys of the field of classical monetary theory, consult Charles Rist,
History of Monetary and Credit Theory (see references), and F. W. Fetter, Development of
British Monetary Orthodoxy, 1797–1875 (Cambridge, MA: Harvard University Press,
1965). See also Wilfredo Santiago-Valiente, “Historical Background of the Classical Mon-
etary Theory and the ‘Real-Bills’ Banking Tradition,” History of Political Economy, vol. 20
(Spring 1988), pp. 43–63. David Ricardo’s contributions to the theory of money and
banking are scrutinized by R. S. Sayers, “Ricardo’s Views on Monetary Questions,”
Quarterly Journal of Economics, vol. 67 (February 1953), pp. 30–49; by J. C. W. Ahiakpor,
“Ricardo on Money: The Operational Significance of the Non-neutrality of Money in the
Short-Run,” History of Political Economy, vol. 17 (Spring 1985), pp. 17–30; and by A.
Aaron, “Banking Between the Invisible and Visible Hands: A Reinterpretation of
Ricardo’s Place within the Classical School,” Oxford Economic Papers, vol. 39 (June
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Chapter 6 ■ Classical Economics (I) 155

1987), pp. 268–281, who argues that Ricardo’s ideas paved the way for central banking.
Jerome de Boyer des Roches, “Cause and Effect in the Gold Points Mechanism: A Criti-
cism of Ricardo’s Criticism of Thornton,” Economic Journal of the History of Economic
Thought, vol. 14 (Winter 2007), pp. 25–53, juxtaposes the ideas of two leading lights of
the era.
G. S. Tavlas, “Some Initial Formulations of the Monetary Growth Rule,” History of
Political Economy, vol. 9 (Winter 1977), pp. 535–547, traces the evolution of the mone-
tary rule to Jeremy Bentham and Henry Thornton. Neil T. Skaggs explores the ideas of
yet another monetary writer of the day, in “John Fullarton’s Law of Reflux and Central
Bank Policy,” History of Political Economy, vol. 23 (Fall 1991), pp. 457–480. But of all the
early theorists, Henry Thornton was the most able. His major work, An Enquiry into the
Nature and Effects of the Paper Credit of Great Britain [1802], has been reprinted, edited
by F. A. Hayek (New York: Farrar & Rinehart, 1939). For more on Thornton, see Hayek,
“Note on the Development of the Doctrine of ‘Forced Saving,’” Quarterly Journal of Eco-
nomics, vol. 47 (November 1932), pp. 123–133; and R. L. Hetzel, “Henry Thornton: Sem-
inal Monetary Theorist and Father of the Modern Central Bank,” Federal Reserve Bank
of Richmond Economic Review, vol. 73 (July/August 1987), pp. 3–16. Jean-Stephane
Mesonnier, “Interest Rate Gaps and Monetary Policy in the Work of Henry Thornton:
Beyond a Retrospective Wicksellian Reading,” European Journal of the History of Eco-
nomic Thought, vol. 14 (Fall 2007), pp. 657–680, claims that Thornton’s analyses offer a
framework for regulating the value of money through adjustments to the bank rate. See
also, Heinz D. Kurz, “The Genesis of Macroeconomics: New Ideas from Sir William Petty
to Henry Thornton,” European Journal of the History of Economic Thought, vol. 19 (Fall
2012), pp. 683–686.
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Classical Economics (II)

The Ricardian System and Its Critics

We have seen that Adam Smith established the foundations of classical value theory
and the first scientifically rigorous theory of economic growth. The Wealth of
Nations fired the imagination of its readers, and the “new” field of political econ-
omy became a serious and timely topic of interest and debate. The pivotal nature of
Smith’s work is that it represented both a culmination of previous developments
and a catalyst for future advances and refinements. One of those persons inspired
by Smith to stretch the new science was David Ricardo (1772–1823).
Ricardo was born in London, the third of seventeen children of a Jewish immi-
grant stockbroker. With but a modicum of commercial education, he parlayed a
modest stake into a sizable fortune by making shrewd investments in securities and
real estate. In 1799, while on vacation and bored, he picked up Adam Smith’s
Wealth of Nations and soon became engrossed in it. Thus began a serious intellec-
tual hobby. Ten years later he began writing pamphlets and arguing economic ques-
tions in the press, an avocation that morphed into a consuming intellectual pursuit.
What ensured Ricardo’s place in the history of economics was his ability to forge a
general analytic system that yielded sweeping conclusions based on relatively few,
basic principles. His “system” was a monument to the efficacy of deductive reason-
ing. He founded his analysis on three fundamental ideas that he borrowed from
other writers: (1) classical rent theory, (2) Malthus’s population principle, and (3)
the wages-fund doctrine. Since the second and third propositions have already been
examined in earlier chapters, we shall establish the first before proceeding to an
explanation of the full Ricardian system.

■ THE CLASSICAL DOCTRINE OF LAND RENT

The theory of rent played a pivotal role in the development of classical macro-
economics and in its “generalized” form is an important cog in contemporary eco-
nomics. What began as a theory of land rent evolved into a more general theory of
any (unearned) surplus that emanates from exclusive ownership or privilege. The
generalized notion of economic rent, which is sometimes indistinguishable from the
related concept of profit, will be explored again later, but it has already been used as
an interpretive device in our treatment of mercantilism (see chapter 3). The “gener-
alized” notion of rent emerged as a direct consequence of Ricardo’s treatment.

156
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Chapter 7 ■ Classical Economics (II) 157

Ricardo regarded rent as value in excess of real production—something caused by

incident of ownership rather than by fundamental economic value imparted by free
and equal trade. However, we should not get ahead of ourselves in this regard.
The first tract on land rent that could be called “classical” in the sense used here
was written by James Anderson (1739–1808), a Scottish farmer and inventor. In
1777, Anderson published a pamphlet that clearly stated in embryonic form the prin-
ciple of diminishing returns. This was followed by the more or less simultaneous and
independent discoveries of basically the same idea in 1815 by Sir Edward West, T. R.
Malthus, Robert Torrens, and David Ricardo. We knowingly overlook the differences
between these writers in order to concentrate on a somewhat unified theory of rent
that typifies the classical period. We focus on Ricardo even though he disclaimed
originality and acknowledged his debt to both Malthus and West in this regard.
From Anderson to Ricardo, the immediate impetus for the development of the
classical doctrine of rent was the Corn Laws controversy, which arose during the
Napoleonic wars. Napoleon’s embargo on British ports effectively kept foreign
grain out of England, forcing British farmers to increase production of domestic
grain in order to feed the population. Because costs of production were higher in
England than abroad, the price of British grain rose. Between 1790 and 1810, Brit-
ish corn prices rose 18 percent per year on average. Not surprisingly land rents also
increased; so much so landlords developed a vested interest in continuing to restrict
grain imports. Parliament accommodated the landlords by passing protective legis-
lation in the form of the Corn Laws of 1815. This very issue of agricultural protec-
tionism and its effects on income distribution and economic growth stimulated the
development of classical rent theory.
Malthus defined land rent as “that portion of the value of the whole produce
which remains to the owner of land, after all the outgoings [i.e., costs] belonging to
its cultivation, of whatever kind, have been paid, including the profits of the capital
employed, estimated according to the usual and ordinary rate of the profits of agri-
cultural stock at the time being” (Inquiry, p. 179). He understood that land rent is
tied to the value of land’s output, and that value is determined by the normal and
necessary costs of production. But according to Malthus, rent does not affect agri-
cultural prices in the same way as other costs. He said:
The price of produce in every progressive country must be just about equal to the
cost of production on land of the poorest quality actually in use; or to the cost of
raising additional produce on old land, which yields only the usual returns of agri-
cultural stock with little or no rent. (Inquiry, pp. 205–206)

In this passage Malthus established that there is a no-rent margin of production, at

which the price of produce will cover all of the costs of land excluding rent. As
regards this price, Malthus claimed:
It is quite obvious that the price cannot be less; or such land would not be culti-
vated, nor such capital employed. Nor can it ever much exceed this price, because
the poor land progressively taken into cultivation, yields at first little or no rent;
and because it will always answer to any farmer who can command capital, to lay
it out on his land, if the additional produce resulting from it will fully repay the
profits of his stock, although it yields nothing to the landlord.
It follows then, that the price of raw produce, in reference to the whole quantity
raised, is sold at the natural or necessary price, that is, at the price necessary to
obtain the actual amount of produce, although by far the largest part is sold at a
price very much above that which is necessary to its production. (Inquiry, p. 206)
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158 Part II ■ The Classical Period

In other words, what Malthus was saying is that rent does not exist at the mar-
gin (i.e., on the worst land in cultivation) and arises on better lands only when
poorer lands are brought into use. Ricardo was more explicit about this critical
point. Describing land rent as “payment for the original and indestructible powers
of the soil,” he wrote:
If all land had the same properties, if it were unlimited in quantity and uniform in
quality, no charge could be made for its use, unless where it possessed peculiar
advantages of situation. It is only, then, because land is not unlimited in quantity
and uniform in quality, and because in the progress of population, land of an infe-
rior quality, or less advantageously situated, is called into cultivation, that rent is
ever paid for the use of it. When in the progress of society, land of the second
degree of fertility is taken into cultivation, rent immediately commences on that of
the first quality, and the amount of that rent will depend on the difference in the
quality of these two portions of land. (Works, I, p. 70)

In this way, Ricardo identified rent at the extensive margin of cultivation (i.e., when
more land is taken into cultivation). But he also recognized that because of dimin-
ishing returns on land of the same quality rent also arises on the intensive margin.
It often, and indeed commonly happens, that before . . . the inferior lands are culti-
vated, capital can be employed more productively on those lands which are
already in cultivation. It may perhaps be found, that by doubling the original capi-
tal employed on . . . [this land], though the produce will not be doubled . . . it may
be increased . . . [by another magnitude], and that this quantity exceeds what
could be obtained by employing the same capital, on [other] land.
In such case, capital will be preferably employed on the old land, and will
equally create a rent; for rent is always the difference between the produce
obtained by the employment of two equal quantities of capital and labour. (Works,
I, p. 71. Emphasis added)

By restricting the importation of grain the Corn Laws forced more intensive and
extensive land cultivation in England. Ricardo showed that diminishing returns
existed at both the intensive margin (more inputs applied to the same land) and the
extensive margin (the same inputs applied to different types of land). Hence, agri-
cultural protectionism raises land rents. Table 7-1 illustrates Ricardo’s theory in
numerical terms.
The first column in the table shows combined units of labor and capital, which
are assumed to be added to production in fixed proportions (e.g., one man, one
shovel). Lands of different fertility (but fixed amounts) are represented by different
grades, such that No. 1 represents land of the highest fertility and Nos. 2 to 5 repre-
sent lands of lesser fertility, in descending order. The marginal product (MP) of cap-
ital and labor is the change in total product resulting from the addition of one more
capital/labor input to production. In conformance with the law of diminishing
returns, marginal product declines as more inputs are added to each type of land.
As conventionally defined, and in this context, diminishing returns to labor occur
only on the intensive margin. But experience also tells us that total product declines
as production moves out to poorer lands. At the extensive margin, decreasing total
output is due to differences in fertility.
Using Ricardo’s definition of rent as “the difference between the produce
obtained by the employment of two equal quantities of capital and labour,” we may
identify from table 7-1 the real rents paid at both the intensive and extensive mar-
gins. Thus, if only No. 1 land was cultivated, a real rent of 10 bushels would arise on
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Chapter 7 ■ Classical Economics (II) 159

Table 7-1 Ricardo’s Rent Theory Illustrated

Capital Total and Marginal Products to Types of Land

and Labor No. 1 (MP1) No. 2 (MP2) No. 3 (MO3) No. 4 (MP4) No. 5 (MP5)
0 0 0 0 0 0
1 100 (100) 90 (90) 80 (80) 70 (70) 60 (60)
2 190 (90) 170 (80) 150 (70) 130 (60) 110 (50)
3 270 (80) 240 (70) 210 (60) 180 (50) 150 (40)
4 340 (70) 300 (60) 260 (50) 220 (40) 180 (30)
5 400 (60) 350 (50) 300 (40) 250 (30) 200 (20)

it after the introduction of the second “dose” of capital and labor (100 – 90 = 10).
Introduction of a third dose of capital and labor on No. 1 land would subsequently
raise total rent on that land to 30 bushels (100 – 80 + 90 – 80 = 30), and so on. At the
extensive margin, rent is the difference between output on the best land and the
worst land in cultivation for equal amounts of capital and labor applied to each.
Thus, if No. 1, No. 2, and No. 3 land each receive three doses of capital and labor,
rent on No. 1 land would be 60 bushels (270 – 210 = 60), and rent on No. 2 land
would be 30 bushels (240 – 210 = 30). As always, there would be no rent at the mar-
gin of the last land in use.
Once information is known about the prices of inputs and outputs in table 7-1
the optimum allocation of total expenditures among types of land can be deduced.
Suppose the price per bushel of corn was $1, so that the numbers in table 7-1 can be
converted to revenues merely by placing dollar signs in front of them. It can be
deduced from the table that if the price of each dose of capital and labor (per pro-
duction period) was $100, production would take place only on No. 1 land. But if the
price of the input was $60 per dose, it would be profitable to extend production to
the point where marginal revenue (i.e., MP × price of corn) equals marginal input
cost ($60). This would entail extending production to No. 5 land, employing five
units of capital and labor on No. 1 land, four on No. 2, three on No. 3, two on No. 4,
and one on No. 5 (to complete your understanding, verify this in table 7-1).
It should be pointed out that this theory explains agricultural rents only. In the
classical theory of rent, it was assumed that land had no alternative uses. Either it
was used to produce a homogenous commodity called “corn,” or it lay fallow. Since
the problem attacked by Malthus and Ricardo was that of determining the distribu-
tion of total output between rent versus wages and profits, they ignored the manu-
facturing sector, where rents were (assumed) negligible, and concentrated fully on
agriculture, which was the major sector of the economy. Their theory allowed capi-
tal and labor to be perfectly mobile, not only between parcels of land but also
between manufacturing and agriculture. Land, of course, was fixed in place and
assumed merely to be brought into or out of agricultural production when economic
circumstances warranted.

■ THE RICARDIAN SYSTEM

For reasons that will be explained momentarily, Ricardo had a far greater
impact on the future direction of economic theory than Malthus, but each played an
important part in the development of the other’s analytical system. Malthus saw a
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160 Part II ■ The Classical Period

close and direct link between the general level of wages and the price of corn. He
argued in favor of the Corn Laws because he felt that free importation of grain
would drive down domestic grain prices (and wages) and bring on a depression.
Ricardo saw a close and inverse link between wages and profits. He argued against
the Corn Laws because he believed they would drive wages up and profits down.
Lower profits meant less capital accumulation and a threat to economic growth. In
answering Malthus, Ricardo constructed an ingenious argument, built on the labor
theory of value and the classical theory of rent.

The Labor Theory of Value: Empirical or Analytical?

Few misconceptions in the history of economics have been perpetuated as
extensively as the simplistic version of Ricardo’s theory of value. The interpretation
that persists despite attempts to expunge it is a strict uncompromising theory that
actually derives little or no support from Ricardo’s writings. Ironically, it was not
Ricardo’s critics (e.g., Malthus and Samuel Bailey) but his ardent disciples who
were mostly responsible for the misinterpretation. We prefer to characterize
Ricardo’s theory of value as a “real-cost” theory, which emphasizes the cost of labor
but not to the exclusion of all other costs.
The central problem posed by Ricardo in his Principles of Political Economy
and Taxation was how changes occur in the relative, aggregate-income shares of
land, labor, and capital and what effect these changes have on capital accumulation
and economic growth. The determination of rent was an integral part of this prob-
lem, but every theory of income distribution must rest on a theory of value, and
Ricardo did not find Smith’s value theory congenial to his particular concerns. Spe-
cifically, he pointed out certain deficiencies in Smith’s doctrine of natural value.
Smith argued that a rise in the price of one factor (e.g., wages) would increase the
price of goods produced by that factor (e.g., labor). While this view explained
changes in nominal prices, Ricardo found it incapable of explaining changes in rela-
tive prices.
Ricardo believed that Smith’s restriction of the labor theory of value to a “prim-
itive economy” was unnecessary because with certain modifications it provided the
best general explanation of relative prices. To him the relation between value and
labor time expended in production was straightforward: “Every increase of the
quantity of labor must augment the value of that commodity on which it is exer-
cised, as every diminution must lower it” (Works, I, p. 13). Although Ricardo never
wavered from this basic position, he nevertheless added several qualifications
required to make the theory more realistic. In the process, his theory of value
ceased to be a pure labor theory. However, Ricardo consistently sidestepped his own
qualifications in subsequent analysis and policy and made use of a simple labor the-
ory in order to reach general conclusions.
The first exception to the above rule that Ricardo allowed was in the case of
nonreproducible goods. “There are some commodities,” he maintained, “the value
of which is determined by scarcity alone. No labour can increase the quantity of
such goods, and therefore their value cannot be lowered by an increased supply.”
The value of a Picasso painting or a bottle of a rare, exclusive vintage wine, in
Ricardo’s words, “is wholly independent of the quantity of labor originally neces-
sary to produce them, and varies with the varying wealth and inclinations of those
who are desirous to possess them.” In a quantitative sense, however, this exception
was unimportant to Ricardo, because “these commodities . . . form a very small part
of the mass of commodities daily exchanged in the market” (Works, I, p. 12).
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Chapter 7 ■ Classical Economics (II) 161

Ricardo pressed more important qualifications on the labor theory of value

regarding the role and importance of capital, which he treated as “indirect” or
“embodied” labor. Following Smith, Ricardo distinguished between fixed and circu-
lating capital. Circulating capital “is rapidly perishable and requires to be frequently
reproduced,” whereas fixed capital “is of slow consumption.” Value will therefore
increase as the ratio of fixed to circulating capital increases and as the durability of
capital increases. Ricardo explained:
Suppose two men employ one hundred men each for a year in the construction of
two machines, and another man employs the same number of men in cultivating
corn, each of the machines at the end of the year will be of the same value as the
corn, for they will each be produced by the same quantity of labour. Suppose one
of the owners of one of the machines to employ it, with the assistance of one hun-
dred men, the following year in making cloth, and the owner of the other machine
to employ his also, with the assistance likewise of one hundred men, in making
cotton goods, while the farmer continues to employ one hundred men as before in
the cultivation of corn. During the second year they will all have employed the
same quantity of labour, but the goods and machine together of the clothier, and
also of the cotton manufacturer, will be the result of the labour of two hundred
men, employed for a year; or rather, of the labour of one hundred men employed
for two years; whereas the corn will be produced by the labour of one hundred
men for one year, consequently if the corn be of the value of 500£ the machine and
cloth of the clothier together, ought to be of the value of 1000£ and the machine
and cotton goods of the cotton manufacturer, ought to be also of twice the value of
the corn. But they will be of more than twice the value of corn, for the profit on the
clothier’s and cotton manufacturer’s capital the first year has been added to their
capitals, while that of the farmer has been expanded and enjoyed. On account then
of the different degrees of durability of their capitals, or, which is the same thing,
on account of the amount of time which must elapse before one set of commodities
can be brought to market, they will be valuable, not exactly in proportion to the
quantity of labour bestowed on them . . . but something more, to compensate for
the greater length of time which must elapse before the most valuable can be
brought to market. (Works, I, pp. 33–34)

We see from this passage that Ricardo recognized the two ways in which capital
affects the value of goods: (1) capital used up in production constitutes an addition
to the value of the product, and (2) capital employed per unit of time must be com-
pensated (at the going rate of interest). Ricardo’s insistence that time as well as
labor is an important element of value constituted a genuine contribution to eco-
nomics, for which he subsequently received little, if any, credit.
From an analytical standpoint, then, it is clear that Ricardo based value on the
real costs of labor and capital. On conceptual grounds his theory differed from
Smith’s in that it excluded rent from costs. But on empirical grounds Ricardo
argued that the relative quantities of labor used in production are the major deter-
minants of relative market values. In terms of analytical method, Ricardo master-
fully employed abstract, deductive reasoning. He preferred to base the principles of
his analytical system on a single, dominant variable rather than on a number of
lesser ones of dubious effect. To this end, he warned his readers (after noting the
above effects of capital on value): “In the subsequent part of this work, though I
shall occasionally refer to this cause of variation [i.e., time], I shall consider all the
great variations which take place in the relative value of commodities to be pro-
duced by the greater or less quantity of labour which may be required from time to
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162 Part II ■ The Classical Period

time to produce them” (Works, I, pp. 36–37). Whatever fault one finds with
Ricardo’s analysis, he cannot be accused of neglecting or hiding his assumptions.
Despite its rigor, Ricardo’s value theory contained several deficiencies. In the
first place, he did not deal adequately with qualitative differences in labor. Ricardo
assumed that wage adjustments for qualitative differences in labor would occur in
the marketplace and that once determined, these differences would vary little. Since
he was seeking a measure of market value in the first place, this is a circular argu-
ment. In the second place, the exclusion of rent from costs can be justified only if
land has no alternative uses (which Ricardo assumed, but unrealistically). More-
over, the Ricardian theory of value limited the influence of market demand to non-
reproducible goods, which constitute a small number of goods traded in daily
exchanges. In a more technical sense, Ricardo’s theory was inadequate in the case
where goods are not produced subject to constant average costs of production.

The Nature of Economic Progress: Toward the Stationary State

The theory of value, reduced to Ricardo’s level of simplification, plus the theory
of rent, provided the key to resolving the central problem of income distribution. It
was, of course, necessary to relate the theory of value to the theory of prices in a
complex economy. Ricardo did this by relating market price to the costs of produc-
tion in the marginal (no-rent) firm. He noted:
The exchangeable value of all commodities, whether they be manufactured, or the
produce of the mines, or the produce of the land, is always regulated, not by the
less quantity of labour that will suffice for their production under circumstances
highly favorable, and exclusively enjoyed by those who have peculiar facilities of
production; but by the greater quantity of labour necessarily bestowed on their
production by those who continue to produce them under the most unfavorable
circumstances. (Works, I, p. 73)

Ricardo recognized that there is no perfect measure of value, since any mea-
sure chosen varies with fluctuations in wages and profit rates. We noted earlier that
different durabilities of capital, and different ratios of fixed to circulating capital,
will affect market prices differently if wages change relative to profits. Thus,
Ricardo devised an analytical gimmick—the “average firm”—in which both the ratio
of capital to labor and capital durability are assumed equal to the economy average.
Armed with these tools Ricardo set about solving the problem of income distribu-
tion and its changes over time.
Table 7-2 illustrates the nature of income distribution on no-rent land. Suppose
that three doses of labor and capital on a given farm produce 270 bushels of corn
per year. By virtue of being advanced from the wages-fund, the cost of each labor
input constitutes an expenditure of circulating capital, and through annual depreci-
ation the cost of each capital input constitutes an expenditure of fixed capital. By
Ricardo’s definition total profits each production period are equal to total revenues
minus the sum of fixed and circulating capital expenditures. Now assume that the
price per bushel of corn is $1, that the wage rate per worker is 10 bushels of corn
and $10 of other necessities (the latter can be given in dollar terms because they are
assumed to be produced under conditions of constant cost), and that the annual
depreciation per unit of capital is $10. Profits on No. 1 land would be calculated as
shown in table 7-2.
If all land were equally fertile, profits could continue at the same rate. But as
capital and population increase, cultivation must be extended to No. 2 land, where
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Chapter 7 ■ Classical Economics (II) 163

three doses of labor and capital pro-

duce only 240 bushels of corn. Techni-
Table 7-2 Income Distribution on
cally, more labor and capital are now No-Rent Land
needed to produce the same output on Value of produce = 270 × $1 = $270
No. 2 land as on No. 1 land. Therefore, Wage rate = (10 × $1) + $10 = 20
the price of corn must rise to $1.125 Wage bill = 3 × $20 = 60
(i.e., 270/240 × $1.00 = $1.125). In Depreciation = 3 × $10 = 30
Ricardo’s system, this increase in the Total profit = $270 – $90 = 180
price of corn has the effect of raising Rent = 0
money wages and aggregate rents and
of lowering profits. The ensuing distri-
butional pattern is illustrated in table 7-3.
Table 7-3 demonstrates what we learned earlier—that rent arises on No. 1 land
only when production with the same amount of capital and labor is extended to No.
2 land. The calculation of rent is, as Ricardo indicated, the value of the initial firm’s
output less the value of the marginal firm’s output. This illustration can be extended
to additional firms (i.e., types of land), of course, but the distributional effects of
economic growth are already clear. Increased agricultural production leads to
higher money wages but the same real wages. Invoking Malthus’s population prin-
ciple, Ricardo argued that wage rates would be at subsistence levels in the long run.
On the other hand, higher nominal wage rates and increasing aggregate rents place
a two-way squeeze on profits. Competition tends to equalize profits for all firms in a
given industry, but profits are inevitably diminished as output increases. Eventually
a minimum profit rate is reached, at which point additional capital accumulation
and new investment ceases. Ricardo called this point the “stationary state.” Theoret-
ically, this minimum profit rate is zero; practically, however, it may be slightly above
this level.
The process that Ricardo described may therefore be restated as a paradox: The
logical result of economic growth is stagnation! Within the context of Ricardo’s ana-
lytical system, this gloomy prospect is unassailable, but only because Ricardo
uncritically accepted Malthus’s population principle and did not allow for techno-
logical progress. In its final version the stationary state arises in the following man-
ner: The average wage rate is determined by the proportion of fixed and circulating
capital (i.e., the wages-fund) to the population. As long as profits are positive, the
capital stock will increase, and the increased demand for labor caused by a growing
wages-fund will temporarily increase the average wage rate. But when wage rates
rise above subsistence, population increases. A larger population requires a greater
food supply, so that, barring imports, cultivation must be extended to inferior lands.
As cultivation pushes outward, aggregate rents increase and profits fall, moving the
economy toward a long-run equilibrium, or stationary state.

Table 7-3 Income Distribution as Cultivation Expands

No. 1 Land No. 2 Land
Value of product 270 × $1.125 = $303.75 240 × $1.125 = $270.00
Wage rate (10 × $1.125) + $10 = 21.25 (10 × $1.125) + $10 = 21.25
Wage bill 3 × $21.25 = 63.75 3 × $21.25 = 63.75
Depreciation 3 × $10 = 30.00 3 × $10 = 30.00
Profits $303.75 – 93.75 – 33.7 = 176.25 $270 – 93.75 = 176.25
Rent = 33.75 = 0
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164 Part II ■ The Classical Period

Shortly after the appearance of Ricardo’s Principles, a number of writers rallied

to his doctrine and method. Perhaps the most able of these writers was John Ram-
say McCulloch, a frequent contributor to The Edinburgh Review. McCulloch was
joined by James Mill, the father of John Stuart (see chapter 8), and Thomas
DeQuincey; together they formed a tight-knit band of Ricardians. But they were
opposed by Malthus, now a member of the Royal Society and professor of political
economy at the East India Company College, and Nassau Senior, who became the
first professor of political economy at Oxford University in 1825.

■ THE RICARDO–MALTHUS CORRESPONDENCE

From their first meeting in 1811, there was little of fundamental importance in
political economy that Malthus and Ricardo agreed on, a fact revealed in their
lengthy correspondence with each other over two decades. Many disagreements
were minor, but in 1815 their respective investigations of the Corn Laws put them
on opposite sides of the free-trade issue.

The Corn Laws Controversy

Ricardo viewed rent as a socially unnecessary payment (i.e., a current payment
made but not necessary to bring forth the available supply of land). Thus, when
land rents rise (as Ricardo argued they would under the Corn Laws) they do so at
the expense of profits. Because Ricardo saw profit as the engine that drove eco-
nomic progress, he perceived in the Corn Laws a threat to economic growth, and
therefore he argued vigorously in favor of free trade.
Malthus, however, argued that since workers’ purchasing power was closely
tied to the price of corn, higher corn prices benefitted workers.1 As we noted earlier,
it was common practice for classical writers on political economy to speak of “corn
wages” in an attempt to describe real purchasing power. Therefore, a crucial ques-
tion in the Corn Laws debate was whether or not higher corn prices meant higher
real wages. Ricardo thought not, and he argued accordingly. Malthus took the oppo-
site stand and argued in favor of the Corn Laws.
Their antagonism on this and other points of economics constituted merely the
first of many famous disagreements that would ensue among future economists.
George Bernard Shaw wryly expressed a common frustration among noneconomists
when he said: “If you took all the economists in the world and laid them end to end,
they still wouldn’t reach a conclusion.” Are there no permanent truths in economics?
Obviously, economists do disagree. And, as in the case of Malthus and Ricardo,
disagreement is often based on interpretation, method, or policy rather than on the-
oretical principles. We have already seen that Malthus and Ricardo agreed on the
basic theory of rent. Yet, debates on interpretation, method, and policy leave consid-
erable room for value judgments, which in turn reduce the frequency of unanimity
among participants of the debate.

Economic Method
One of the substantive disagreements between Malthus and Ricardo concerned
economic method, as demonstrated in the Malthus–Ricardo debate on exchange
value. Recall that Ricardo treated costs as the determinant of value but strove for

1
For clarification on this point, see Grampp, “Malthus on Money Wages and Welfare.”
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Chapter 7 ■ Classical Economics (II) 165

simplification to the point that he treated a single variable (i.e., labor) as the only
significant one. Malthus, on the other hand, less prone to abstractions, was more
interested in economic principles “with a view to their practical application.” He
therefore insisted on incorporating Ricardo’s cost analysis into a supply-and-
demand framework. In retrospect it is hard to fault Malthus on this matter, but
Ricardo’s theory nevertheless dominated. The reasons for this are not entirely
clear. There were two aspects of the value question that Malthus addressed. The
first was an explanation of exchange value; the second was an explanation of the
measure of value.
According to Malthus, the principle of supply and demand determines what
Adam Smith called “natural price” as well as market price. He defined demand as
the will combined with the power to purchase; and supply as the quantity of com-
modities for sale combined with the intention to sell them (Principles, p. 61). “But
however great this will and these means may be among the demanders of a com-
modity,” Malthus argued, “none of them will be disposed to give a high price for it, if
they can obtain it at a low one; and as long as the means and competition of the sell-
ers continue to bring the quantity wanted to market at a low price, the real intensity
of the demand will not show itself” (Principles, p. 63). Malthus then correctly con-
cluded that the causes of an increased price are “an increase in the number, wants,
and means of the demanders, or a deficiency in the supply; and the causes which
lower the price are a diminution in the number, wants, and means of the demand-
ers, or an increased abundance in its supply” (Principles, p. 64).
As sensible as this now seems, Ricardo rejected Malthus’s argument because he
understood the term “demand” to mean something different. In fact, a comparative
study of the works of both authors shows that Malthus and Ricardo often talked to
each other at cross-purposes and that the whole confusion on the role of demand
and supply could have been cleared up if they had each understood the difference
between a change in quantity demanded (i.e., movement along a demand schedule)
and a change in demand (i.e., shift of the schedule). The notion of supply and
demand schedules, however, had not yet found its way, explicitly, into economic
analysis. For his part, Ricardo viewed Malthus’s efforts as an undue concern with
trivia. In two letters to Malthus, he wrote:
If I am too theoretical (which I really believe is the case), you I think are too practi-
cal. There are so many combinations and so many operating causes in political
economy that there is a great danger in appealing to experience in favor of a par-
ticular doctrine, unless we are sure that all the causes of variation are seen and
their effects duly estimated. (Works, VI, p. 295)

Our differences may in some respects, I think, be ascribed to your considering my

book as more practical than I intended it to be. My object was to elucidate princi-
ples, and to do this I imagined strong cases that I might show the operation of
those principles. (Works, VIII, p. 184)

Their differences were not trivial. Ricardo’s theory of value was oversimplified
and long-run in its outlook, but it was the cornerstone on which his entire analytical
system stood. If abandoned, the whole theoretical structure would collapse. Under-
standably, Ricardo resisted vehemently.
Compared with his views on the nature of exchange value, Malthus’s ideas on
the measure of value underwent many changes through his successive works. We
are left with the impression that he was not quite sure of his mind on this subject, a
failing that intruded on other parts of his economics as well. In the final analysis,
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166 Part II ■ The Classical Period

this wavering aspect of Malthus’s thought presented a weak defense against the
onslaught of Ricardo’s relentless logic. In the end, it may explain why Ricardo, not
Malthus, had the greater influence on British classical economics.

Say’s Law and Underconsumption

Disagreement over value theory bled into other analytical departures. Malthus
challenged Ricardo’s theory of profits as well. A major corollary of Ricardo’s analy-
sis was that the cost of producing food controls wages (directly) and profits (indi-
rectly through the effect on wages). Higher corn prices lead to higher money wages
and falling profits in the Ricardian system. Malthus, however, would not concede
that higher food prices were the only or even the major reason for lower profits.
Invoking Smith’s distinction between “productive” and “unproductive” consump-
tion, Malthus singled out insufficient aggregate demand as a cause of weak invest-
ment incentives and consequent reduction of profits.
Malthus’s argument runs as follows: Aggregate demand is segregated into neces-
sities and luxuries. That part of production devoted to the “necessities of life” creates
its own demand, whereas the demand for that part devoted to “convenience and lux-
uries” depends on the consumption habits of the “nonproductive” elements of society
(e.g., the landlords). Since the landlords do not always spend their incomes like other
groups in society (i.e., on consumption goods), it is possible that an oversupply of
commodities might exist. What is required to guarantee a steady expansion of output
and to eliminate an oversupply of goods is a sufficient level of “effectual demand,”
and this, Malthus thought, would not be guaranteed by the mere importation of
cheap food. Malthus presented his concept of effectual demand in a letter to Ricardo:
Effectual demand consists of two elements, the power and will to purchase. The
power to purchase may perhaps be represented correctly by the produce of the
country whether small or great; but the will to purchase will always be the greatest,
the smaller the produce compared with the population, and the more scantily the
wants of society are supplied. When capital is abundant it is not easy to find new
objects sufficiently in demand. In a country with little comparative capital the value
of yearly produce may very rapidly increase from the greatness of demand. In short
I by no means think that the power to purchase necessarily involves a proportionate
will to purchase, and I cannot agree . . . that in reference to a nation, supply can
never exceed demand. A nation must certainly have the power of purchasing all that
it produces, but I can easily conceive it not to have the will. (Works, VI, pp. 131–132)

The classical idea that Malthus rejected in this passage took its name from a
French expositor most closely connected with the notion that “supply creates its
own demand,” Jean-Baptiste Say. This short phrase, popularly known as Say’s Law,
does not do justice to the fundamental principle exposited by Say. More correctly,
Say’s Law maintains that in the process of production exactly enough income is
generated to purchase the output produced, and it follows that—barring hoarding—
all the income so generated will be spent to purchase that output. Few notions were
so completely assimilated into the mainstream of classical economics as Say’s Law.
Malthus’s criticism of Say’s Law therefore indelibly marked him as a maverick
among economists, a fact that nevertheless endeared him to that well-known pio-
neer of modern macroeconomic theory, and fellow graduate of Cambridge Univer-
sity, John Maynard Keynes (see chapter 21).
Although Malthus’s assault on Say’s Law had little effect on orthodox econom-
ics before Keynes, it contains at least one major insight into the savings-investment
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Chapter 7 ■ Classical Economics (II) 167

decisions that so concerned Keynes at a later date. The idea of an optimum propen-
sity to save is inherent in Malthus’s thought and is affirmed in the following passage
from his Principles:
If consumption exceed production, the capital of a country must be diminished,
and its wealth must be gradually destroyed from its want of power to produce; if
production be in great excess above consumption, the motive to accumulate and
produce must cease from the want of an effectual demand. . . . The two extremes
are obvious; and it follows that there must be some intermediate point, though the
resources of political economy may not be able to ascertain it, where, taking into
consideration both the power to produce and the will to consume, the encourage-
ment to the increase of wealth is the greatest. (Principles, p. 7)

In other words, Malthus recognized that consumption expenditures represent

demand and that savings represent potential demand (through investment), but that
the latter by no means guarantee effective demand. In more modern jargon, ex post
saving is always equal to ex post investment (a fact that Malthus apparently
accepted), but ex ante saving need not always equal ex ante investment.2 Thus, Mal-
thus argued the possibility of a general glut.
Malthus’s criticism of Say’s Law was important in two respects, one immediate,
the other postponed. The immediate effect was a challenge to Ricardo’s theory of
profit. The delayed effect was a stimulus to Keynesian analysis. In its own time,
Malthus’s analysis of aggregate saving had little impact, since he neither specified
the market forces capable of maintaining the optimum rate of saving nor analyzed
the purely monetary causes of overproduction. As a consequence, Say’s Law was
successfully defended by Ricardo and his followers, and it subsequently became an
entrenched proposition of classical economics. (On the spread of economic theory,
see the box, The Force of Ideas: “Marketing” Classical Economics.)

The Force of Ideas: Marketing Classical Economics

Classical economics, at least as presented by the great theorists reviewed in this chapter,
was admittedly difficult to digest for the average reader. British academics and intellectuals
might be expected to have mastered at least some of the arguments of the classical writers
(especially Malthus’s ideas on population), but literacy was still limited in nineteenth-century
England and Europe, and books were expensive enough to be beyond the reach of the aver-
age worker and perhaps even some elements of the middle class. Learning the principles of
political economy, then (and now), was not an easy task. Several writers tried to break
through this wall of difficulty. James Mill’s Elements of Political Economy (1812) and Jane Mar-
cet’s Conversations on Political Economy (1816) were both pitched to audiences of young mid-
dle-class readers.
Apparently the most successful of the popularizers of political economy was Harriet Mar-
tineau, the daughter of a Norwich textile manufacturer. An accomplished journalist and nov-
elist, she pitched economics to working-class readers in a series of twenty-five novelettes of
about 125 pages each, appearing monthly between 1832 and 1834. Like her contemporary
writers of “serious fiction,” Martineau had to support herself and her dependents in the peri-
odical press. So she wrote for weighty journals, such as the Edinburgh Review and the Westmin-

(continued)

2
This point is explained further in the Keynesian context in chap. 21.
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168 Part II ■ The Classical Period

ster Review, and published more than 1,600 articles in London’s Daily News. Her enormously
popular Illustrations of Political Economy (1832) was a great success and brought her financial
independence in an era when women writers were uncommon, especially in the area of polit-
ical economy. She followed her early success with another best seller, Poor Laws and Paupers
Illustrated (1834).
Martineau mastered (at a workable level at least) the elements of political economy and
was intent on providing contemporary illustrations of difficult concepts. Earlier treatments, as
she pointed out in the preface to her first book, did “not give us what we want—the science
in a familiar, practical form. They give us its history; they give us its philosophy; but we want
its picture” (Illustrations, p. xi). Martineau’s “pictures” consisted of fictional parables dealing
with poverty, welfare policies also known as the Poor Law reforms, unionization, general rela-
tions between capital and labor, the factory acts, working conditions for women and children,
and health. (Each book was followed with an enumeration of the principles to be learned
from the story.)
Life in the Wilds (Book 1 of Illustrations) deals with a “primitive” community with plenty of
labor but scarce capital. As capital accumulates in the community, little by little, the society
begins to prosper. Martineau explains how, far from being antithetical to the interests of labor,
capital cooperates with labor and creates leisure, opportunity, and, most of all, self-reliance.
As she points out, “Labour was that of which there was the greatest deficiency in the commu-
nity; and the means of shortening and easing labour was therefore the most valuable present
which could be conferred” (Illustrations, p. 110).
Some of Martineau’s most effective short novels also dealt with such “noneconomic” top-
ics as the abolition of slavery (which she staunchly favored) and the status of women (she was
an early “feminist”). Nevertheless, she held fast to the position that the application of classical
economic principles would and could bring about a well-ordered society. In The Hamlets
(1836) Martineau drew a clear lesson: Poor Laws welfare reforms proposed by Senior, Malthus,
and the other classical writers deserved support because they redirected incentives toward
industriousness and self-reliance. In other essays she emphasized the futility of labor unions in
permanently increasing the wages of labor, and the negative impact of “factory legislation” on
the fate of working women and children.
Martineau had her critics both in and out of the ranks of contemporary economists. The
Romantics, who generally viewed capitalism and the Industrial Revolution with disdain, were
particularly virulent in their criticisms of her suggestions for helping the poor. Charles Dickens,
who agreed with Martineau on some matters, such as the abolition of slavery and the educa-
tion of the deaf and blind, frequently attacked her economic views. The flavor of Dickens’s
antagonism is captured in his comment about Martineau’s treatment of factory accidents.
Dickens claimed it was impossible, as Martineau had attempted, “to justify, by arithmetic, a
thing unjustifiable by any code of morals.”* John Stuart Mill was another critic, alleging that
Martineau had reduced laissez-faire to “an absurdity.” Their dispute might have been “per-
sonal.” At the height of her popularity, Martineau was selling 10,000 copies of her books per
month, whereas in four years Mill sold only 3,000 copies of his Principles of Political Economy.†
Martineau clearly had an impact on the spread of political economy and on the society in
which she lived. Always a champion of education as the primary means of bringing the poor
out of poverty, she firmly rejected the idea that prosperity and a more just income distribu-
tion should be left to government. No one held a firmer belief that desirable social change
could be brought about with a widespread inculcation of the principles of political economy.
*Quoted in Gillian Thomas, Harriet Martineau, p. 82.
†
See Margaret G. O’Donnell, “Harriet Martineau,” pp. 62–63.
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Chapter 7 ■ Classical Economics (II) 169

Ricardo and Entrepreneurship

Ricardo was content to relegate the entrepreneur to a minor role (actually,
almost no role). Fritz Redlich (“Toward the Understanding,” p. 715) called this an
“unfortunate legacy,” because denying a central and pivotal role to the entrepreneur
suggests that profit (meaning any return beyond mere replacement of capital) is not
legitimate in a capitalist economy. By emphasizing the importance of capital and
labor to the neglect of entrepreneurship Ricardo passed the “unfortunate legacy” on
to Karl Marx, who extolled labor above all else, and created the capitalist bogey
who sucks profit from the “industrious” people of the economy.
Classical economics in general had very little to say about the origin and nature
of investment opportunities. This is especially true of Ricardo; he assumed that cap-
italists act rationally in seeking to maximize profits, but he ignored the trouble and
risk involved in investing. Although he did not fall into the trap of assuming that all
investment was profitable, like most classical economists, Ricardo treated innova-
tion as mainly external to the economic system. Moreover, his theory of the station-
ary state supposes that as wealth increases, eventually all further opportunities for
profitable investment disappear. This stands in marked contrast to the Schumpete-
rian view (chapter 23), which enlarged the scope and breadth of entrepreneurial
activity and made it a centerpiece of his theory of economic development.
Ricardo failed entirely to pursue the suggestion of his contemporary, Jean-Bap-
tiste Say, who formalized the term entrepreneur and defined it meaningfully some
fourteen years before Ricardo’s Principles appeared. At least one version of Say’s
work was available to Ricardo in English translation during this fourteen-year
period. Yet, as Arthur Cole (“An Approach,” p. 3) noted, “Not merely is the term
[entrepreneur] itself absent in Ricardo’s writings, but no concept of business lead-
ers as agents of change (other than as shadowy bearers of technological improve-
ments) is embraced in his treatment of economic principles.” It is noteworthy that in
the correspondence between Say and Ricardo, neither the nature nor the role of the
entrepreneur is once mentioned, their usual discussion focusing instead on the
topic of value. Entrepreneurship was thriving as Ricardo was writing his Principles
to be sure, and a system of capitalism was well underway. But the pivotal roles of
investment by capitalist-entrepreneurs was yet to be clearly described.

■ NASSAU SENIOR AND THE EMERGENCE OF “SCIENTIFIC” ECONOMICS

In the nineteenth century three Englishmen established the main stepping-
stones between Adam Smith and John Stuart Mill: Ricardo, Malthus, and Nassau
Senior. Born in 1790 in Berkshire, Senior was the eldest son of the Vicar of Durn-
ford. He was educated at Eton and later at Oxford, where he obtained a law degree
in 1815, the same year Malthus, West, Ricardo, and Torrens published their pam-
phlets on rent. Law practice did not suit Senior’s temperament or ambitions, how-
ever, and after some postgraduate work in political economy, he was named to the
first endowed chair of political economy at Oxford in 1825. Appointed to various
governmental commissions in the 1830s and 1840s, Senior was instrumental in
shaping legislative reforms in education, factory conditions, and the Poor Laws (see
chapter 9).
Chief among his published works was An Outline of the Science of Political
Economy, first printed in 1836 and revised by Senior in 1850. Although criticized for
lack of organization and consistency, Senior’s Outline is an important milestone in
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170 Part II ■ The Classical Period

the history of economics, not only for its criticism of Ricardian economics but also
for its original contributions. Senior’s contributions fall under two major headings:
(1) his formulation of the scope and method of economic inquiry and (2) his impor-
tant modifications of the Ricardian theories of value and costs.

Senior on Economic Method

An unexciting but necessary stage of development of any academic discipline is
the identification and organization of basic principles, along axiomatic lines, to
form a genuinely scientific framework. Senior was totally engrossed in this project,
which qualifies him, in the view of Joseph Schumpeter, as the first “pure theorist” in
economics. Certainly his subjective originality and his tireless attempts to unify and
systematize economic theory entitle Senior to a more prominent place in the history
of economics than he is generally accorded.
Senior began his Outline by defining the boundaries of economic inquiry. Politi-
cal economy, he avowed, is “the science which treats of the nature, the production,
and the distribution of wealth.” He warned that other writers used the term “politi-
cal economy” in a much wider sense—to include government, for example—but that
the outcome of their efforts had been decidedly unscientific. He strove to make eco-
nomic inquiry essentially positive (i.e., devoid of value judgments), because the
province of the economist is “not happiness, but wealth” (Outline, p. 2). He affirmed
his methodological position in no uncertain terms:
[The economist’s] premises consist of a very few general propositions, the result of
observation, or consciousness, and scarcely requiring proof, or even formal state-
ment, which almost every man, as soon as he hears them, admits as familiar to his
thoughts, or at least as included in his previous knowledge: and his inferences are
nearly as general, and, if he has reasoned correctly, as certain, as his premises.
But his conclusions, whatever be their generality and their truth, do not autho-
rize him in adding a single syllable of advice. That privilege belongs to the writer
or statesman who has considered all the causes which may promote or impede the
general welfare of those whom he addresses, not to the theorist who has consid-
ered only one, though among the most important, of those causes. The business of
a Political Economist is neither to recommend nor to dissuade, but to state general
principles, which it is fatal to neglect, but neither advisable, nor perhaps practica-
ble, to use as the sole, or even the principal, guides in the actual conduct of
affairs. . . . To decide in each case how far these conclusions are to be acted upon,
belong to the act of government, an act to which Political Economy is only one of
many subservient Sciences. (Outline, pp. 2–3)

The tendency of too many writers to confound the science of economics with the art
of government was responsible, in Senior’s view, for the unfavorable public preju-
dices in his day against political economy and political economists. Essentially, he
believed economics should be an exercise in reasoning, not a fact-gathering expedi-
tion. He was prepared to state the facts on which the general principles of econom-
ics rest in a few sentences, “and indeed in a very few words.” The difficulty of
mastering economics, he said, lay not in observing and stating these few proposi-
tions but in reasoning from them correctly.
Those “few sentences” to which Senior alluded took the form of four basic pos-
tulates, or axioms, on which economic theory is based. Here are Senior’s postulates
in his own words (Outline, p. 26):
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Chapter 7 ■ Classical Economics (II) 171

1. that every man desires to obtain additional wealth with as little sacrifice as possible
2. that the population of the world, or in other words, the number of persons inhab-
iting it, is limited only by a fear of a deficiency of those articles of wealth which
the habits of the individuals of each class of its inhabitants lead them to require
3. that the powers of labour, and of the other instruments which produce wealth, may
be indefinitely increased by using their products as the means of further production
4. that, agricultural skill remaining the same, additional labour employed on the
land within a given district produces in general a less proportionate return, or,
in other words, that though, with every increase of the labour bestowed, the
aggregate return is increased, the increase of the return is not in proportion to
the increase of the labour

The second and fourth postulates present, respectively, Senior’s guarded affir-
mation of Malthus’s population principle and the classic law of diminishing returns,
but not without important modifications of each. Senior was willing to accept Mal-
thus’s population principle in the abstract, but he had little faith in its empirical
validity. He added a check that has gained relevance with the passage of time. Indi-
viduals' desire to better their position in the world is at least as important as their
sexual desire. By not realizing this, Senior argued, Malthus overlooked a strong,
additional check to the growth of population.
Another reason for Senior’s optimism on the population question as opposed to
Malthus’s pessimism relates to his interpretation of the laws of increasing and
decreasing returns in industry and agriculture. In his fourth postulate, Senior gave
precise expression (in the modern sense) to the law of decreasing returns by adding
the proviso that technology must be held constant. Ricardo undoubtedly recognized
that the validity of this law rests on the constant-technology assumption, but he
never explicitly stated it. In explaining his fourth postulate, however, Senior voiced
his conviction that the normal state of affairs in industry is increasing returns. He
based this view on the questionable assumption that labor skills tend to increase in
some sort of relation to increased population and capital, a view that runs counter
to the orthodox Malthusian doctrine but that was nevertheless accepted by a sur-
prisingly large number of writers in Senior’s day.
Without downplaying the significance of Senior’s modifications to the popula-
tion principle, we turn our attention to his first and third postulates, because in the
first instance Senior improved the classical and Ricardian theories of exchange
value, and in the second he advanced a much improved theory of capital and interest.

Value and Costs

In terms of its impact on the subsequent development of economic theory,
Senior’s modifications of the Ricardian theory of value were more important than
those introduced by Malthus. His major departures from Ricardo include: (1) substi-
tution of a utility theory of value for Ricardo’s “labor theory,” and (2) refinements of
Ricardo’s production theory in light of monopolistic business practices.
Several Continental writers in the first half of the nineteenth century (e.g., Say
and Condillac) perceived the fact that utility is more than a mere condition of value,
as Ricardo had stated; it is a cause of value. However, they were unable to do any-
thing analytically with this notion before Jules Dupuit, in 1844, presented his con-
cept of marginal utility (see chapter 13); so utility theory accomplished nothing
until much later. Senior did better than others in this respect, and was recognized
by Léon Walras (see chapter 17), a paragon of neoclassical value theory, for his
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172 Part II ■ The Classical Period

insightful treatment of utility and value. The chief adversary of the labor theory of
value in the nineteenth century was always the supply-and-demand theory. Malthus,
for example, went right to it and concentrated on it exclusively. Senior also adopted
it, but in general he handled the demand-supply discussion better than Malthus.
The higher flight of Senior’s discussion was due to his recognition not only of the
importance of relative utility but also of the interdependence between relative utility
and relative scarcity.
Some economists think that Senior spent an inordinate amount of time and
effort on definitions. Yet, his attention to detail has to be put in proper context. Par-
ticularly in the early stages of its development most of the confusion and disagree-
ments in economics arose from imprecise or ambiguous use of terms. Sciences
progress when they are able to narrow their focus and concentrate their attention
on precise phenomena. Having earlier defined economics as the science of wealth,
Senior took the next logical step, defining wealth, value, and utility. Wealth, he
affirmed, includes all goods and services that (1) possess utility, (2) are relatively
scarce, and (3) are capable of being transferred. This definition is at once broader
than Adam Smith’s—because it includes services as well as physical products—and
very modern: It recognizes the pivotal importance of both demand factors (utility)
and supply factors (scarcity).
Senior also “modernized” the definitions of value and utility. Value is “that qual-
ity in anything which fits it to be given and received in exchange; or in other words,
to be lent or sold, hired or purchased.” And utility “denotes no intrinsic quality in
the things we call useful; it merely expresses their relations to the pains and plea-
sures of mankind” (Outline, p. 7). Finally, Senior clearly set forth the notion of
diminishing marginal utility and its relation to relative scarcity in his discussion of
humans’ love of variety in consumption:
Not only are there limits to the pleasure which commodities of any given class can
afford, but the pleasure diminishes in a rapidly increasing ratio long before those
limits are reached. Two articles of the same kind will seldom afford twice the plea-
sure of one, and still less will ten give five times the pleasure of two. In proportion,
therefore, as any article is abundant, the number of those who are provided with it,
and do not wish, or wish but little, to increase their provision, is likely to be great;
and so far as they are concerned, the additional supply loses all, or nearly all, its
utility. (Outline, pp. 11–12)

What stands out in this passage is Senior’s clear recognition that both utility
and scarcity together determine value. Surely Senior had in his grasp the key to
unlock the classical paradox of value! But he didn’t take the vital next step, which
was to apply mathematical reasoning (i.e., differential calculus) to the matter. For
the most part, British economists were either unable or unwilling to go this far. But
in France, Antoine-Augustin Cournot and Jules Dupuit embarked on this path
before very long (see chapter 13).
Monopoly. Ricardo’s influence on Senior was considerable, even though they
differed on several key points. Senior maintained, for instance, that “of the three
conditions of value—utility, transferableness, and limitation of supply—the last is by
far the most important” (Outline, p. 11). His discussion of value was therefore col-
ored by a concern for those forces that affect costs of production and consequently
limit supply. Chief among these forces was monopoly. Senior perceived monopoly
in relative, not absolute, terms. He distinguished four degrees of monopoly and
explained how each impacts supply (Outline, pp. 103–105):
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Chapter 7 ■ Classical Economics (II) 173

1. A monopoly in which the producer does not have exclusive producing powers
but in which he has exclusive facilities that he may use indefinitely with equal or
increasing advantage (as in the case where exclusive patents are necessary to
produce a certain product)
2. A monopoly in which the monopolist is the only producer but in which, because
of the uniqueness of the product, he cannot increase the amount of his produce
(as in the case of certain French vineyards, where increased output is impossible
without destroying the unique properties of the wine produced)
3. A monopoly in which the monopolist is the only producer and can increase indef-
initely, with equal or increasing advantage, the amount of his produce (as in the
case of book publishing, where the product is protected by copyright, and the rel-
ative cost of publication diminishes as the number of copies published increases)
4. A monopoly in which the monopolist is not the only producer but has peculiar
facilities which diminish and ultimately disappear as output is increased (as in
most cases of economic production, including agriculture, where land or fertility
must ultimately run out as output is increased)
These four cases are important because the effect of each case on production
costs either establishes or does not establish an upper and lower limit to market
price and therefore opens the way for varying degrees of demand to determine
price. In the first case, for example, market price comes closer to the seller’s cost of
production than any other monopolized commodity, since competition among sell-
ers without the exclusive facility (e.g., patent) will tend to keep prices in line with
their costs of production. A patent monopolist may, of course, enjoy pure profits but
is effectively barred from selling at a price above the nonpatented competition,
although the actual price will depend on conditions of demand as well as on condi-
tions of production.
The second case is that of completely inelastic supply, in which there is no
upper limit on price except the level of demand, while the lower limit to price is
equal to costs of production. The third case is the same as the first except that since
the monopoly is absolute, there is no upper limit to price save that imposed by
demand. The fourth case is the most general. It includes production under condi-
tions of differential advantage and diminishing returns. This is really the Ricardian
case, except that in Senior’s formulation price depends not only on the production
costs of the marginal firm but also on demand.
One has only to read Cournot (see chapter 13) and Senior side by side to realize
how loose the theory of monopoly was before 1838. Nevertheless, by classifying the
major cases of value the way he did, Senior succeeded in reconciling Ricardo’s anal-
ysis with the supply-demand theory. A review of Senior’s four cases reveals that
cost of production is the controlling criterion in some cases and that demand is the
controlling criterion in others, but the two are always interacting. It is true that
Senior, having gotten this far, did not push the supply-demand analysis as far as he
could have in evaluating the factors of production, but he certainly illuminated the
path for those who came after him.
Capital and Interest. Senior also extended Ricardo’s real-cost analysis by add-
ing the cost of “abstinence” to the cost of labor. In the somewhat paradoxical state-
ment of his third postulate, Senior hinted at the fact that in the long run roundabout
methods of production are more productive than direct methods, a fact that the Aus-
trian economist Eugen Böhm-Bawerk (see chapter 14) clarified a generation later.
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174 Part II ■ The Classical Period

“Roundaboutness” means postponing production of consumption goods by using

labor and raw materials first to produce capital goods, which are then used along
with additional labor and raw materials to produce more consumer goods than
could have been produced with first producing the capital to be used with labor and
raw materials. A classic example of increased efficiency from roundabout produc-
tion is illustrated in the story of the fictional hero Robinson Crusoe. You undoubt-
edly know the story. Finding himself shipwrecked and stranded on a deserted island,
Crusoe faces the economic necessity of survival. Let us assume that Crusoe’s island
contains an abundant supply of fish. The most direct method of production that Cru-
soe can adopt is to catch fish by hand, which is a clumsy means of production. But if
he postponed fishing long enough to hew a pole and fashion a hook or make a bow
and arrow (crude forms of capital goods), he would catch more fish at a faster rate
than would be possible using the most direct, but least efficient, method.
The example is simple, but it illustrates a sophisticated principle, namely that
capital accumulation requires postponement of consumption, or what Senior clum-
sily called, “abstinence.” Abstinence is the name Senior gave to conduct necessary
to generate profit. He meant it to convey two ideas: “Abstinence expresses both the
act of abstaining from the unproductive use of capital, and also the similar conduct
of the man who devotes his labour to the production of remote rather than immedi-
ate results” (Outline, p. 89). In this regard, abstinence constitutes a precondition for
the production of “intermediate” goods (i.e., capital), and it provides the key to the
third postulate: “that the powers of labour, and of the other instruments which pro-
duce wealth, may be indefinitely increased by using their products as the means of
further production” (Outline, p. 26). Since human nature prefers instant gratifica-
tion to delayed satisfaction, people are not inclined to postpone consumption unless
they are compensated. The postponement of consumption is “abstinence;” the
reward for this sacrifice is “interest.”
Senior’s description of interest as a return to abstinence was his most original
contribution to economics, and it soon became assimilated into the mainstream of
classical economic theory. In this regard he surpassed Smith, Malthus, and Ricardo,
and his analysis of capital and interest stood as the most complete in British eco-
nomics until William Stanley Jevons (see chapter 15) made further improvements.
A retrospective view of Senior’s performance must conclude, therefore, that in the
process of formulating modifications of Ricardo’s analysis, he made important con-
tributions to the corpus of economic theory.

■ THE SUPREMACY OF RICARDIAN ECONOMICS

It is curious that although very little of pure Ricardian analysis remains in the
mainstream of modern economics and very much of the analysis of his early critics
does, Ricardo’s influence on other economic writers was a dominant force through
much of the nineteenth century. Always in a numerical minority, Ricardo and the
Ricardians nevertheless carried the day in early British economics. Every major
British economist of the nineteenth century, including John Stuart Mill (see chapter
8) and Alfred Marshall (see chapter 16), paid tribute to Ricardo, even while rejecting
or reshaping some of his fundamental ideas.
The reasons for this phenomenon had as much to do with the nature of the
Ricardian opposition as with the aggressiveness of Ricardo’s disciples. Malthus’s
writings, for example, belie a theoretical looseness and an intellectual vacillation
that undermined their effectiveness as a logical alternative to Ricardo’s. Even Senior,
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Chapter 7 ■ Classical Economics (II) 175

whose method and analysis were more rigid than Malthus’s, darted and swerved on
a number of minor theoretical points. Moreover, Senior’s failure to connect his mod-
ifications of Ricardo with the question of income distribution probably had an unfa-
vorable effect on the ability of those contributions to attract a wider audience. As a
result, Ricardo was in the peculiar position of being able to use impeccable logic to
defend his system and simultaneously destroy opposing arguments, which were
based on mere common sense rather than rigorous logic. The fact that Ricardo could
do so convincingly and endear himself to other economists tells us much about his
vast intellectual powers and also about the kind of people economists admire.
Moreover, there is something very positive about Ricardo’s performance that
must be noted, or else we fail to grasp what economics, as a science, is really about.
The point is simply this: Ricardo’s tightly reasoned analytical system—unmatched
by his predecessors or his contemporaries—contained a methodological consistency
that was of paramount importance to the successful development of a fledgling sci-
ence. In retrospect it seems that Senior’s overall performance and his specific
attempts to give economics a scientific foundation, would have been improbable, if
not impossible, without the prior performance of Ricardo. Hence, apart from the
content of contemporary economics, Ricardo made a permanent and indelible con-
tribution to the method economists follow in their intellectual pursuits.

■ THE ELEGANT DYNAMICS OF THE CLASSICAL SYSTEM

We now borrow a pedagogic tool from William J. Baumol (Economic Dynamics,
chap. 2) in order to summarize the essence of classical economics in fairly concise
terms. Those British economists who lived and wrote after Malthus and before Mill
constitute the group whose economics are summarized here. A synthesis is all that
is attempted, since there certainly was no unanimity of views on all economic topics
among members of the classical school.
The major concern of the classical writers was, of course, economic growth, or
the transition from a progressive state to a stationary state. The less desirable sta-
tionary state was viewed as the inevitable outcome of economic history. Classical
(Ricardian) economic analysis was, therefore, long-run, based on a few simple
(sometimes questionable) assumptions from which sweeping generalizations about
economic development were made. Key elements in the process were (1) the Mal-
thusian population principle, (2) the principle of diminishing returns in agriculture,
and (3) the wages-fund doctrine.
The fundamental argument of classical growth theory follows simple lines. In an
expanding economy, the level of investment and wages is high and growing. Capital
accumulation proceeds apace. But high wages induce population growth, and the
consequent pressures on the food supply—coupled with a fixed, existing quantity of
fertile land—lead to diminishing returns to capital and labor in agriculture and the
necessity of utilizing inferior grades of land to feed a growing population. Conse-
quently, costs of production increase and profits fall. Falling profits cause a decrease
in accumulation and investment as the stationary state is approached. Actual arrival
of the stationary state could be postponed indefinitely through a series of highly pro-
ductive inventions, but no classical writer denied its inevitability in the long run.
The process just described may be viewed graphically as a movement toward
the stationary state over time—decades or perhaps even centuries. Consider figure
7-1. The size of the working population is measured on the horizontal axis. The ver-
tical axis in figure 7-1 measures total product and total wages (in real terms) but
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176 Part II ■ The Classical Period

Total wage
and total S
Y
product Y‫׳‬
after rent
Y*
Y

Y2
S3
Y1
S2

S1

O P1 P2 P3 P* P Working
population

Figure 7-1 At population OP1 total output is Y1P1 and total wages are S1P1. Profits of
Y1S1 will increase the demand for labor and push wages up to Y1P1. Since wages are
above subsistence at this level, population will increase to OP2, thus tracing out the
stepwise path to long-run equilibrium.

does not include total rent, which Ricardo treated as a mere transfer of income from
one class to another. Thus, whenever profits fall—other things being equal—rents
rise, and the stationary state is reached when profits fall to zero.
The slope of line OS in figure 7-1 is equal to the ratio of total subsistence wage
payments to the size of the working population (e.g., Y*P* divided by OP*).
Although there is little evidence that Ricardo—or, for that matter, any of the classi-
cal economists—consistently regarded the subsistence wage as a constant propor-
tion of total output, figure 7-1 assumes, for simplicity, that it is. Thus, at output level
Y1 and population P1, the subsistence wage per worker would be equivalent to the
ratio S1P1/OP1. Likewise, at output and population levels Y2 and P2, respectively, the
subsistence wage would be S2P2/OP2. Moreover, since the level of subsistence as a
proportion of output is assumed constant, S1P1/OP1 = S2P2/OP2.
Let us begin the analysis at an early stage of the classical economy, where pop-
ulation is small (say, OP1) compared with other resources and where profits, the
rate of accumulation, and wages are therefore all relatively high. It can be seen that
the dynamic path to stationary-state equilibrium depends on the speed at which the
population adjusts to changes in the level of market wages. At population OP1, total
output (after rent) would be Y1P1, and total wages would be S1P1. Given Ricardo’s
residual theory, total profits would equal Y1S1.
According to the wages-fund doctrine, the presence of accumulated profits
leads to increased demand for labor, and the increased competition for labor even-
tually pushes wages up to Y1P1, at which point profits are squeezed out and accu-
mulation ceases. But since wages are above subsistence at Y1P1, population begins
to increase (to OP2), and wages eventually return to subsistence at S2P2.
At OP2, however, population is in temporary equilibrium only, for the increase in
population to that level is accompanied by an increase in output from Y1 to Y2, thus
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Chapter 7 ■ Classical Economics (II) 177

opening up profits again in the amount of Y2S2. This new accumulation causes wages
and population to rise again, thus tracing out the stepwise path in figure 7-1. The econ-
omy reaches the stationary state at population level P*. Profits have disappeared from
the system, wages are at the subsistence level, and rents on land of the highest fertility
are at a maximum. In short, the dynamic working out of the classical theory—i.e., Mal-
thusian population theory, diminishing returns in agriculture, the subsistence theory
of wages, the classical theory of capital accumulation (the wages-fund doctrine), and
the residual theory of profits—predicts a long-run, stationary-state equilibrium.
The stepwise adjustment path to stationary-state equilibrium in figure 7-1
assumes that population adjustments take place fairly rapidly, although this may
not actually be the case. In reality, the adjustment path may follow (from below) the
total-product curve OY. If population expands slowly, for example, then long before
it reaches OP2 some profit may reappear, propelling the process onward and keep-
ing wages up above subsistence and near the total-product curve OY. Postponement
of the stationary state is illustrated in figure 7-1 by an increase in productivity,
brought about, perhaps, by improvements in technology. This increased productiv-
ity shifts the total-product curve upward to OY  and moves the point of stationary
equilibrium to the right, to point Y .
In this manner, the classical economists provided a sweeping analysis of the
economic process. Their method is essentially deductive, although the classical
dynamics is based on several empirical hypotheses that may or may not have been
valid at the time (e.g., the assumption that all saving is automatically invested).
Moreover, at least one of the hypotheses—the population principle—contained non-
economic variables that in contemporary analysis would be relegated to an exoge-
nous role. Nevertheless, the classical dynamics represented a bold and striking
approach to the policy problems of the time.

■ CONCLUSION
More than any other writer after Smith, Ricardo set forth the research para-
digm of economics for the next generation of British economists. Ricardo treated
political economy as an abstract discipline, a means to discover general laws of
society—laws of equilibrium and laws of progress. Its practical consequences were
of less concern. As a result, Ricardo’s followers tended to view economic theory as
detached from practice. Malthus and Senior fought against this detachment, but
with limited success. Despite its abstract nature Ricardo’s analytical system pro-
vided a powerful means by which to establish clear-cut policy proposals. British
economists therefore rallied to its core. Generations later, Keynes had the sheer
power of Ricardo’s intellect in mind when he said: “Ricardo conquered England as
completely as the Holy Inquisition conquered Spain” (General Theory, p. 32).

REFERENCES
Baumol, W. J. Economic Dynamics, 3d ed. New York: Macmillan, 1970.
Cole, Arthur H. “An Approach to the Study of Entrepreneurship: A Tribute to Edwin F.
Gay,” Journal of Economic History, vol. 6 (1946), pp. 1–15.
Grampp, W. D. “Malthus on Money Wages and Welfare,” American Economic Review,
vol. 46 (December 1956), pp. 924–936.
Keynes, J. M. The General Theory of Employment, Interest and Money. London: Macmil-
lan, 1936.
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Malthus, T. R. An Inquiry into the Nature and Progress of Rent, and the Principles by
Which It Is Regulated, reprinted in The Pamphlets of Thomas Robert Malthus. New
York: A. M. Kelley, 1970 [1815].
———. The Principles of Political Economy, Considered with a View to Their Practical
Application, 2d ed. New York: A. M. Kelley, 1951 [1836].
Martineau, Harriet. Illustrations of Political Economy. London: Charles Fox (1832).
———. The Hamlets: A Tale. Boston: James Monroe & Co. (1836).
O’Donnell, Margaret. “Harriet Martineau: A Popular Early Economics Educator,” Journal
of Economic Education (Fall 1983), pp. 59–64.
Redlich, Fritz. “Toward the Understanding of an Unfortunate Legacy,” Kyklos, vol. 19
(1966), pp. 709–716.
Ricardo, David. The Works and Correspondence of David Ricardo, 10 vols., Piero Sraffa
(ed.), with the collaboration of M. Dobb. London: Cambridge University Press,
1951–1955.
Schumpeter, Joseph. History of Economic Analysis, E. B. Schumpeter (ed.). New York:
Oxford University Press, 1954.
Senior, N. W. An Outline of the Science of Political Economy. New York: A. M. Kelley,
1938 [1836].
Thomas, Gillian. Harriet Martineau. Boston: Twayne, 1985.

NOTES FOR FURTHER READING

Murray Milgate and Shannon Stimson, After Adam Smith: A Century of Transforma-
tion and Political Economy (Princeton: Princeton University Press, 2009), provide an
interesting account of an economy as an ordered social system “resembling a machine,”
an analogy suggested by Newtonian mechanics, and trace its effect on subsequent writ-
ers, including those found in this chapter and the next. Donald Winch reviews their book
and its approach, “Review Essay: Politics and Political Economy After Adam Smith,”
Journal of the History of Economic Thought, vol. 33 (March 2011), pp. 119–129.
The closest thing to a full-scale biography of Ricardo is James P. Henderson, The
Life and Economics of David Ricardo (Boston: Kluwer Academic Publishers, 1997), pub-
lished by Henderson’s colleagues after his death in 1995. Mark Blaug, Ricardian Eco-
nomics (New Haven, CT: Yale University Press, 1958), presents an excellent and
thorough study of Ricardo. An older, though not necessarily inferior, treatise is J. H. Hol-
lander’s David Ricardo (Baltimore: Johns Hopkins, 1910). Assistance in getting through
the main parts of Ricardo’s Principles is provided by Oswald St. Clair’s Key to Ricardo
(London: Routledge, 1957), which at one time was among the holdings of virtually every
economics library in the country.
The influence of Ricardo on his contemporaries can be traced through articles by S. G.
Checkland, “The Propagation of Ricardian Economics in England,” Economica, vol. 16
(February 1949), pp. 40–52; Sam Hollander, “The Reception of Ricardian Economics,”
Oxford Economic Papers, vol. 29 (July 1977), pp. 221–257; R. L. Meek, “The Decline of
Ricardian Economics in England,” Economica, vol. 17 (February 1950), pp. 43–62; and F. W.
Fetter, “The Rise and Decline of Ricardian Economics,” History of Political Economy, vol. 1
(Fall 1969), pp. 370–387. Other retrospectives can be found in J. R. Hicks and Samuel Hol-
lander, “Mr. Ricardo and the Moderns.” Quarterly Journal of Economics, vol. 91 (August
1977), pp. 351–370, who discuss the rebirth of Ricardian economics in more modern dress;
K. J. Arrow, “Ricardo’s Work as Viewed by Later Economists,” Journal of the History of
Economic Thought, vol. 13 (Spring 1991), pp. 70–77; and L. E. Johnson, “Professor Arrow’s
Ricardo,” Journal of the History of Economic Thought, vol. 15 (Spring 1993), pp. 54–71.
Two articles by Christophe Depoortère explore Ricardo’s method: “On Ricardo’s
Method: The Unitarian Influence Examined,” History of Political Economy, vol. 34 (Sum-
Ekelund-Hebert 6E.book Page 179 Thursday, August 1, 2013 11:03 AM

Chapter 7 ■ Classical Economics (II) 179

mer 2002), pp. 499–504; and same author, “On Ricardo’s Method: The Scottish Connec-
tion Considered,” History of Political Economy, vol. 40 (Spring 2008), pp. 73–110. This
last article reconsiders Ricardo’s stance on hypotheses and abstractions in economics,
focusing on a possible connection between Ricardo and Dugald Stewart. See also, Sergio
Cremaschi and Marcelo Dascal, “Malthus and Ricardo on Economic Methodology,” His-
tory of Political Economy, vol. 28 (Fall 1996), pp. 475–511; and Sergio Cremaschi,
“Ricardo and the Utilitarians,” The European Journal of the History of Economic
Thought, vol. 11 (Fall 2004), pp. 377–403, which rejects as myth the claim that Ricardo
was dependent on Bentham and/or Mill. For more insights into what made Ricardo tick,
see N. Churchman, “David Ricardo on Public Policy: The Question of Motive,” Journal of
the History of Economic Thought, vol. 17 (Spring 1995), pp. 133–152.
Ricardo’s value theory is the subject of ongoing review, criticism, and reinterpreta-
tion. Two articles by G. J. Stigler have become “classic,” both reprinted in Stigler, Essays
in the History of Economics (Chicago: The University of Chicago Press, 1965): “Ricardo
and the 93% Labor Theory of Value,” American Economic Review, vol. 48 (June 1958),
pp. 357–367; and “The Ricardian Theory of Value and Distribution,” Journal of Political
Economy, vol. 60 (June 1952), pp. 187–207. Francisco L. Lopes, “The Ricardo Puzzle,”
History of Political Economy, vol. 40 (Winter 2008), pp. 595–611, explains Ricardo’s
dogged adherence to a labor theory of value, despite his own doubts about its accuracy,
as the only way for him to avoid Malthus’s criticism. Giuliana Campanelli, “Ricardo’s
‘Curious Effect’: A Mathematical Formulation,” History of Political Economy, vol. 28
(Winter 1996), pp. 691–702, provides a mathematical presentation of Ricardo’s main
ideas on fixed capital and its effect on value. For a cross-section of views and various
reinterpretations of Ricardo’s theory of value, see M. J. Carlson, “The Epistemological
Status of Ricardo’s Labor Theory,” History of Political Economy, vol. 30 (Summer 1998),
pp. 293–334; and the much earlier assessment by J. M. Cassels, “A Reinterpretation of
Ricardo on Value,” Quarterly Journal of Economics, vol. 46 (May 1935), pp. 518–532.
Ricardo was reinterpreted yet again by S. C. Rankin, “Supply and Demand in Ricardian
Price Theory: A Reinterpretation,” Oxford Economic Papers, vol. 32 (July 1980), pp. 241–
262; L. E. Johnson, “Ricardo’s Labor Theory of the Determinant of Value,” Atlantic Eco-
nomic Journal, vol. 12 (March 1984), pp. 50–59; A. Burgstaller, “Demand and Relative
Price in Ricardo: An Examination of Outstanding Issues,” History of Political Economy,
vol. 19 (Summer 1987), pp. 207–215; and C. Casarosa, “A New Formulation of the Ricard-
ian System,” Oxford Economic Papers, vol. 30 (March 1978), pp. 38–63. R. H. Timber-
lake, “The Classical Search for an Invariable Measure of Value,” Quarterly Review of
Economics and Business, vol. 6 (Spring 1966), pp. 37–44, is worth reading.
The Ricardian theory of profits has been another lightning rod of controversy. See
John Eatwell, “The Interpretation of Ricardo’s Essay on Profits,” Economica, vol. 42
(May 1975), pp. 182–187; Terry Peach, “David Ricardo’s Early Treatment of Profitability:
A New Interpretation,” Economic Journal, vol. 94 (December 1984), pp. 733–751; Sam
Hollander, “On a ‘New Interpretation’ of Ricardo’s Early Treatment of Profitability,” Eco-
nomic Journal, vol. 96 (December 1986), pp. 1091–1097; R. Prendergast, “David
Ricardo’s Early Treatment of Profitability: A New Interpretation: A Comment,” Eco-
nomic Journal, vol. 96 (December 1986), pp. 1098–1104; and Peach’s reply to his critics,
“Ricardo’s Early Treatment of Profitability: Reply,” Economic Journal, vol. 96 (December
1986), pp. 1105–1112. Sam Hollander, The Economics of David Ricardo (Toronto: Univer-
sity of Toronto Press, 1979), touched off a virulent controversy by his wholesale reinter-
pretation of Ricardo’s economics. The issue of profitability in Ricardo’s writings is
perhaps obscured by the shifting nature of profits in various editions of the Principles. In
contrast to the preceding debate between Peach, Hollander, and others, see J. B. Davis,
“Ricardo’s Theory of Profit in the Third Edition of the Principles,” Journal of the History
of Economic Thought, vol. 15 (Spring 1993), pp. 90–108.
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180 Part II ■ The Classical Period

Ricardo’s participation in political debate was related mostly to his wish to curb an
expanding role of government. Nancy Churchman, “Public Debt Policy and Public
Extravagance: The Ricardo-Malthus Debate,” History of Political Economy, vol. 31 (Win-
ter 1999), pp. 653–673, demonstrates that both his economic analysis and his political
theory led Ricardo to conclude that government involvement in the economy should be
confined to a narrow range of activities. William Dixon, “Ricardo: Economic Thought
and Social Order,” Journal of the History of Economic Thought, vol. 30 (June 2008), pp.
235–253, compares Ricardo’s free-market liberalism with the work of Thomas Paine,
emphasizing Ricardo’s vision of a well-functioning economic order based on free trade
and the extension of the franchise; and Timothy Davis, “David Ricardo, Financier and
Empirical Economist,” The European Journal of the History of Economic Thought, vol. 9
(Spring 2002), pp. 1–16, examines Ricardo’s grounding in the “real world.”
Here is a potpourri of articles and books on other topics in Ricardo’s writings. Roy J.
Ruffin, “David Ricardo’s Discovery of Comparative Advantage,” History of Political
Economy, vol. 34 (Winter 2002), pp. 727–748; C. S. Shoup, Ricardo on Taxation (New
York: Columbia University Press, 1960); Hans Brems, “Ricardo’s Long-Run Equilib-
rium,” History of Political Economy, vol. 2 (Fall 1970), pp. 225–245; M. J. Gootzeit, “The
Corn Laws and Wage Adjustment in a Short-Run Ricardian Model,” History of Political
Economy, vol. 5 (Spring 1973), pp. 50–71; R. Brandis, “The Structure of Wages and
Ricardian Wage Theory,” Journal of the History of Economic Thought, vol. 12 (Spring
1990), pp. 76–80; A. Stirati, “Smith’s Legacy and the Definitions of the Natural Wage in
Ricardo,” Journal of the History of Economic Thought, vol. 17 (Spring 1995), pp. 106–133;
Sam Hollander, “Ricardo and the Corn Laws: A Revision,” History of Political Economy,
vol. 9 (Spring 1977), pp. 1–47; same author, “On the Endogeneity of the Margin and
Related Issues in Ricardian Economics,” Journal of the History of Economic Thought, vol.
13 (Fall 1991), pp. 159–174; and again, “The Development of Ricardo’s Position on
Machinery,” History of Political Economy, vol. 3 (Spring 1971), pp. 105–135. An obscure
contemporary of Ricardo who also discussed the issue of machinery and its effect on
employment was John Tozer. See, Paola Tubaro, “Producer Choice and Technical Unem-
ployment: John E. Tozer’s Mathematical Model (1838).” The European Journal of the
History of Economic Thought, vol. 15 (Fall 2008), pp. 433–454.
Some insights into Ricardo’s mind-set and his reactions to Malthus’s Principles can
be gained from a study of vol. 2 of the masterful Sraffa edition of Ricardo’s Works (see
references), which reproduces Ricardo’s notes and marginalia appended to his personal
copy of Malthus’s Principles. Sraffa’s own interpretation of Ricardo is considered by
some to be idiosyncratic. See, for example, Paul A. Samuelson, “Classical and Neoclassi-
cal Harmonies and Dissonances,” The European Journal of the History of Economic
Thought, vol. 14 (June 2007), pp. 243–271.
On the value debate between Malthus and Ricardo, see V. E. Smith, “Malthus’ The-
ory of Demand and Its Influence on Value Theory,” Scottish Journal of Political Economy,
vol. 3 (October 1956), pp. 205–220; and Omar Pancoast, “Malthus versus Ricardo,” Politi-
cal Science Quarterly, vol. 58 (1943), pp. 47–66. The contentious nature of Malthus and
his maverick standing among his contemporaries is discussed by W. D. Grampp, “Mal-
thus and his Contemporaries,” History of Political Economy, vol. 6 (Fall 1974), pp. 278–
304. See also M. B. Harvey-Phillips, “Malthus’ Theodicy: The Intellectual Background to
His Contribution to Political Economy,” History of Political Economy, vol. 16 (Winter
1984), pp. 591–608. Some historians contend that there are two Malthuses: the Malthus
of the Essay on Population and the Malthus of The Principles of Political Economy. J. J.
Spengler, “Malthus’ Total Population Theory: A Restatement and Reappraisal,” Cana-
dian Journal of Economics and Political Science, vol. 2 (February, May 1945), pp. 83–110,
234–264, attempts to integrate the two. Malthus’s position on the Corn Laws continues to
be controversial. Grampp presents one view (see references), but J. J. Spengler, “Mal-
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Chapter 7 ■ Classical Economics (II) 181

thus the Malthusian vs. Malthus the Economist,” Southern Economic Journal, vol. 24
(July 1957), pp. 1–11, presents another. For an earlier view on the same subject, see H. G.
Johnson, “Malthus on the High Price of Provisions,” Canadian Journal of Economics and
Political Science, vol. 15 (May 1949), pp. 190–202.
Malthus may be gaining more respect as an economist than a populationist due to
contributions by Takuo Dome, “Malthus on Taxation and National Debt,” History of
Political Economy, vol. 29 (Summer 1997), pp. 275–294; A. M. C. Waterman, “Hume, Mal-
thus and the Stability of Equilibrium,” History of Political Economy, vol. 20 (Spring
1988), pp. 85–94; and same author, “Reappraisal of ‘Malthus the Economist,’ 1933–97,”
History of Political Economy, vol. 30 (Summer 1998), pp. 293–334. G. Gilbert, “Economic
Growth and the Poor in Malthus’ Essay on Population,” History of Political Economy, vol.
12 (Spring 1980), pp. 83–96, discusses the impact of economic growth on the working
classes. Samuel Hollander claims to have uncovered an “about-face” by Malthus in his
“Malthus’s Abandonment of Agricultural Protectionism: A Discovery in the History of
Economic Thought,” American Economic Review, vol. 82 (June 1992), pp. 650–659. But
the “discovery” provoked a mini-debate between J. M. Pullen, “Malthus on Agricultural
Protection: An Alternative View,” History of Political Economy, vol. 27 (Fall 1995), pp.
517–530; and Hollander, “More on Malthus and Agricultural Protection,” History of Polit-
ical Economy, vol. 27 (Fall 1995), pp. 531–538.
Several authors have explored Malthus’s views on aggregate demand, economic
growth, and business cycles. For a sampling, see W. A. Eltis, “Malthus’s Theory of Effec-
tive Demand and Growth,” Oxford Economic Papers, vol. 32 (March 1980), pp. 19–56; J.
J. O’Leary, “Malthus and Keynes,” Journal of Political Economy, vol. 50 (December 1942),
pp. 901–919; same author, “Malthus’ General Theory of Employment and the Post-Napo-
leonic Depression,” Journal of Economic History, vol. 3 (1943), pp. 185–200; Samuel Hol-
lander, “Malthus and the Post-Napoleonic Depression,” History of Political Economy, vol.
1 (Fall 1969), pp. 306–335; L. A. Dow, “Malthus on Sticky Wages, the Upper Turning
Point, and General Glut,” History of Political Economy, vol. 9 (Fall 1977), pp. 303–321;
and A. M. C. Waterman, “On the Malthusian Theory of Long Swings,” Canadian Journal
of Economics, vol. 20 (May 1987), pp. 257–270.
The tenor of the time can be judged by the works of other writers besides Malthus
and Ricardo. Matthew Smith, “Thomas Tooke on the Corn Laws,” History of Political
Economy, vol. 41 (Summer 2009), pp. 343–382, examines Tooke’s support of the classical
liberal ideal of free trade and explains Tooke’s conviction that the Corn Laws caused price
instability, redistributed income to landlords from workers, and imposed serious difficul-
ties on the lower income classes. A fine portrait of Sir Edward West that goes beyond his
contribution to classical rent theory is presented by W. D. Grampp, “Edward West Recon-
sidered,” History of Political Economy, vol. 2 (Fall 1970), pp. 316–343. A writer whose ideas
were picked up by Malthus and used against Ricardo was James Maitland (1759–1839),
the eighth Earl of Lauderdale, who published under that name. Although it was consid-
ered highly unorthodox in its day Lauderdale’s Inquiry into the Nature and Origin of Pub-
lic Wealth (1804) was a substantial analytical contribution. On the connection between
Lauderdale and Malthus, see Morton Paglin, Malthus and Lauderdale: The Anti-Ricardian
Tradition (New York: A. M. Kelley, 1961). Lauderdale has also been linked to Keynes. See
Maurice Mann, “Lord Lauderdale: Underconsumptionist and Keynesian Predecessor,”
Social Science (June 1959), pp. 153–162; and P. Lambert, “Lauderdale, Malthus et Keynes,”
Revue d’économie politique (January–February 1966), pp. 32–56. B. A. Corry, Money, Sav-
ing and Investment in English Economics, 1800–1850 (New York: St. Martin’s, 1962), and
R. G. Link, English Theories of Economic Fluctuations, 1815–1848 (New York: Columbia
University Press, 1959), provide a somewhat wider sweep of Lauderdale’s contributions.
A number of British writers set themselves against Ricardo, especially in regard to
his theories of value and rent. Among them were Samuel Bailey, John Craig, Richard
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182 Part II ■ The Classical Period

Jones, William F. Lloyd, Mountifort Longfield, and Robert Torrens. For the full force of
these other arguments see R. M. Rauner, Samuel Bailey and the Classical Theory of
Value (Cambridge, MA: Harvard University Press, 1961); B. W. Thor, “The Economic
Theories of John Craig, a Forgotten Economist,” Quarterly Journal of Economics, vol. 52
(August 1938), pp. 697–707; W. L. Miller, “Richard Jones’s Contributions to the Theory of
Rent,” History of Political Economy, vol. 9 (Fall 1977), pp. 346–365; R. M. Romano, “Wil-
liam Forster Lloyd—A Non-Ricardian,” History of Political Economy, vol. 9 (Fall 1977),
pp. 412–441; L. S. Moss, “Mountifort Longfield’s Supply and Demand Theory of Price
and Its Place in the Development of British Economic Theory,” History of Political Econ-
omy, vol. 6 (Winter 1974), pp. 405–434; and Lionel Robbins, Robert Torrens and the Evo-
lution of Classical Economics (New York: St. Martin’s, 1958). Against his challengers,
Ricardo had the faithful and tireless J. R. McCulloch, who defended Ricardo against all
comers. The standard work on McCulloch is D. P. O’Brien’s J. R. McCulloch: A Study in
Classical Economics (London: G. Allen, 1970).
Judging by the dearth of secondary literature, not everyone shares Schumpeter’s
high opinion of Nassau Senior as a theorist. Marian Bowley, Nassau Senior and Classical
Economics (London: G. Allen, 1937), is the standard reference; but see also, S. L. Levy,
Nassau W. Senior: The Prophet of Modern Capitalism (Boston: Humphries, 1943). Levy
collected and edited some of Senior’s previously unpublished writings under the title
Industrial Efficiency and Social Economy, 2 vols. (New York: Holt, 1928). Finally, Say’s
Law and its importance for classical macroeconomics are treated extensively in Thomas
Sowell, Say’s Law (Princeton, NJ: Princeton University Press, 1972).
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Classical Economics (III)

John Stuart Mill

John Stuart Mill (1806–1873) was both progeny and prodigy. His father was James
Mill, economist, disciple of Jeremy Bentham, and author of the compendious His-
tory of British India. As an ardent follower of Bentham, James Mill believed in
“home schooling.” He undertook responsibility for the education of his eldest son,
John Stuart, and started early on. In his Autobiography, John Stuart Mill recounted
his unusual and exacting education: At the age of three he began to learn Greek and
arithmetic; somewhat later he studied the histories of Hume, Gibbon, and Plutarch
(works borrowed from Bentham’s library); by the age of eight he had read the
works of the great Greek philosophers (Herodotus, Xenophon, Plato, and Diogenes)
in their native language and began a study of Latin.
When he was twelve, Mill embarked on studies in logic, reading classic treatises
in English and Latin. The following year he read Ricardo’s Principles, submitting
himself daily to his father’s grilling questions on political economy. Mill later
opined: “I do not believe that any scientific teaching ever was more thorough, or
better fitted for training the faculties, than the mode in which logic and political
economy were taught to me by my father” (Autobiography, p. 20). By the tender age
of fourteen, Mill had received the equivalent of a university education, and was dis-
patched to teach what he had learned to his younger brothers and sisters. Because
Mill’s father sheltered him from the usual childhood contacts, he approached adult-
hood unaware that his upbringing was extraordinary. In a reflective mood, he wrote:
What I could do, could assuredly be done by any poor boy or girl of average capac-
ity and healthy physical constitution: and if I have accomplished anything, I owe it,
among other fortunate circumstances, to the fact that through the early training
bestowed on me by my father, I started, I may fairly say, with an advantage of a
quarter of a century over my contemporaries. (Autobiography, p. 21)

In 1823, Mill joined his father in the service of the East India Company, and he
remained with that enterprise until his retirement thirty-five years later. His duties
were not especially taxing and his mind kept teeming with ideas that found expres-
sion in articles he published on various philosophical and literary topics. His first
major work, A System of Logic, published in 1843, was favorably received and ran
to several editions, as did his very successful Principles of Political Economy, which
appeared for the first time in 1848. These two works assured Mill’s reputation as
one of the outstanding thinkers of his day. He followed his early successes in fairly

183
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184 Part II ■ The Classical Period

rapid succession with On Liberty (1859), Considerations of Representative Govern-

ment (1861), Utilitarianism (1863), Auguste Comte and Positivism (1865), and The
Subjection of Women (1869). Mill enriched four main areas of intellectual inquiry:
(1) the problem of method in the social sciences, (2) clarification of the (Bentham-
ite) principle of utility, (3) the nature and limits of individual freedom, and (4) the
theory of representative government. However, his economic contributions concern
us most.

■ MILL’S INTELLECTUAL TRANSITION

The rigors of Mill’s early education and their weight on his young mind were a
proximate cause of a prolonged period of mental depression that began when he
was twenty years old. During his “blue” period, Mill concluded that none of the
goals in life for which he had been trained were capable of bringing true happiness.
He became aware of certain gaps and inadequacies in his upbringing and he turned
to a group of Romantic writers for consolation.

Exposure to the Romantics

In an attempt to develop a more robust “internal culture,” Mill read the works of
the Romantic poets Coleridge and Wordsworth, and the ideas of the French philoso-
phers of the Enlightenment. The writings of the poets, especially, not only gave Mill
solace in his depression but also induced him to rethink certain ideas on the subject
of economics. Coleridge and Wordsworth openly expressed their antagonism toward
economics. They were later joined in their discontent by literary critics Thomas Car-
lyle,1 Charles Dickens, and John Ruskin. Individually and as a group these authors
held industrialism responsible for the decline of social sensibilities and the quality of
life. Economics took the brunt of their criticism because they viewed political econ-
omy as the science of industrialism. Claiming to be protectors of the old order, the
Romantics denied the efficacy of scientific inquiry. They judged economists guilty by
association, failing to see that analysts do not necessarily give their stamp of
approval to the existing order when they seek to explain it. Few economists of the
day even took such bland criticism seriously. Mill was a prominent exception.

Mill and Comte

During his mental “crisis,” Mill absorbed the ideas of Auguste Comte, the
French philosopher and founder of sociology and positivism. Comte espoused a
general science of man, which he named sociology.2 He envisioned political econ-
omy as a branch of the general science of sociology but lamented its lack of empiri-
cal and historical relevance. He called for a new method as well as a new ordering
of the social sciences. He called this new method positivism, by which he meant
empiricism, or induction.
Mill reacted to diverse criticisms from Comte and the Romantics by reconstruct-
ing the philosophical and methodological foundations of his own views on political
economy. He was sympathetic to Comte’s attempts to construct a general science of
humanity, but he nevertheless defended economics as a separate science, relevant to
1
Having read Malthus on population, it was Carlyle who dubbed economics “the dismal science.”
2
Sociology, today, as a separate discipline, has become much more specialized than Comte’s origi-
nal vision of it. To Comte, sociology was to be an all-embracing study of humans, including eco-
nomics, psychology, anthropology, history, and the like.
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Chapter 8 ■ Classical Economics (III) 185

humans’ social well-being. He also acknowledged the merits of the inductive method,
but he defended the deductive method as inherently useful to a social science.
Mill maintained that the empirical, or inductive, method could not be relied on
exclusively in the social arena because causes of social phenomena are often com-
plex and interwoven, and effects are not easily distinguishable from one another.
Deduction is a desirable check against the errors of casual empiricism, Mill
believed, but it need not lead to dogmatic acceptance of ideas and theories that can-
not be supported by fact. Thus, facts are a desirable check to pure deduction. In
short, Mill achieved a delicate balance between the inductive–deductive extremes in
economic method.

■ THE STRUCTURE OF MILL’S ECONOMIC INQUIRY

The delicate balance Mill sought between inductive and deductive reasoning is
evident in his major economic work, Principles of Political Economy. In matters of
theory he reaffirmed and enlarged the Ricardian framework, while simultaneously
incorporating new ideas and new supportive evidence on numerous matters of
political economy. Mill’s Principles was a major success. Used as a text for almost
sixty years (until replaced by Alfred Marshall’s Principles), it was and is a complete
treatise on classical economic theory, economic policy, and social philosophy. In this
chapter we concentrate on the development and significance of Mill’s economic the-
ory; in the next we shall examine more fully his economic philosophy and policies.

The Character and Aim of Principles

The character and aim of Mill’s Principles are best described by Mill himself:
For practical purposes, Political Economy is inseparably intertwined with many
other branches of Social Philosophy. Except on matters of mere detail, there are
perhaps no practical questions, even among those which approach nearest to the
character of purely economical questions, which admit of being decided on eco-
nomical premises alone. And it is because Adam Smith never loses sight of this
truth; because, in his applications of Political Economy, he perpetually appeals to
other and often far larger considerations than pure Political Economy affords—that
he gives that well-grounded feeling of command over the principles of the subject
for purposes of practice. . . . It appears to the present writer that a work similar in
its object and general conception to that of Adam Smith, but adapted to the more
extended knowledge and improved ideas of the present age, is the kind of contribu-
tion which Political Economy at present requires. (Principles, pp. xxvii–xxviii)

From this passage one gets a glimmer of economics as a broad field of inquiry. Else-
where Mill said that one is not likely to be a good economist if he is nothing else—
reflecting, perhaps, Comte’s perception that economics is a mere part of a larger
“science of man.” Clearly Mill emphasized the dual character of his work—theory
and applications—from the outset. His goal was clear: to summarize and synthesize
all the economic knowledge up to his day.
This methodological eclecticism gave the Principles a unique flavor. Through
his contact with Auguste Comte and the Saint-Simonians (see chapter 11), he came
to assert the now famous dichotomy between the economic laws of production and
the social laws of distribution. The former, according to Mill, are unchangeable;
they are governed by natural laws. Ricardo and his followers had perfected these
laws, Mill thought, and taken together, they constituted economics in the narrow
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186 Part II ■ The Classical Period

sense, as a separate science. But the laws of distribution, he insisted, are almost
entirely a matter of human will and institutions, not determined by economics
alone, but affected by changing values, mores, social philosophies, and tastes. The
laws of distribution are therefore malleable, and to understand them fully one must
look beyond economics to the historical laws that underlie economic progress.
Much of Comte’s thought concerned the discovery of these historical laws. His
celebrated view of history expressed in the “law of three stages” asserts that the
development of the human intellect progresses through three separate and distinct
stages: (1) the theological stage, in which human behavior and other phenomena are
attributed to a deity, or to “magic”; (2) the metaphysical stage, in which the essence,
or “nature,” of a thing is substituted for divine personalities (e.g., natural law as an
explanatory device); and finally (3) the positive stage, in which the scientific method
is employed in finding truth. Comte attributed all social and economic progress to
the perfection of the human intellect as it passes through these three stages.
Like many early treatises, Mill’s Principles is divided into “books,” or sections.
The (immutable) economics of production, value, and exchange are generally con-
fined to Books, I, II, and III, whereas Mill’s (malleable) social views are aired in
Book IV (“Influence of the Progress of Society on Production and Distribution”) and
Book V (“On the Influence of Government”).

Mill on Production
Mill’s ideas on production are firmly grounded in Ricardo’s Principles, plus the
(minimal) post-Ricardian refinements on that topic. The key roles in economic prog-
ress played by productive and unproductive labor, Say’s Law, capital accumulation,
the Malthusian population doctrine, and the wages-fund doctrine are all presented by
Mill with great clarity. Like most economists in the post-Smith tradition Mill assigned
a crucial role to capital and to capital accumulation in explaining production and eco-
nomic development. He attached great importance to his “five fundamental proposi-
tions respecting capital,” which restated the classical theory of economic progress.
In a nutshell Mill argued that, given Say’s Law, employment and increased lev-
els of output are dependent on the accumulation and investment of capital. Part of
the investment in capital, the result of saving, is required to tide labor over a discon-
tinuous production period. Although he later seemed to recant this idea, Mill
revealed a clear understanding of the wages-fund doctrine:
There can be no more industry than is supplied with materials to work up and food
to eat. Self-evident as the thing is, it is often forgotten, that the people of a country
are maintained and have their wants supplied, not by the produce of present
labour, but of past. They consume what has been produced, not what is about to be
produced. Now, of what has been produced, a part only is allocated to the support
of productive labour; and there will not and cannot be more of that labour than the
portion so allotted (which is the capital of the country) can feed, and provide with
the materials and instruments of production. (Principles, p. 64)

Unemployment of resources—other than as a temporary state of affairs—was

not considered possible because of Say’s Law. Contrary to the Malthusian position,
saving would automatically be turned into another form of spending (i.e., invest-
ment), and a general glut of goods from underconsumption was impossible. Mill, in
short, never considered that there could be a lack of aggregate demand in the eco-
nomic system. But as we shall see momentarily, Mill cleared up earlier confusions
regarding Say’s Law and the insufficiency of aggregate demand.
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Chapter 8 ■ Classical Economics (III) 187

Mill on Economic Growth

Mill summarized and improved the classical theory of economic development.
Like Ricardo, he believed the law of diminishing returns was a key factor limiting
economic growth. Another limit was a declining incentive to invest. In general, how-
ever, Mill focused on the crucial variables of capital accumulation, population
growth, and technology. Combining these principles with diminishing returns to
agriculture, Mill offered a clear and comprehensive discussion of the classical the-
ory of economic development.
Owing to diminishing returns and weakening incentives to invest, Mill argued
that the economy was being propelled from a progressive state to a stationary state
(see chapter 7). But Mill was one of the few, if not the only, classical economist to
put forth a positive view of the stationary state. He regarded this long-run equilib-
rium position as a precondition for meaningful social reform. Only after the station-
ary state was reached could problems of equity in distribution be evaluated and
social reforms proceed apace. Remember that distribution belonged to a set of eco-
nomic relationships that were malleable in Mill’s mind. What was required after the
inexorable laws of economics had run their course was the enlightenment and wis-
dom of statesmen/legislators to enact meaningful reforms that would enhance
social well-being. In light of subsequent developments in economics, especially the
development of public choice theory (chapter 24) this stance by Mill is likely to be
seen as naive. But setting aside for the moment his stance on distribution, Mill’s
statement of the dynamics of classical production theory achieved a depth of clarity
and understanding of classical dynamics unsurpassed by any other writer of the
classical era.

■ MILL’S THEORETICAL ADVANCES

The popular view of the economist John Stuart Mill is that he was a sophisti-
cated synthesizer of little theoretical originality. Yet, this assessment is short-
sighted. George Stigler (“The Nature and Role of Originality”) argues persuasively
that it would be difficult to point to a writer of greater theoretical originality than
Mill. The purpose of this section is to elaborate on a few of Mill’s more significant
theoretical contributions. Though Mill himself did not emphasize the importance of
these theoretical ideas (the theory of joint supply is found in a footnote, for exam-
ple), they nevertheless indicate that he was more of a bridge between classical and
neoclassical analysis than has commonly been perceived. The issues chosen for
elaboration below are not exhaustive, but are selected to demonstrate the under-
stated originality of Mill’s contributions to economic analysis.

Supply and Demand

The first clear British contribution to static-equilibrium price formation in the
modern sense was developed by John Stuart Mill. Utilizing purely verbal analysis,
he advanced the theory of equilibrium price on several fronts. He fully recognized
the analytical necessity of abstracting and simplifying the principles underlying the
functional relation between price and quantity demanded and supplied. He noted,
for example, that “in considering the exchange value scientifically, it is expedient to
abstract from it all causes except those which originate in the very commodity
under consideration” (Principles, p. 438). Having mastered the method of abstract
reasoning exemplified in Ricardo, Mill was able to give a correct formulation of
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188 Part II ■ The Classical Period

demand and supply as schedules showing the functional relation between price and
quantity demanded and supplied, ceteris paribus.
Noting the terminological confusion that previous writers had exhibited, Mill
proposed that the proper mathematical relation to express demand and supply is an
equation, not a ratio, as had so often been supposed in economic literature (by Mal-
thus, among others):
A ratio between demand and supply is only intelligible if by demand we mean
quantity demanded, and if the ratio intended is that between the quantity
demanded and the quantity supplied. But again, the quantity demanded is not a
fixed quantity, even at the same time and place; it varies according to the value; if
the thing is cheap, there is usually a demand for more of it than when it is dear.
(Principles, p. 446)

The idea of a ratio, as between demand and supply, is [therefore] out of place, and
has no concern in the matter: the proper mathematical analogy is that of an equa-
tion. Demand and supply, the quantity demanded and the quantity supplied, will be
made equal. If unequal at any moment, competition equalizes them, and the man-
ner in which this is done is by an adjustment of the value. If the demand increases,
the value rises; if the demand diminishes, the value falls: again, if the supply falls
off, the value rises; and falls if the supply is increased. (Principles, p. 448)

Most early formulations of value-and-demand theory relied on circular reason-

ing. Misunderstanding the correct nature of demand could lead to the allegation
that demand depends in part on value but that value is determined by demand.
Given Mill’s distinction, however, if “demand increases” (or decreases) is read as a
rightward (leftward) shift in demand, Mill’s compact statement is almost entirely
analogous to modern explanations of the mechanics of price changes. He therefore
presented a perfectly adequate distinction between price-determined and price-
determining changes in demand and supply. Mill’s performance in this regard was
not matched in England until Fleeming Jenkin presented a graphical exposition on
supply and demand two decades later in his 1870 essay, “The Graphic Representa-
tion of the Laws of Supply and Demand, and Their Application to Labour.” Mill was,
moreover, one of Alfred Marshall’s most important sources on the subject.

Joint Supply
Another contribution of importance to the technical advance of value theory
was Mill’s development of the theory of jointly supplied goods. Although Marshall is
often given credit for the invention of the concept (he simply added the graphics),
Mill stated the principle concisely in his Principles (his chapter entitled “Some Pecu-
liar Cases of Value”):
It sometimes happens that two different commodities have what may be termed a
joint cost of production. They are both products of the same operation, or set of
operations, and the outlay is incurred for the sake of both together, not part for one
and part for the other. The same outlay would have to be incurred for either of the
two, if the other were not wanted or used at all. There are not a few instances of
commodities thus associated in their production: for example, coke and coal-gas
are both produced from the same material, and by the same operation. In a more
partial sense, mutton and wool are an example: beef, hides, and tallow: calves and
dairy produce: chickens and eggs. Cost of production can have nothing to do with
deciding the value of the associated commodities relatively to each other. It only
decides their joint value. The gas and the coke together have to repay the expenses
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Chapter 8 ■ Classical Economics (III) 189

of their production, with the ordinary profit. To do this, a given quantity of gas,
together with the coke which is the residuum of its manufacture, must exchange
for other things in the ratio of their joint costs of production. But how much of the
remuneration of the producer shall be derived from the coke, and how much from
the gas, remains to be decided. Cost of production does not determine their prices,
but the sum of their prices. (Principles, pp. 569–570)

The Problem. The question raised by Mill in this regard is: Given a single cost
function, how are profits from the two separate productions to be allocated to the
jointly produced goods? Calculation of profits presupposes, of course, that prices
can be determined for separate commodities. Mill’s directions for determining a
simultaneous equilibrium were explicit:
Equilibrium will be attained when the demand for each article fits so well with the
demand for the other, that the quantity required of each is exactly as much as is
generated in producing the quantity required of the other. If there is any surplus or
deficiency on either side; if there is a demand for coke, and not a demand for all
the gas produced along with it; or vice versa; the values and prices of the two
things will readjust themselves so that both shall find a market. (Principles, p. 571)

The Solution. Mill’s solution to the joint-supply problem may be restated as

follows: In the case where goods are produced jointly in fixed proportions, the equi-
librium price of each product must be such as to clear its market, subject to the con-
dition that the sum of the two prices equals their (average) joint costs. His
apparently complete understanding of this special aspect of competitive pricing,
without benefit of mathematical analysis, seems remarkable today.
Alfred Marshall (chapter 16) later enhanced our understanding of this complex
problem by supplying graphics consistent with Mill’s solution. These graphics are
found in a footnote to chapter 6, Book V, of Marshall’s Principles of Economics, and
are replicated below in figure 8-l. The joint products in this application are beef and
hides. Both products derive from steers but have different prices according to the
demand in each submarket. SS  is a joint-supply, or average-cost, function for
steers. The total demand for steers is represented by demand curve DD , which is

Demand for hides S ‫( ׳‬AC) Steers (beef and hides)

Price of D
s‫ ׳‬Beef
steers A
d
G
B

C F
D ‫ ׳‬Steers (beef and hides)
S E
d ‫ ׳‬Beef
s

O M N Quantity of steers

Figure 8-1 At competitive equilibrium N, the price of beef (NF) is determined by the
intersection of ss and dd , and the price of hides (GF) is determined by subtracting NF
from the total supply function.
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190 Part II ■ The Classical Period

the vertical summation of the separate demands for beef and hides. The demand
function for beef is shown as dd, so the demand for hides may be easily derived by
vertically subtracting the demand for beef from the total demand for steers. Thus, at
total quantity M of steers produced, MB represents the demand price for beef and
BA represents the demand price for hides.
A special type of supply curve can be derived for beef, moreover. It is obtained
by subtracting the demand price for hides from the supply price of the composite
output, steers. As we have seen, the demand price for hides at quantity M is equal to
BA. Subtracting BA from the total supply function yields a derived supply price for
beef at quantity M of ME and thus a supply price for hides of EC. Following this pro-
cedure, the dashed supply function for beef (ss) can be traced for each quantity.
Competitive equilibrium, as Mill clearly understood, is achieved when N steers
are produced. At quantity N, the price of beef (NF) is achieved by the intersection of
the supply-and-demand curves for beef (ss and dd). The price of hides is similarly
determined (GF). The competitive market for both goods is in equilibrium when the
quantity N is produced.3 Several interesting characteristics of the Mill–Marshall
model should be noted. First, an increase in the demand for one of the goods, say,
hides, increases the supply of the other (in this case beef) and thus lowers its price.
Second, an increase in average cost (SS ) raises the price of both the jointly produced
goods. Moreover, these two results, as well as the construction of the Mill–Marshall
analysis, depend on an assumption of fixity in the proportions of goods produced;
i.e., an increase in steer production implies a proportionate increase in the produc-
tion of beef and hides. Other models may be constructed on nonproportionality
assumptions, of course, but do not reflect the “classic” formulation of the problem.
The peculiar case of joint supply may seem idiosyncratic in many product mar-
kets, but Mill’s theory played an important part in trying to resolve problems in the
areas of transportation and public-utility economics. More recently it has been used
in public-goods models and in problems involving the supply of by-products, such
as pollution. Mill’s joint-supply theory was, in sum, a contribution of great signifi-
cance for economic analysis.

The Doctrine of Alternative Costs

The issue of land rent as a necessary (or unnecessary) payment of production
was left in a muddled state by Ricardo’s unyielding treatment of rent as an infra-
marginal surplus. Recall that in the strict sense Ricardo’s theory holds only if agri-
cultural land has no alternative uses. Mill clarified the nature of rent by expositing
the doctrine of alternative costs and applying it to land uses. In Book III, chapter 5
of his Principles he wrote:
Land is used for other purposes than for agriculture, especially for residence; and
when so used, yields a rent. . . . The ground rent of a building, and the rent of a gar-
den or park attached to it, will not be less than the rent which the same land would
afford in agriculture. . . . But when land capable of yielding rent in agriculture is
applied to some other purpose, the rent which it would have yielded is an element
of the cost of production of the commodity which it is employed to produce. (p. 475)

In other words, agricultural rent is not a cost of production when land has no alter-
native uses (Ricardo’s case) but becomes a necessary cost of production once alter-
native uses are admitted.

3
Note that at this point the sum of the two prices (NF + FG) equals their joint costs of production, NG.
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Chapter 8 ■ Classical Economics (III) 191

The Economics of the Firm

As fascinating as Adam Smith’s discussion of a pin manufactory was, it
described a small-scale production process. With the passage of time, and the full
flowering of the Industrial Revolution, manufacturing in Britain was undertaken on
increasingly larger scales. Mill was sensitive to this development and alert to the
consequences for economics—in his treatment of the laws of production he pre-
sented the first systematic discussion in a general treatise of the principle of econo-
mies of scale.
Smith correctly noted that the division of labor is one factor contributing to the
growth of firms. Mill acknowledged that the division of labor is “one of the principle
causes of large manufactories” (Principles, p. 132), but he also recognized the
importance of scale. Another cause of firm growth, he said, “is the introduction of
processes requiring expensive machinery. Expensive machinery supposes a large
capital; and is not resorted to except with the intention of producing, and the hope
of selling, as much of the article as comes up to the full powers of the machine”
(Principles, p. 135).
Using the Post Office to illustrate his case of how a large, centralized enterprise
scores efficiencies over small, decentralized business, Mill deduced the principle of
economies of scale and proposed a simple test of whether or not such economies
are present in any concrete case:
As a general rule, the expenses of a business do not increase by any means propor-
tionally to the quantity of business. . . . Whether or not the advantages obtained by
operating on a large scale preponderate in any particular case over the more
watchful attention, and greater regard to minor gains and losses, usually found in
small establishments, can be ascertained, in a state of free competition, by an
unfailing test. Wherever there are large and small establishments in the same busi-
ness, that one of the two which in existing circumstances carries on the production
at greatest advantage will be able to undersell the other. The power of permanently
underselling can only, generally speaking, be derived from increased effectiveness
of labour; and this, when obtained by a more extended division of employment, or
by a classification tending to a better economy of skill, always implies a greater
produce from the same labour, and not merely the same produce from less labour:
it increases not the surplus only, but the gross produce of industry. If an increased
quantity of the particular article is not required, and part of the labourers in conse-
quence lose their employment, the capital which maintained and employed them is
also set at liberty; and the general produce of the country is increased by some
other application of their labour. (Principles, p. 134)

The Theory of Noncompeting Labor Groups

First Cantillon, then Adam Smith, recognized certain inequalities in wages
because of the nature of the employments themselves and not because of any short-
comings of the laws of competition. Economists call these inequalities “equilibrium
wage differences.” Smith’s discussion of equilibrium wage differences was based on
the notion of full occupational mobility of the labor force in the long run. Mill, how-
ever, recognized an artificial barrier to labor mobility caused by the costs of education:
If unskilled labourers had it in their power to compete with skilled, by merely tak-
ing the trouble of learning the trade, the differences of wages might not exceed
what would compensate them for that trouble. . . . But the fact that a course of
instruction is required, of even a low degree of costliness, or that the labourer must
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192 Part II ■ The Classical Period

be maintained for a considerable time from other sources, suffices everywhere to

exclude the great body of the labouring people from the possibility of such compe-
tition. . . . So complete . . . has hitherto been the separation, so strongly marked
the line of demarcation, between the different grades of labourers, as to be almost
equivalent to an hereditary distinction of caste; each employment being chiefly
recruited from the children of those already employed in it, or in employments of
the same rank with it in social estimation, or from the children of persons who, if
originally on a lower rank, have succeeded in raising themselves by their exer-
tions. (Principles, pp. 391–393)

Because the disparities that persist in certain labor markets cannot be explained by
the principle of competition, these segments are called “noncompeting labor groups.”
Advanced training/education equips some workers with skills that cannot easily be
duplicated, bestowing on affected workers a certain degree of monopoly power that
can be exploited in the sale of their services. Professional football players do not
compete (for wages) in any meaningful sense with insurance salesmen, for example.

The Theory of Market Gluts

Say’s Law held broad sway over macroeconomic theory until John Maynard
Keynes (chapter 21) totally discredited the idea. But the relationship between con-
sumption and production was always nettlesome for the classical economists. The
widespread view was that general overproduction of economic output cannot per-
sist in the long run because market forces will correct temporary imbalances. Faced
with oversupply, prices will fall in competitive markets, giving stimulus to more
consumption, thus causing the surplus goods to be consumed. This is the principle
that came to be known as “Say’s Law” (see chapter 7). Mill was the earliest writer to
recognize the limits to Say’s Law and correctly state the condition for its validity.
The key, Mill recognized, is understanding the role of financial instruments in the
market economy:
There can never, it is said, be a want of buyers for all commodities; because who-
ever offers a commodity for sale, desires to obtain a commodity in exchange for it,
and is therefore a buyer by the mere fact of his being a seller. The sellers and the
buyers, for all commodities taken together, must, by the metaphysical necessity of
the case, be an exact equipoise to each other; and if there be more sellers than buy-
ers of one thing, there must be more buyers than sellers of another.
This argument [Say’s law] is evidently founded on the supposition of a state of
barter; and on that supposition, it is perfectly incontestable. When two persons
perform an act of barter, each of them is at once a seller and a buyer. . . . If, how-
ever, we suppose that money is used, these propositions cease to be exactly
true. . . . Interchange by means of money is . . ., as has been often observed, ulti-
mately nothing but barter. But there is this difference—that in the case of barter,
the selling and the buying are simultaneously confounded in one operation; you
sell what you have and buy what you want, by one indivisible act, and you cannot
do the one without doing the other. Now the effect of the employment of money,
and even the utility of it, is, that it enables this one act of interchange to be divided
into two separate acts or operations, one of which may be performed now, and the
other a year hence, or whenever it shall be most convenient. (“Influence,” p. 276)

It follows that at a given time people may wish to hurry sales of goods and postpone
purchases—this is a period of general glut. But this glut may simply imply pent-up
purchasing power held in the form of money or money substitutes. According to Mill:
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Chapter 8 ■ Classical Economics (III) 193

In order to render the argument for the impossibility of an excess of all commodi-
ties applicable to the case in which a circulating medium is employed, money must
itself be considered a commodity. It must undoubtedly be admitted that there can-
not be an excess of all other commodities, and an excess of money at the same
time. (“Influence,” p. 277)

Mill’s “Neoclassical” Contributions

While Mill became the repository and grand master of classical thought, his
role as a creative theorist who pointed the way to neoclassical economic analysis
has been neglected. The list of contributions, discussed (however briefly) above,
should be enough to dispel the notion of Mill as a slavish imitator/synthesizer of
classical economics. His conceptualization and explanation of demand theory
alone, including the “peculiar” case of joint supply and demand, places him in a
direct line from Smith (chapter 5) to Marshall (chapter 16), and continues to inform
contemporary branches of economic theory, including the theory and practice of
economic regulation and the conditions surrounding the demands for public goods.
Moreover, Mill’s purely theoretical achievements did not stop there. The role of
price adjustments in establishing conditions of reciprocal equilibrium in several
markets simultaneously was not a central theme in economic analysis until the neo-
classical period and beyond. Major credit for this advance belongs to Léon Walras
(chapter 17), who constructed a general equilibrium system of economic analysis in
the generation that followed Mill. However, Mill’s verbal model of reciprocal
demand in the theory of international trade was a major building block in the con-
struction of such a system.4 In conception (if not in formalization and development)
general equilibrium theory could justly be termed “Millian” as well as “Walrasian.”
In short, Mill’s incisive contributions to value theory mark him as a bold and origi-
nal pioneer during the high time of classical economics.

■ MILL’S NORMATIVE ECONOMICS

Frequently regarded as the last great classical economist, Mill swam against the
current of intellectual and socialist criticism of classical political economy by
Romantics, socialists, and other heterodox thinkers. Being who he was, Mill could
not help but be affected by this criticism. He often took even the most bizarre social-
ist critics more seriously than they deserved. For a time, he was almost a Saint-
Simonian, although in his later life he found difficulties in the Saint-Simonian doc-
trine too elusive to resolve. Mill remained sympathetic to the ideals of socialism
throughout his life, even though he found little force in the analysis of socialist writ-
ers. He was committed to social reform, but wished to promote it in a way that
would preserve and enhance individual freedom and dignity as much as possible.
This humanistic concern for greater equality of wealth and opportunity sets Mill
apart from other classical economists. He attempted, as we said before, a delicate
balancing act. His theoretical adroitness displayed in the first three books of the Prin-
ciples is counterpoised by his reformist élan displayed in the last two books. Books IV
and V emphasize applications of political economy for the improvement of humanity,
and Mill made it clear where he stood on the relation of theory versus practice in eco-
nomics. He once wrote to a friend: “I regard the purely abstract investigations of

4
Due to space constraints and the highly specialized nature of the subject, Mill’s theory of interna-
tional values is not explored in this book, but it can be found in Book III of his Principles.
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194 Part II ■ The Classical Period

political economy . . . as of very minor importance compared with the great practical
questions which the progress of democracy and the spread of socialist opinions are
pressing on” (Letters, I, seminar 170). It should be noted, however, that Mill never
lost sight of the importance of theory as the proper foundation for taking policy posi-
tions. The last two books of the Principles, then, unlike the first three, are teleological
(goal-oriented). They reveal Mill’s concern for such social reforms as wealth redistri-
bution, equality of women, workers’ rights, consumerism, and education.

The Stationary State Revisited

The stationary state (chapter 7) as devised by Ricardo, and modified by Mill,
was part of the teleological orientation of Books IV and V of the Principles. Mill
broke with the Ricardian tradition, which viewed the stationary state as the end
product of economic development. Mill made it the launching pad for an improved
social system. To Mill, the stationary state became almost a kind of utopia, in which,
having achieved affluence, the state could get on with solving the problems that
really matter—namely, equality of wealth and opportunity.
Mill announced his break from the classical tradition in Book IV, where he
attacked the idea of wealth accumulation merely for the sake of accumulation.
Speaking in the first person, Mill said:
I cannot . . . regard the stationary state of capital and wealth with the unaffected
aversion so generally manifested towards it by political economists of the old
school. I am inclined to believe that it would be, on the whole, a very considerable
improvement on our present condition. I confess I am not charmed with the ideal
of life held out by those who think that the normal state of human beings is that of
struggling to get on. (Principles, p. 748)

In other places, too, Mill sounds remarkably modern—almost in league with those
economists who denounce economic growth for its own sake.5 But there is a word
of caution from Mill for those who would “improve” society by first tearing it down:
It is only in the backward countries of the world that increased production is still
an important object: in those most advanced, what is economically needed is a bet-
ter distribution, of which one indispensable means is a stricter restraint on popula-
tion. Levelling institutions, either of a just or unjust kind, cannot alone accomplish
it; they may lower the heights of society, but they cannot, of themselves, perma-
nently raise the depths. (Principles, p. 749)

In this passage Mill reveals his conviction that true social reform does not consist
merely in the destruction of oppressive institutions, but rather in “the joint effect of
the prudence and frugality of individuals, and of a system of legislation favoring
equality of fortunes, so far as is consistent with the just claim of the individual to the
fruits, whether great or small, of his or her own industry” (Principles, p. 749).

Wealth Redistribution
Mill favored wealth redistribution, not income redistribution. The distinction
between the two is not trivial. Mill did not wish to dampen productive incentives. As
his father before him, he believed that individuals should be allowed to “reap the
fruits of their own industry,” which is to say that every person has a right to the

5
Most vocal among later economists who joined this chorus are John Kenneth Galbraith (see chap-
ter 19) and E. J. Mishan, Costs of Economic Growth.
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Chapter 8 ■ Classical Economics (III) 195

income she or he earns. But neither James nor John Stuart sanctioned the accumu-
lation of wealth as an end in itself. Both men believed that beyond a certain limit,
further material gains are frivolous. In the younger Mill, this aversion to overaccu-
mulation provoked a proposal to limit the size of bequests. He wrote:
Were I framing a code of laws according to what seems to me best in itself, without
regard to existing opinions and sentiments, I should prefer to restrict . . . what any
one should be permitted to acquire, by bequest or inheritance. Each person should
have power to dispose by will of his or her whole property; but not to lavish it in
enriching some one individual, beyond a certain maximum, which should be fixed
sufficiently high to afford the means of comfortable independence. The inequalities
of property which arise from unequal industry, frugality, perseverance, talents, and
to a certain extent even opportunities, are inseparable from the principle of private
property, and if we accept the principle we must bear with these consequences of
it: but I see nothing objectionable in fixing a limit to what any one may acquire by
the mere favour of others; without any exercise of his faculties, and in requiring
that if he desires any further, he shall work for it. (Principles, pp. 227–228)

Clearly, what Mill advocated was a world in which people are free from the
pressing demands of economic necessity and open to improvements in the quality of
life. He shared this idea with the Romantic poets, although he rejected their fulgent
criticisms of political economy. But the kind of limits that Mill would impose on indi-
vidual wealth involves value judgments and therefore belongs to the realm of norma-
tive economics. Issues of this sort cannot be resolved by positive economics, which
confines itself to objective issues. Mill was quite emphatic about the stationary state
as a good thing. Because of its liberating effect from the grinding necessities of eco-
nomic survival, he saw in it expanded opportunities for human development:
It is scarcely necessary to remark that a stationary condition of capital and popula-
tion implies no stationary state of human improvement. There would be as much
scope as ever for all kinds of mental culture, and moral and social progress; as
much room for improving the Art of Living, and much more likelihood of its being
improved, when minds ceased to be engrossed by the art of getting on. (Principles,
p. 751)

Government and Laissez-Faire

A major part of Mill’s normative economics concerns the proper role and influ-
ence of government, which he took up in Book V of the Principles. He began by dis-
tinguishing between the necessary functions of government and its optional
functions. The necessary functions “are either inseparable from the idea of govern-
ment or exercised habitually and without objection by all governments” (Principles,
p. 796). Other functions, however, are not universally accepted, and therefore gov-
ernment action in these instances is controversial.
This distinction between necessary and optional functions is important only inso-
far as it enabled Mill at this stage of analysis to minimize discussions of the former
and concentrate on the latter. Included in Mill’s list of necessary government func-
tions are the power to tax, coin money, and establish a uniform system of weights and
measurements; protection against force and fraud; the administration of justice and
the enforcement of contracts; the establishment and protection of property rights,
including prescriptions on the use of the environment; protection of the interests of
minors and mental incompetents; and the provision of certain public goods and ser-
vices, such as roads, canals, dams, bridges, harbors, lighthouses, and sanitation.
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196 Part II ■ The Classical Period

Mill defended government activity in these areas with a lengthy digression on

the economic effects of all manner of taxes, direct and indirect. His exhaustive
treatment of these issues has endured through the ages. Nevertheless, it is a detour
that threatens the continuity of Mill’s narrative in Book V on the proper grounds for
government action. Returning to this core issue in the final chapter of the Princi-
ples, Mill placed the burden of proof on those who would advocate government
intervention. He himself stood squarely in the classical tradition by reaffirming the
maxim that laissez-faire should be the rule and that any departure from it, “unless
required by some great good, is a certain evil” (Principles, p. 950).
But just as Adam Smith was less doctrinaire on the matter of government inter-
ference than he is typically made out to be, John Stuart Mill was even less so. The
key to Mill’s philosophical position on the limits of the laissez-faire principle lies in
his recognition that government interference under capitalism could be required by
some great good. In this respect, Mill never shook off the early influence of Jeremy
Bentham. Thus, Mill was able to list several exceptions to the doctrine of laissez-
faire without compromising the basic principle. His exceptions allow government
intervention in the areas of consumer protection, general education, preservation of
the environment, selective enforcement of “permanent” contracts based on future
experience (e.g., marriage), public-utility regulation, and public charity.
In short, Mill recognized, and in some cases enunciated for the first time, the
majority of popular exceptions to laissez-faire that have become an integral part of
modern capitalism, at least in the United States. The hundreds of watchdog agen-
cies and regulatory commissions of government in the United States6 are logical
extensions of Mill’s desire to make capitalism fairer and more humane. The specific
details of Mill’s policy concerns and proposals are considered in chapter 9. In fair-
ness to Mill, he was very explicit about the caveats the state should employ in insti-
tuting such measures, and he would not necessarily approve of all existing
amendments to the institutions of capitalism. Nevertheless, it is his willingness to
make such amendments that underlines the transitional nature of his works and
thoughts and that marks Mill as a modern economist in many respects.

■ MILL AND THE DECLINE OF CLASSICAL ECONOMICS

John Stuart Mill was unquestionably a product of his intellectual environment,
but he was also a molder of it. Fully within the classical tradition, he devoted his
intellectual efforts to synthesizing and improving economic knowledge at a time
when economics was beset on all sides by Romantic, social, and methodological
criticism. He enriched economic theory by his own analytical contributions, and he
did not hesitate to issue normative proclamations to underscore practical applica-
tions of economic knowledge. Mill skillfully displayed the interconnections between
theory and policy, but he never confused the two. Wherever he advanced his norma-
tive views, he warned his readers of their arbitrariness. Even so, he revealed a spirit
of disinterested inquiry by carefully presenting both the advantages and the disad-
vantages of any given proposition or course of action.
His influence on other economists and social thinkers was deep and long last-
ing. In his own century, Mill’s concern for fundamental questions and his multifac-

6
Professor Bauer-Romazani provides a short list of major regulatory agencies and commissions at
http://academics.smcvt.edu/cbauer-ramazani/BU113/fed_agencies.htm. A complete list of U.S.
government departments and agencies can be found at http://www.usa.gov/directory/federal/
index.shtml.
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Chapter 8 ■ Classical Economics (III) 197

eted talents as economist, philosopher, and logician insulated him against the
attacks of lesser minds. (For a glimpse of Mill’s contribution to economic method,
see the box, Method Squabbles 2: Mill on Economic Method.) Indeed, Mill’s legacy
endures. As is true of most great thinkers, the questions he raised have proved more
durable than the answers he gave. In this chapter we have concentrated on Mill’s
theoretical performance, with a few side glances at his policy proposals. In the next
two chapters we shall see how Mill’s ideas on policy, alongside those of his contem-
porary, Edwin Chadwick, became part of the political landscape of Great Britain.

Method Squabbles 2: Mill on Economic Method

In addition to his stellar contributions to economic theory and policy, John Stuart Mill was
one of the first economists to state clearly what has become the dominant method of eco-
nomic inquiry. While both Nassau Senior and David Ricardo made contributions to the estab-
lishment of a mainstream method for economists, Mill gave the nature of economic science its
most effective expression in Book VI of his A System of Logic (1843). In simplified terms, Mill
rejected methodological extremes and declared economics a science akin to chemistry or
physics but dealing with a different, more complex subject matter—human nature. Therefore
economics was a “social” science, not as advanced, perhaps, as more traditional sciences, but a
science nevertheless.
Mill appealed to the physical sciences of his time in order to illustrate the bona fides of eco-
nomics. Meteorology was, like economics, an imperfect science. In 1843 scientific inquiry had
not yet succeeded in ascertaining the “order of antecedence and consequence” among meteo-
rological phenomena so as to be able to predict the weather at any particular place and with
any accurate degree of probability. (Indeed, such prediction is still imperfect, but it is much
improved from Mill’s day). But no one, said Mill, can doubt “that if we were acquainted with all
the antecedent circumstances, we could . . . predict (except for difficulties of calculation) the
state of the weather at any future time. Meteorology, therefore, not only has in itself every nat-
ural requisite for being, but actually is, a science; though, from the difficulty of observing the
facts on which the phenomena depend (a difficulty inherent in the peculiar nature of those
phenomena), the science is extremely imperfect.”* Mill thought “tidology” (the study of tides)
was a more “advanced” science, even though it too was in flux. The gravitational pulls of sun
and moon in relation to the earth’s gravitational field were clear determinants, but influences
of a “local and causal nature” (the configuration of the ocean bottom, direction of the wind,
etc.) also had to be accounted for. Unlike meteorology, tidology could be used to predict on
the basis of known general laws; in other words, it was in a more advanced state of completion.
Like these natural sciences economic “science” was still a work “in progress,” in Mill’s opin-
ion. It benefited from the use of both inductive (from specific experience to general cases) and
deductive (from general laws to specific cases) reasoning. On the one hand Mill rejected the
extreme methods of the “experimentalists” (inductivists), and on the other he declared the
method of the “geometricians” (pure deductivists) inadequate. He maintained that the funda-
mental axioms on which economics was based were inductive—built up from empirical evi-
dence in a continuous process of improving and modifying them. Like meteorology and
tidology, the “laws” and axioms of political economy were in constant flux, based as they were
on the evidence collected in their application. In sum, the act of deduction was required to
draw valid conclusions based on inductively derived axioms.
Mill cautioned, however, that the social scientist always has to be on guard in the applica-
tion of scientific “laws.” If economics were not based on empirically derived axioms, he
claimed, it would be like astronomy, in which “the data . . . are as certain as the laws them-

(continued)
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198 Part II ■ The Classical Period

selves.” But in economics, “the circumstances . . . , which influence the condition and progress
of society, are innumerable, and perpetually changing; though they all change in obedience
to causes, and therefore to laws, the multitude of the causes is so great as to defy our limited
powers of calculation.Ӡ
Mill therefore supported a determinist method for economics composed of inductive and
deductive elements. The multitude of possible changes in human behavior and events, and
the difficulty (only partially resolved today) of “testing” and data gathering, made prediction a
perilous business. It is possible to discern tendencies—thus giving rise to the notion of eco-
nomics as a science of tendencies—but a better understanding of these phenomena, which
give rise to economic theory, is the true object of social science. In his day Mill was disap-
pointed that economists had not amassed enough knowledge for anything like exact “predic-
tion,” although he did believe that there was enough for “guidance.” Today, in a time when
the Nobel Prize is routinely awarded in economic science, we know a bit more. However, the
method Mill established for gathering knowledge remains much the same.
* J. S. Mill, Logic, pp. 30–31.
†
Logic, p. 63.

Classical economics was, of course, never without its critics. The Malthusian
population doctrine and the differential-rent theory, for example, underwent fre-
quent attacks by radicals, socialists, and reformers throughout the nineteenth cen-
tury. But in an 1869 issue of the Fortnightly Review a curious event took place within
the classical orthodoxy of Great Britain that shook the foundations of the classical
theoretical system. John Stuart Mill recanted the wages-fund doctrine.

The Wages-Fund Revisited

Recall from chapter 5 that the wages-fund doctrine held that during any given
production period, a stock of circulating capital is advanced to laborers to tide them
over to the next production period. This stock of circulating capital is determined by
many variables, including the productivity of labor and capital accumulated in pre-
vious periods, the amount of capital invested in previous periods, and so forth. In
crude terms, the doctrine indicated that at a macroeconomic level, the average wage
rate over the period of production is determined by dividing the number of laborers
into the stock of circulating capital. Thus, in real terms, a maximum real wage (that
is, all the goods consumed by laborers) is established at the beginning of the pro-
duction period. Properly stated, and given the assumption of a discrete time period
of production, the wages-fund doctrine forms an integral and inextricable part of
the dynamics of the classical system (see chapter 7).
Confusions Surrounding the Doctrine. Numerous confusions always sur-
rounded the wages-fund doctrine. One of them concerns the introduction of money
wage payments, which serve as the proxy for real wages. If the fund is understood
as a money amount, then the amount going to labor could indeed be elastic and
variable. But the stock of real wage goods on hand is nonaugmentable (at a given
time), irrespective of the amount or variability of money wages paid. Money wages,
then, are not the “capital” of the wages-fund theory. Even Adam Smith, who pro-
vided early and otherwise clear statements of the wages-fund theory, was not
immune to the problem. As Frank Taussig pointed out with reference to Smith’s
treatment of the doctrine:
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Chapter 8 ■ Classical Economics (III) 199

Sometimes, indeed most commonly, this “stock” is conceived in terms of money or

as consisting of funds in the hands of the immediate employer. Sometimes the
money payments are described as of no essential importance, as only steps toward
the distribution of real wages. The uncertainty and confusion which thus showed
itself in Adam Smith continued to appear in almost all the discussions of wages for
fully a century after his time. (Wages and Capital, p. 145)

Micro Theory versus Macro Theory. Another difficult problem concerned the
attempt, by both defenders and critics, to read a microeconomic theory of wage
determination into statements about the wages-fund. For example, Francis A.
Walker, an American critic of the concept, argued that the wages-fund doctrine
ignored the varying productivity of workers and therefore did not explain relative
wage rates between different types of laborers or between laborers of different coun-
tries (e.g., the East Indians and the British). Walker was joined in this criticism by
many others. Unfortunately, and in spite of misuse on the part of its proponents, the
wages-fund doctrine was designed only as a rough-and-ready macroeconomic argu-
ment. It was not until the development of the marginal-productivity theory decades
later that a satisfactory explanation of individual wage determination was broached.

Mill’s Recantation7
All the main elements of the classical wages-fund doctrine were present in
Mill’s Principles, including the assumption of a point-input/point-output production
process. Mill’s theoretical view of the doctrine assumed that the present remunera-
tion of labor was the consequence of past applications of capital and labor, and he
held that a proportion of total output was destined for labor in advance of produc-
tion. Moreover, Mill applied the doctrine at an aggregate level and in real terms.
By 1869, Mill had altered his views on the wages-fund doctrine, touching off a
great deal of controversy. Some explanations given for Mill’s recantation are based
on extra-theoretical considerations. For example, since Mill recanted the doctrine in
his review of a book by W. T. Thornton, some attribute his action to friendship with
Thornton. Some believe Mill recanted because of his commitment to social reform.
Others believe that Mill was influenced by his wife, Harriet Taylor—a staunch
reformer—or by the philosopher Auguste Comte. While none of these influences
should be discounted completely, a close examination of Mill’s writings suggests
that by 1869 he had changed his theoretical view of the wages-fund. For that reason
we look to resolve this matter of shifting theoretical grounds.
The central issue in Mill’s recantation concerned the fixity of the fund ear-
marked for the payment of labor. The idea of a fixed fund in the short run implied
that in the aggregate, workers could claim no more in wage payments than an
amount that would exactly deplete the fund. Thus, the doctrine of the wages-fund
was frequently used to demonstrate the futility of efforts by labor unions to raise
their aggregate compensation. The long run was a different matter—no classical
economist argued that the fund was fixed over the long run. However, some
advanced the argument that if labor unions were too aggressive in pushing their
claims, profit expectations would decline, so that in the future less capital would
flow into the fund, thereby reducing real wages eventually. In later life, Mill became
sympathetic to labor unions, and this may have been the impetus that led him to
reexamine the wages-fund theory, in particular the subject of its short-run fixity.

7
This section follows closely the argument presented by R. B. Ekelund, Jr., “A Short-Run Classical
Model of Capital and Wages.”
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200 Part II ■ The Classical Period

In his 1869 review of Thornton’s book On Labour, Mill rejected the popularly
held assumption that the size of the fund is fixed. Of the aggregate amount that is
spent on wages, Mill now asserted only that there is some upper limit. He wrote:
There is an impassable limit to the amount which can be so expended; it cannot
exceed the aggregate means of employing classes. It cannot come up to those
means; for the employers have also to maintain themselves and their families. But,
short of this limit, it is not, in any sense of the word, a fixed amount. (“Thornton on
Labour,” p. 516)

Mill refined the argument by dividing the employer-capitalist’s means into two parts:
capital and income on that capital. While the former is usually equated in classical
economic nomenclature with the wages-fund, Mill argued that the capitalist could add
to that amount by discretionary reductions of income. Capitalists, in other words,
might respond to exogenous variables (e.g., union pressure, different profit expecta-
tions, etc.) by voluntarily reducing expenditures on themselves and their family in
order to spend more on labor. In this way, Mill apparently thought that labor unions
might be able to redistribute income in favor of the workers. Unfortunately, Mill’s
argument did not distinguish between money wages and real wages, or between short-
run and long-run effects. Consequently, his recantation rests on dubious grounds.
A Short-Run Wages-Fund Model. In order to expose the deficiencies of Mill’s
recantation, we shall place it in the context of a short-run wages-fund model adher-
ing to the usual classical assumptions. Those assumptions are:
1. Production takes place within a point-input/point-output production process.
2. The entire output of the economy is composed of fixed capital, wage goods, and
capitalist consumables. There is, moreover, no transference of demands between
markets; i.e., wage earners do not transfer demands from wage goods to capital-
ist consumables and vice versa.
3. Production in all industries is marked by a constant ratio of fixed to circulating
capital.
4. Perfect competition (i.e., constant costs of production) exists everywhere.
5. The money supply is fixed for the term in question.
6. Population and productivity remain unchanged during the period in question.
Under these assumptions, the aggregate stock of goods in real terms during any
period, say t1 is determined by past production beginning at t0 and cannot be
increased during the interval, t1 t2. In real terms, consumption and investment deci-
sions are made at the beginning of t1 and the entire stock of goods is depleted by the
end of the period (at the start of t2), albeit at different rates of use. For example,
consider figure 8-2, where the total stock of goods at t1 is represented by OY0,
divided so that OM0 is equal to fixed capital (e.g., machinery), M0W0 is equal to
wage goods available for purchase by workers, and W0Y0 is equal to capitalist con-
sumables. This tripartite division conforms to Mill’s representation. Under the usual
assumptions of the wages-fund theory, these various stocks are used up during the
production period, so that at the end of t1 each has fallen to zero.
Now let us examine the effects of a decision by the capitalist to reduce his or
her own real income (W0 Y0 ) in order to spend more on labor, the prospect Mill
raised in his recantation. The effects of this redistribution of income are carried
through in figures 8-3a and 8-3b. The former depicts the market for goods that are
bought by workers, the latter the market for goods purchased by capitalists. Under
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Chapter 8 ■ Classical Economics (III) 201

the rigid supply conditions of the wages-fund model, output in each period is fixed
and determined by the previous period. Thus, the supply curves in figures 8-3a and
8-3b are vertical lines. A voluntary reduction in real income by capitalists will cause
the demand for capitalist consumables to shift to the left, lowering the average price
of such goods from Pc to Pc . In like manner, an increase in workers’ real income
will shift the demand for wage goods to the right, thereby raising the average price
of those goods from Pw to Pw .
The conclusion of this analysis is that under the assumptions of the classical
wages-fund doctrine, the effects of any reallocation of funds by capitalists in favor of

Y0

W0

M0
Figure 8-2 The
total stock of goods
available (Y0) at the
end of period t1 O
diminishes to zero. t1 t2

St1 St1

P'w Pc

Pw Dt1 P'c Dt0

Dt0 Dt1

O q1 Wage O q1 Capitalist
goods consumables
(a) (b)

Figure 8-3 As the demand for wage goods increases from Dt0 to Dt1, prices will rise
from Pw to Pw . In the long run, the entry of new firms will shift supply, causing prices to
fall back to Pw . A similar effect will occur in the capitalist consumables market, in which
a leftward supply shift will force prices back up to Pc . Over time, the quantities in both
markets will also adjust.
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202 Part II ■ The Classical Period

labor are solely upon prices in the two markets. Furthermore, given a constant money
stock and constant velocity, the price changes in the two markets will be proportion-
ate in opposite directions, so that the aggregate price level will not be affected. More
important from the standpoint of the laboring classes, the increase in money wages
occasioned by the transfer of income from the capitalist class produces a price
increase in wage goods that offsets the rise in money wages. Real wages remain
unaffected by the transfer. Since Mill implied that workers would be better off under
such a transfer, it seems clear that he confused real wages with money wages.
Long-Run Adjustments. The nature of the long-run adjustments that would
accompany the kind of income redistribution just considered does not hold any
brighter prospects for permanent increases in real wages. Given price changes in
the two markets traced above, higher profits in the wage-goods industry would sig-
nal new firms to enter, whereas lower profits in the capitalist-consumables market
would encourage some firms to exit. These long-run changes can be envisioned by
shifting the vertical supply curve to the right in figure 8-3a and to the left in figure 8-
3b. Under constant-cost conditions, price would tend to return to Pw in figure 8-3a
and to Pc in figure 8-3b. The adjustments in each market might be lengthy, but the
tendency would be for prices to return to the level they were before the suggested
income transfer. The point that Mill seemed to forget (or deny) in his 1869 recanta-
tion is that in the classical world, permanent increases in real wages are traceable to
real factors only, such as improvements in technology or some other increase in
worker productivity.
Mill’s recantation of the wages-fund doctrine and the subsequent confusion
that it caused in the ranks of the classical orthodoxy is but one factor among a host
of other possible reasons for the decline of classical economics. The rise of margin-
alism (see chapters 13 to 15) is often cited as a reason for this decline; another is the
inroads made in the nineteenth century by historicist and socialist critics of eco-
nomic orthodoxy (see chapter 11). Great policy debates, such as those over free
trade, the rent issue, and trade unions, also played a role in the questioning of clas-
sical theory, especially in England and America. Presumably, all these developments
contributed to the decline of classical economics as a dominant paradigm.

■ ENTREPRENEURISM AT THE CLASSICAL SUMMIT

John Stuart Mill’s Principles of Political Economy is a watershed in British clas-
sical economics because it consists of a mature statement of the economic paradigm
first developed by Smith and successively refined in Britain by Ricardo, Malthus,
Senior, and others. It is also a kind of bridge between the economics of the old
school (1776–1870) and the new (1871–1920). Yet, like his British forebears, Mill
contributed little to the theory of entrepreneurship. He lamented the fact that
“undertaker”—the English word popularly used to translate the French term entre-
preneur—did not adequately convey the desired economic meaning (Principles, p.
406n). But throughout his economic works Mill treated entrepreneurs and their eco-
nomic reward somewhat ambiguously. Echoing Say he identified the functions of
entrepreneurs as direction, control, and superintendence. In one place he observed
that the qualities of direction and superintendence are always in short supply (Prin-
ciples, p. 108), and in another, he suggested that superior business talents always
receive a kind of rent alongside ordinary profits (Principles, p. 476). But in the final
analysis, he offered no clear-cut distinction between the capitalist and the entrepre-
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Chapter 8 ■ Classical Economics (III) 203

neur, insisting that the return to the latter is composed of a risk premium and a
wage of superintendence. He was, in the end, a mere caretaker of a notion that
remained throughout classical economics pretty much in the shadow of Cantillon.
Schumpeter (History, p. 555) credits Say with the first distinct conceptualization
of the entrepreneur apart from the capitalist; but even Say did not make full use of
his own insight, nor did he see clearly all of its analytic possibilities. Among the Eng-
lish, Bentham “pushed the envelope”, but he was more concerned with institutional
reform (e.g., the Panopticon and other schemes) than with the development of core
analytic principles that were strictly economic. Mill, of course, knew Bentham and
read Say, but he followed up on neither one’s suggestions where the entrepreneur
was concerned. He kept the entrepreneur in the background of his distribution the-
ory by focusing mainly on land, labor, and capital as agents of production. This sug-
gests, at least by implication, that the entrepreneur is either a special laborer, or a
combination of laborer and capitalist. It does not seem that Mill seriously entertained
the idea of the entrepreneur as innovator. Where he discussed the labor of invention
and discovery, for example, Mill treated its reward as merely a kind of wage.
Mill defined the capitalist’s reward as the sum of an opportunity cost for post-
poning consumption (i.e., Nassau Senior’s concept of “abstinence”), plus an indem-
nity for risk of capital, plus the “wages of superintendence.” He asserted further
that the wages of superintendence are not regulated by the same principle as work-
ers’ wages. Specifically, he maintained that the wages of superintendence are not
advanced from capital, like the wages of other workers, but arise in profit, which is
not realized until production is completed.
In Mill’s time, the wages of labor were explained by the wages-fund doctrine,
and in this view, the total amount that can be paid to labor is limited by the amount
of capital previously accumulated. By separating the wages of superintendence
from circulating capital Mill implied that there is no such limit on the wages of
superintendence. But we are still left with a kind of functional “merger” between
capitalist and entrepreneur in British classical economics that worked against a
clear and unambiguous statement of the entrepreneur and his or her pivotal role in
the competitive market process.

■ CONCLUSION
In terms of economic theory, John Stuart Mill represents the culmination of eco-
nomic analysis begun by Adam Smith and extended by Malthus, Say, Ricardo and
Senior. Dubbed “classical economics,” this body of thought was cogent and logically
correct. While its assumptions encompassed many broad and challengeable general-
izations, its logic was sweeping and elegant. However, economists in the last third of
the nineteenth century appeared to be asking questions that the classical theoretical
system could not answer satisfactorily, if at all. The policy conclusions of classical
theory simply were not acceptable to the majority of social scientists.8 Increasingly
attention turned away from macroeconomic issues to individual (microeconomic)
behavior, and as it did economic analysis advanced in a new direction.
Can classical economics, then, have died in any meaningful sense? Though it is
often easier to view intellectual history in terms of sharp breaks with past ideas,
such a view would do a serious disservice to the classical economists and to their
8
There were exceptions, of course. The American social critic Henry George, in his popular book
Progress and Poverty (1879), rejected the wages-fund doctrine while recasting the Ricardian the-
ory of differential land rents into a policy of urban-site value taxation.
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204 Part II ■ The Classical Period

theoretical structure. Old theories do not die, and unlike old soldiers, they don’t
even fade away. For instance, Alfred Marshall, the great neoclassical contributor to
microeconomics, was very adamant in his admiration for, and use of, Ricardo’s the-
ory of cost in formulating partial-equilibrium analysis.
Marshall was one of many inheritors of the classical tradition who leaned heav-
ily on Mill and his antecedents. It is difficult to improve on Marshall’s description of
the transition from the classical to the neoclassical. He wrote:
The change may, perhaps, be regarded as a passing onward from that early stage in
the development of scientific method, in which the operations of Nature are repre-
sented as conventionally simplified for the purpose of enabling them to be described
in short and easy sentences, to that higher stage in which they are studied more
carefully, and represented more nearly as they are, even at the expense of some loss
of simplicity and definiteness, and even apparent lucidity. (Principles, p. 766)

Few episodes in the history of economic thought match the achievements of the
classical economists in discovering and formulating the operations of an entire eco-
nomic system. In addition, they established the method upon which modern eco-
nomic reasoning is based. Although the assumptions of classical economics were in
fact simplistic, its proponents attempted nothing less than global analysis of entire
economies. One might legitimately wonder whether such large ends would or could
be sought by contemporary economists. “Progress” and the quest for technical
accuracy have probably robbed us of the will, but the classical theoretical structure
remains as an inspiration for such an attempt. In struggling with the problems of
economic development in developing nations, contemporary economists have
returned on occasion to the simple analytics of classical dynamics. In other words,
not only were classical ideas incorporated into neoclassical economics, they became
the soil in which neoclassical economics grew.

REFERENCES
Ekelund, R. B., Jr. “A Short-Run Classical Model of Capital and Wages: Mill’s Recantation
of the Wages-Fund,” Oxford Economic Papers, vol. 28 (March 1976), pp. 66–85.
Marshall, Alfred. Principles of Economics, 8th ed. London: Macmillan, 1964 [1890].
Mill, J. S. “Thornton on Labour and Its Claims,” Fortnightly Review (May, June 1869), pp.
505–518, 680–700.
———. Letters of John Stuart Mill, 2 vols., H. S. R. Elliot (ed.). London: Longmans, 1910.
———. The Logic of the Moral Sciences. LaSalle, IL: Open Court, 1988 [1843].
———. “Of the Influence of Consumption on Production,” in Essays on Some Unsettled
Questions of Political Economy, vol. 4 of Collected Works of John Stuart Mill, J. M.
Robson (ed.). Toronto: University of Toronto Press, 1967 [1844].
———. Autobiography of John Stuart Mill. New York: Columbia University Press, 1924
[1873].
———. Principles of Political Economy, W. J. Ashley (ed.). New York: A. M. Kelley, 1965
[1848].
Mishan, E. J. The Costs of Economic Growth. London: Staples, 1967.
Schumpeter, Joseph. History of Economic Analysis, E. B. Schumpeter (ed.). New York:
Oxford University Press, 1954.
Stigler, G. J. “The Nature and Role of Originality in Scientific Progress,” Economica, n.s.,
vol. 22 (November 1955), pp. 293–302.
Taussig, F. W. Wages and Capital. New York: A. M. Kelley, 1968 [1896].
Thornton, W. T. On Labour: Its Wrongful Claims and Rightful Dues, Its Actual Present
and Possible Future. London: Macmillan, 1869.
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Chapter 8 ■ Classical Economics (III) 205

NOTES FOR FURTHER READING

Insights into Mill’s life and unusual upbringing are contained in frank detail in his
Autobiography (see references), which was, according to his wishes, not published until
the year of his death (1873). See also Alexander Bain, John Stuart Mill, A Criticism: With
Personal Recollections (London: Longmans, 1882); Herbert Spencer et al., John Stuart
Mill: His Life and Works (Boston: Osgood and Co., 1873); W. L. Courtney, Life of John
Stuart Mill (London: Secker & Warburg, 1954); and Bertrand Russell, “John Stuart Mill,”
in Portraits from Memory and Other Essays (London: G. Allen, 1956).
Mill’s multidimensional thought covers such fields as logic, philosophy, and eco-
nomics. His contributions to the field of logic were epoch making. It is best to start with
Mill himself. See J. S. Mill, A System of Logic (London: Longmans, Green, 1884); and
same author, “On the Logic of the Moral Sciences,” in H. M. Magid (ed.), A System of
Logic (Indianapolis: Bobbs-Merill, 1965). Mill’s classic essays, “On Liberty,” “Utilitarian-
ism,” and excerpts from “Considerations on Representative Government,” have been
edited and reprinted by Marshall Cohen in The Philosophy of John Stuart Mill (New
York: Modern Library, 1961). See also R. P. Anschutz, The Philosophy of John Stuart Mill
(London: Oxford University Press, 1953). At one stage of his life, Mill was attracted by
the positivist philosophy of Auguste Comte. See J. S. Mill, Auguste Comte and Positivism
(London: Lippincott, 1865); and Mill’s correspondence with Comte, Lettres inédites de
John Stuart Mill á Auguste Comte (Paris: Felix Alcan, 1899), available only in French. R.
B. Ekelund and Emilie Olsen, “Comte, Mill and Cairnes: The Positivist-Empiricist Inter-
lude in Late Classical Economics,” Journal of Economic Issues, vol. 7 (September 1973),
pp. 383–416, explore the impact of Comte’s positivism on Mill and Cairnes. For more on
Mill’s methodology see J. K. Whitaker, “John Stuart Mill’s Methodology,” Journal of Polit-
ical Economy, vol. 83 (October 1975), pp. 1033–1050.
Considering Mill’s economics in the more narrow sense, it is noteworthy that almost
everything written on Mill by other economists has been collected under the editorship
of John C. Wood, John Stuart Mill: Critical Assessments (London: Croom Helm, 1987).
Pedro Schwartz, The New Political Economy of John Stuart Mill (Durham, NC: Duke
University Press, 1973), reviews Mill’s views on economic policy, demonstrating the rele-
vance of Mill’s thought for contemporary capitalism. The indefatigable Sam Hollander,
The Economics of John Stuart Mill (Toronto: University of Toronto Press, 1985), has
undertaken, in two volumes, a wholesale reinterpretation of Mill’s economics in which
he advances the controversial claim that there was no real intellectual break between
classical and neoclassical (i.e., Marshallian) economics. However, Dimitris Sotiropoulos,
“Why John Stuart Mill Should Not be Enlisted among Neoclassical Economists,” The
European Journal of the History of Economic Thought, vol. 16 (Fall 2009), pp. 455–473,
maintains that Mill distanced himself from the utilitarianism of Bentham and the ques-
tionable assumptions underlying the felicific calculus, making his system different from
the principles established by Jevons, Marshall, Walras, and Menger. A. Hirsch, “John
Stuart Mill on Verification and the Business of Science,” History of Political Economy,
vol. 24 (Winter 1992), pp. 843–866, challenges Hollander’s interpretation of Mill’s view
of science, arguing that Hollander subjugated Mill’s a priori view of science to his “appli-
cations-style” empiricism.
G. J. Stigler defends Mill’s originality as an economist in “The Nature and Role of
Originality in Scientific Progress,” Economica, vol. 22 (November 1955), pp. 293–302,
reprinted in Stigler’s Essays in the History of Economics (Chicago: University of Chicago
Press, 1965), but on the issue of Mill’s priority concerning the theory of joint cost, Stigler
has been challenged by E. G. West, “Joint Supply Theory Before Mill,” History of Political
Economy, vol. 26 (Summer 1994), pp. 267–278. West contends that Adam Smith pre-
ceded Mill on this specialized topic, but his argument requires a somewhat strained
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206 Part II ■ The Classical Period

reading of Smith. Other assessments of Mill in the large picture of economics include V.
W. Bladen, “John Stuart Mill’s Principles: A Centenary Estimate,” American Economic
Review, vol. 39, suppl. (May 1949), pp. 1–12; James Bonar, “John Stuart Mill, the
Reformer: 1806–73,” Indian Journal of Economics, vol. 10 (April 1930), pp. 761–805; W.
D. Grampp, “Classical Economics and Moral Critics,” History of Political Economy, vol. 5
(Fall 1973), pp. 359–374; Neil de Marchi, “The Success of Mill’s Principles,” History of
Political Economy, vol. 6 (Summer 1974), pp. 119–157; same author, “Mill and Cairnes
and the Emergence of Marginalism in England,” History of Political Economy, vol. 4 (Fall
1972), pp. 344–363; and J. P. Platteau, “The Political Economy of John Stuart Mill, or, the
Coexistence of Orthodoxy, Heresy and Prophecy,” International Journal of Social Eco-
nomics, vol. 12 (1985), pp. 3–26. A. L. Harris discusses Mill’s ideas on freedom in two
articles: “J. S. Mill on Monopoly and Socialism,” Journal of Political Economy, vol. 67
(December 1959), pp. 604–611; and “Mill on Freedom and Voluntary Association,”
Review of Social Economy, vol. 18 (March 1960), pp. 27–44. See also, Elynor D. Davis,
“Mill, Socialism, and the English Romantics: An Interpretation,” Economica, vol. 52
(August 1985), pp. 345–358. In a recent spate of papers, E. Forget presents some interest-
ing interpretations of Mill. In particular, see “John Stuart Mill’s Business Cycle,” History
of Political Economy, vol. 22 (Winter 1990), pp. 629–642, in which the author argues that
Mill suffused his analysis with institutional details, analyzing the rational behavior of
market traders possessing varying degrees of imperfect information. Forget maintains
that normal price provided the basis for Mill’s business cycle theory.
The standard treatment of Mill’s theory of international trade and reciprocal
demand is Jacob Viner, Studies in the Theory of International Trade (New York: Harper,
1937), pp. 535–541. Mill’s terms-of-trade argument was expanded by F. Y. Edgeworth in
his Papers Relating to Political Economy, vol. 2 (London: Macmillan, 1925), p. 340ff;
more recently by N. Kaldor, “A Note on Tariffs and the Terms of Trade,” Economica, vol.
7 (November 1940), pp. 377–380; and again by H. G. Johnson, “Optimum Tariffs and
Retaliation,” Review of Economic Studies, vol. 21 (1953–1954), pp. 142–153. The possibil-
ity of “multiple equilibriums” in international trade and of Mill’s alleged attempts to rule
them out is discussed in two papers, one by D. R. Appleyard and J. C. Ingram, “A Recon-
sideration of the Addition to Mill’s ‘Great Chapter,’” History of Political Economy, vol. 11
(Winter 1979), pp. 459–476; and the other by J. S. Chipman, “Mill’s Superstructure: How
Well Does It Stand Up?” History of Political Economy, vol. 11 (Winter 1979), pp. 477–499.
See also the reply by Appleyard and Ingram that follows Chipman in the same issue.
Mill’s rendition of Say’s Law may well have derived from his father, James Mill. On
this matter, see B. Balassa, “John Stuart Mill and the Law of Markets,” Quarterly Journal
of Economics, vol. 73 (May 1959), pp. 263–274; and the comment by L. C. Hunter in the
same journal, vol. 74 (May 1960), pp. 158-162. A clarification of Say’s Law has been
attempted by W. J. Baumol, “Say’s (At Least) Eight Laws, or What Say and James Mill
May Have Really Meant,” Economica, vol. 44 (May 1977), pp. 145–162; but see also W. O.
Thweatt, “Baumol and James Mill on ‘Say’s’ Law of Markets,” Economica, vol. 47
(November 1980), pp. 467–470.
On other specific aspects of Mill’s economics, see L. C. Hunter, “Mill and Cairnes on
the Rate of Interest,” Oxford Economic Papers, vol. 11 (February 1959), pp. 63–97; J. H.
Thompson, “Mill’s Fourth Fundamental Proposition: A Paradox Revisited,” History of
Political Economy, vol. 7 (Summer 1975), pp. 174–192; Sam Hollander, “J. S. Mill on
‘Derived Demand’ and the Wage Fund Theory Recantation,” Eastern Economic Journal,
vol. 10 (January–March 1984), pp. 87–98; W. C. Bush, “Population and Mill’s Peasant-
Proprietor Economy,” History of Political Economy, vol. 5 (Spring 1973), pp. 110–120; M.
E. Bradley, “Mill on Proprietorship, Productivity, and Population: A Theoretical Reap-
praisal,” History of Political Economy, vol. 15 (Fall 1983), pp. 423–429; Nathalie Sigot and
Christophe Beaurain, “John Stuart Mill and the Employment of Married Women: Recon-
Ekelund-Hebert 6E.book Page 207 Thursday, August 1, 2013 11:03 AM

Chapter 8 ■ Classical Economics (III) 207

ciling Utility and Justice,” Journal of the History of Economic Thought, vol. 31 (Septem-
ber 2009), pp. 281–304; Sam Hollander, “Dynamic Equilibrium with Constant Wages: J.
S. Mill’s Malthusian Analysis of the Secular Wage Path,” Kyklos, vol. 37 (1984), pp. 247–
265; same author, “The Wage Path in Classical Growth Models: Ricardo, Malthus and
Mill,” Oxford Economic Papers, vol. 36 (June 1984), pp. 200–212; V. R. Smith, “John Stu-
art Mill’s Famous Distinction between Production and Distribution,” Economic Philoso-
phy, vol. 1 (October 1985), pp. 267–284; and R. B. Ekelund, Jr., and Douglas M. Walker,
“J. S. Mill on the Income Tax Exemption and Inheritance Taxes: The Evidence Reconsid-
ered,” History of Political Economy, vol. 28 (Winter 1996), pp. 559–581. An interesting
exchange on Mill’s “utility” theory is contained in the following papers: M. Bronfen-
brenner, “Poetry, Pushpin and Utility,” Economic Inquiry, vol. 15 (January 1977), pp. 95–
110; M. S. McPherson, “Liberty and the Higher Pleasures: In Defense of Mill,” Economic
Inquiry, vol. 18 (April 1980), pp. 314–318; and the rejoinder by Bronfenbrenner, “Liberty
and Higher Pleasures: A Reply,” Economic Inquiry, vol. 18 (April 1980), pp. 319–320.
The wages-fund controversy and Mill’s role in it were first capably summarized by F.
W. Taussig, Wages and Capital (see references). Marshall’s student and successor, A. C.
Pigou, discusses the grounds of Mill’s famous recantation in “Mill and the Wages Fund,”
Economic Journal, vol. 57 (June 1949), pp. 171–180. William Breit, “Some Neglected
Early Critics of the Wages Fund Theory,” Southwestern Social Science Quarterly, vol. 48
(June 1967), pp. 53–60, probed the early criticisms of the theory, and then examined the
“first round” of the famous controversy, in which Longe, Thornton, and Mill figured
prominently, in “The Wages-Fund Controversy Revisited,” Canadian Journal of Econom-
ics and Political Science, vol. 33 (November 1967), pp. 523–528. Scott Gordon concen-
trates on the latter phase of the controversy in “The Wage-Fund Controversy: The
Second Round,” History of Political Economy, vol. 5 (Spring 1973), pp. 14–35. The inter-
pretation of Mill’s recantation utilized in this chapter is based on R. B. Ekelund, “A
Short-Run” (see references), which has sparked a controversy of its own. For more on
this subject, see J. Vint, “A Two Sector Model of the Wage Fund: Mill’s Recantation Revis-
ited,” British Review of Economic Issues, vol. 3 (Autumn 1981), pp. 71–88; T. Negishi,
“Mill’s Recantation of the Wages Fund: Comment,” Oxford Economic Papers, vol. 37
(March 1985), pp. 148–151; and R. B. Ekelund, “Mill’s Recantation Once Again: Reply,”
Oxford Economic Papers, vol. 37 (March 1985), pp. 152–153. Yet another controversy has
swirled around the issue of whether Mill used a “Malthusian” argument in support of
trade unions. Arguing in favor of such a view, E. G. West and R. W. Hafer, “J. S. Mill,
Unions, and the Wages-Fund Recantation: A Reinterpretation,” Quarterly Journal of Eco-
nomics, vol. 92 (November 1978), pp. 603–619, have challenged Ekelund’s interpretation
of Mill’s recantation, but see the response by R. B. Ekelund and W. F. Kordsmeier, “J. S.
Mill, Unions, and the Wages Fund Recantation: A Reinterpretation-Comment,” Quarterly
Journal of Economics, vol. 96 (August 1981), pp. 531–541.
The seemingly endless parade of opinions on Mill’s recantation continues unabated.
Two entries provide signposts to the directions taken by modern interpretations. J. Vint,
Capital and Wages: A Lakatosian History of the Wages Fund Doctrine (London: Edward
Elgar, 1994), renders a full-scale reinterpretation of the wages-fund doctrine from the
perspective of Imre Lakatos’s “methodology of scientific research programs.” From this
perspective, Vint concludes that the classical economists were rational to advocate the
wages-fund idea, and that it was likewise rational of Mill both to reject it to the extent
that he did and to maintain the doctrine in theory up to the final edition of his Principles.
Given the logical problems within the Lakatosian theory itself, such results are ill-
founded, particularly in its attempt to apply a theory (the wages-fund) within a theory
(the whole of classical analytics). In a different direction (but in a similar normative
vein), E. Forget, “J. S. Mill and the Tory School: The Rhetorical Value of the Recantation,”
History of Political Economy, vol. 24 (Spring 1992), pp. 31–59, exposes Mill as a “political
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208 Part II ■ The Classical Period

animal,” which he undoubtedly was, suggesting that Mill wanted to come down hard on
the Tories and to “wrest political economy from the ideological stronghold of the middle
and upper classes.” Although this interpretation enlightens us to Mill’s political proclivi-
ties, it does not resolve the mystery of Mill’s recantation from the perspective of pure
theory (a fact that Forget freely acknowledges). On pure theoretical grounds, the objec-
tions to the money-fund/real-fund confusion are spurious. The short-run fixity of the
aggregate, average wage rate in the short run is logically assured by the economy-wide
assumption of a discontinuous production function, with fixed-production coefficients.
Moreover, the transference of demands between capitalist consumables (luxuries?) and
goods consumed by the workers (wage-goods) is immaterial to the logic of the fixity of
the fund, as well as to all other parts of Gross Domestic Product. But the controversy will
not die; see Oskar Kurer, “Mill’s Recantation of the Wages-Fund Doctrine: Was Mill
Right, After All?” History of Political Economy, vol. 30 (Fall 1996), pp. 515–536.
A final issue that is related to the wages-fund debate relates to W. T. Thornton, dis-
equilibrium theory, and to Thornton’s supposed explosion of the laws of supply and
demand. T. Negishi, “Thornton’s Criticism of Equilibrium Theory and Mill,” History of
Political Economy, vol. 18 (1986), pp. 567–577, argues that Thornton had a view of equil-
ibration, that it anticipated post-Walrasian “path-dependence,” and that his specification
of supply and demand should be respected. R. B. Ekelund, Jr., and S. Thommesen, “Dis-
equilibrium Theory and Thornton’s Assault on the Laws of Supply and Demand,” History
of Political Economy, vol. 21 (1989), pp. 567–592, argue that Thornton was considerably
less sophisticated, having no intellectual basis for rejecting or establishing anything (see
Negishi’s “Reply” in the same issue). E. Forget, “John Stuart Mill, Francis Longe, and
William Thornton on Demand and Supply,” Journal of the History of Economic Thought,
vol. 13 (Fall 1991), pp. 205–221, in a most interesting contribution, attempts (success-
fully) to reconstruct the analysis to which Thornton believed himself responding. Forget
argues that Thornton was responding to popular fallacies concerning the wages-fund
then extant, concluding (with Ekelund and Thommesen) that Thornton could not have
been a “disequilibrium theorist” or much of a theorist at all. The debate, however, has not
ended. For a dubious and strained resuscitation of Thornton’s arguments, see Michael V.
White, “‘That God-Forgotten Thornton’: Exorcising Higgling after On Labour,” in N. De
Marchi and M. S. Morgan (eds.), Higgling: Transactors and Theory Markets in the His-
tory of Economics, (Durham, NC: Duke University Press, 1994).
In certain quarters of the economics profession Thornton has been enlisted in an
antitheoretical, antiorthodox barrage of criticisms. See, for example Phillip Mirowski,
“Smooth Operator: How Marshall’s Demand and Supply Curves made Neoclassicism
Safe for Public Consumption, but unfit for Science,” in R. Tullberg (ed.), Alfred Marshall
in Retrospect (Aldershot: Edward Elgar, 1990). Robert B. Ekelund, Jr., “W. T. Thornton:
Savant, Idiot, or Idiot-Savant?” Journal of the History of Economic Thought, vol. 19
(Spring 1997), pp. 1–23, rejects Mirowski’s view. However, Thornton was not a one-trick
pony. He made important early contributions to the theory of property rights and eco-
nomic growth. See, in particular, his A Plea for Peasant Proprietors (originally published
in 1848) in Philip Mirowski and Steven Tradewell (eds.), volume 3 of The Economic Writ-
ings of William Thornton, 5 vols., (London: Pickering & Chatto, 1999). Also see Robert B.
Ekelund, Jr., and Mark Thornton, “William T. Thornton and Nineteenth Century Eco-
nomic Policy: A Review Essay,” Journal of the History of Economic Thought, vol. 23
(November 2001), pp. 513–531.
Ekelund-Hebert Part 3.fm Page 209 Wednesday, August 14, 2013 10:57 AM

Part III
RESPONSES TO THE
INDUSTRIAL REVOLUTION—
ORTHODOX AND HETERODOX

As the Industrial Revolution gathered steam, many sensibilities recoiled in horror at

the conditions it encouraged: overcrowded cities, poor sanitation, long work hours,
low wages, industrial accidents, and air and water pollution. Strident voices were
raised against the “evils” of industrialism. Some of the criticism aimed at classical
economics was based more on sentiment than on dispassionate analysis, but a few
theoretical refinements nevertheless found their way into economics alongside the
polemics and cries for reform.
France in particular harbored a number of reformers. It must be remembered
that although the Enlightenment shone brightly there, France held on to mercantil-
ism longer and embraced the Industrial Revolution later than England. Many of the
dissenting voices in France therefore took aim at the monarchy and its sweeping
powers, while others looked to government to correct the excesses of industrialism.
The common theme, if there was one, was social reform, but not necessarily how to
accomplish it. Before Marx entered the picture, reform was based on voluntarism—
an appeal to humanity to willfully change the social system. Marx embarked on a
new path by basing his economic theory on laws of history, so that change in his
system was inevitable and inexorable.
England, as the force of the Industrial Revolution in the nineteenth century took
hold, also experienced major problems as “side effects” of the great leap in technol-
ogy and growth. Urbanization and poverty accompanied the Industrial Revolution.
The class system made income and wealth distribution more rigid than it would
have been in a more egalitarian society (which emerged at the beginning of the
twentieth century). Chapters 9 and 10 consider British “orthodox” classical thinkers’
approach to policy on critical social issues—some of which still affect contemporary
society. Chapter 9 discusses the English distribution of income over the first half of
the century and examines policies relating to welfare, including a discussion of the
revision of the Poor Laws (England’s welfare program at the time) and the Factory
Acts affecting both adult and child labor. The obvious question arose, “Was it possi-
ble to raise people out of poverty?” The answer depends on the nature of human
beings. The questions are the same as they are today: Is poverty a result of the envi-
ronment or is it genetic; that is, is the nature and attitude of humans toward work
malleable? This chapter deals with classical opinions on such matters.
Chapter 10 expands on these ideas and features the economic analysis through
which two thinkers—John Stuart Mill and Edwin Chadwick—viewed the economic

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210 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

and social problems of the day. We give special emphasis to Mill’s analysis of the
English tax system and his advocacy of a progressive inheritance tax (“death
duties”). While emphasizing the importance of incentives, Mill believed that such a
tax might serve to address the class-driven distribution of income. But he discussed
other tax measures as well. Edwin Chadwick analyzed social problems and collected
statistics to support his views of reform. In chapter 10 we focus on Chadwick’s views
on disease, sanitation, and regulation of industries such as railroads. You will dis-
cover a unique and interesting approach to competition in Chadwick’s worldview.
Policy prescriptions to eliminate income disparity and social distinctions came
not only from within the classical world but from evolutionists, historicists, and
socialist-communist writers as well. In chapter 11 you will learn about different crit-
icisms of classical economics and platforms for social reform “outside” the economic
orthodoxy. A brief survey of evolutionist thought, though incomplete, serves to con-
vey the variety of attacks against classical economics. You will also be introduced to
historicism, a critique of economic method that began in Germany but found adher-
ents in England as well (as we shall see in part V). Chapter 12 deals with the eco-
nomics of Karl Marx, which posed a different kind of challenge to classical
economics because it was more systematic in content and more pervasive in impact.
You will learn how Marx borrowed from German philosophy in his attempt to
reshape classical economics into something that had remarkable appeal to “reform-
ers” across the world in the twentieth century, from Vladimir Lenin to Fidel Castro.
Ekelund-Hebert 6E.book Page 211 Thursday, August 1, 2013 11:03 AM

Economic Policy in
the Classical Period
Technology, Labor, and Poverty

While Ricardo and his followers pushed the abstract theory of classical macroeco-
nomics to new heights, actual circumstances of the nineteenth century presented real
(and frustrating) problems for the working classes. Poverty was not an abstraction. It
engulfed the working classes and exacerbated social problems identified with an
industrial economy, especially child labor, urban squalor, crime, and income distribu-
tion. In this chapter and the next we shall examine persistent economic and social
problems of Western society and how economics and economists faced them. Many
of the problems that accompanied the Industrial Revolution proved resistant to per-
manent solution, despite great advances in knowledge and technology. For example,
clean air and water, occupational safety and health, and eradication of disease and
poverty remain major concerns in many parts of the developed and developing world.
Problems like these pose obstacles to economic growth, no less today than a century
or more ago. Sanitation reform, for example, proved a key element in the improve-
ment of labor productivity, the mitigation of poverty, and, ultimately, economic well-
being. It should not surprise us, therefore, that the great minds of the day turned their
attention and analyses to socioeconomic problems of the first magnitude.
In this chapter and the next we analyze some of these critical issues as treated
by traditional economic thinkers. We briefly review the economic and social envi-
ronment of the classical period, with emphasis on urbanization, technology, and
health. We analyze the scope of the problem of income distribution in nineteenth-
century England in order to provide insight into what the classical economists
faced. We place labor and the attitudes of economists and thinkers toward the labor-
ing poor at the core of our discussion. Part of that discussion is related to technolog-
ically driven change, which had an enormous impact on factory workers and child
labor. The British Factory Acts are therefore central to a consideration of the issues
under consideration.
Two names necessarily advance to the head of the practical reformers’ list: Sir
Edwin Chadwick (1800–1890), possibly the single most brilliant social and eco-
nomic reformer of the century, and John Stuart Mill, one of the great classical econ-
omists and thinkers whose theories (in contrast to his policy views) we reviewed in
the preceding chapter. As the last of Bentham’s secretaries, Chadwick aligned his

211
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212 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

reforming zeal, as well as his policy prescriptions, with Bentham’s utilitarianism.

He was instrumental in writing and administering the English Poor Laws of the
1820s and 1830s. His authorship of the Sanitary Reports, submitted to Parliament in
1842 and 1843, further enhanced his standing among England’s greatest social and
economic reformers. Armed with mountains of data, mostly collected himself,
Chadwick tackled problems—and offered solutions—to some of the most pressing
problems of his day. John Stuart Mill, Chadwick’s friend and ally in socioeconomic
reform, may have been Chadwick’s superior on matters of theory but always
deferred to Chadwick on matters of fact. Together Mill and Chadwick presented
important answers to the “radical” reforms posed by writers less steeped in conven-
tional economic thought, such as those writers examined in chapter 11.

■ THE “REAL WORLD” OF CLASSICAL ECONOMICS

The nineteenth century was one of profound change. The technological land-
scape was transformed by the invention and development of the steam engine;
applications of steam power to transportation and manufacturing; and new
advances in chemistry, medicine, and biological sciences. These startling transfor-
mations occurred over an underbelly of social and economic change. The hereditary
aristocracy, an artifact from medieval (feudal) and mercantile times, remained atop
a class structure that skewed income against the middle and poorer classes. Cities,
especially in England and the United States, began to grow at unprecedented rates.
Urbanization proceeded apace as people moved from countryside to cities in search
of jobs related to the burgeoning technologies. London grew from approximately a
million people in 1800, to 2.5 million by 1850, and 6.7 million by the end of the cen-
tury. But enormous problems haunted so much progress. Workers crowded each
other in cities; housing and sanitation were inadequate; air and water were fouled;
and crime, as well as poverty, became a persistent reality.
The transport revolution that railroads spawned had multiple effects on soci-
ety—some good, some bad. Passengers on urban trolleys and railroads enjoyed
lower “time costs,” allowing the well-off to escape the dirty, noisy, crowded cities,
but leaving the inner core of cities to deteriorate. Sanitary conditions worsened as
urban cores were abandoned by the wealthy. Sewage was ubiquitous; in London
alone, as many as a quarter of a million cesspools existed in 1825. Human waste
and refuse was dumped in ditches and under the floorboards of houses. Disposal
systems, such as they were, were often constructed with permeable brick, allowing
leakage that rendered available water unfit to drink. Potable water was supplied
through common-use pumps interspersed throughout the poorest and most dense
parts of cities. Sometimes the water was filtered, and sometimes it was not. Under-
house cesspools created “night soil,” the term used for decomposing human and
other waste. These cesspools often overflowed, dumping contents into rivers that
were commonly used as the “natural” conveyance for disposed waste. The Thames
and its tributaries became germ infested and unwholesome.
Urban crowding and bad sanitation had predictable effects. Fear of random death
became ingrained in the poor and disadvantaged. In the early part of the century one
in three children did not reach the age of five years; the statistic later improved to only
one in five. While the precise source of disease was not known in the early part of the
century, owing partly to the relatively primitive state of science, people lived with the
effects of disease and plague. Plagues of various kinds gained in frequency and viru-
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Chapter 9 ■ Economic Policy in the Classical Period 213

lence between 1820 and 1850. Influenza epidemics killed thousands of Londoners in
1831–1832, followed by a series of cholera, dysentery, and typhoid fever epidemics
between 1836 and 1842. The city was struck repeatedly, with one of the worst typhus
epidemics ravaging it in 1837–1838. Tens of thousands died—rich and poor alike.
Fear of the unknown can have a paralyzing economic effect. It can also endorse
untested hypotheses. One such questionable supposition, perhaps understandable
within the wretched urban environment, was that “miasmas,” or airborne odors,
caused the various plagues. Indeed, odors were so bad that Parliament temporarily
closed its doors from a “great stink” that befell London in 1858. Even prescient
observers such as Edwin Chadwick (chapter 10) subscribed to this theory, although,
more than most, he was open to all evidence. It was not until 1854 and the so-called
“Broad Street cholera outbreak” that Dr. John Snow demonstrated that cholera was
waterborne. Given the slow pace of biological science the scientific community was
reluctant to accept his results.1 Eventually cause and effect were more tightly
linked, as typhus came to be associated with lice, cholera and dysentery with water-
borne bacteria, and so forth.
As the century developed, science advanced and longevity grew apace. The use
of anesthesia and sterilization made surgery more effective in preserving human
life. The discovery of bacteria and advances in chemistry likewise aided the cause.
Improved public sanitation measures eventually broke through the veil of igno-
rance. The long struggle to tame disease and enhance economic productivity
engaged economists and reformers who took stock of the society in their day and
hailed its scientific advances. Their engagement, however, was conducted within
the cultural determinants of a class structure that was in many respects an artifact
of medievalism. The distribution of income and wealth within that class structure
was a cultural lightning rod for the economists who took up the struggle.

■ INCOME DISTRIBUTION IN ENGLAND

The exact dating of the Industrial Revolution in England may be a matter of
debate, but it is clear that the effects were manifest from the mid-eighteenth cen-
tury well into the nineteenth. All of the characteristics of that revolution—including
a massive movement of people from country to urban environments—have been
clear to historians for many years. The ultimate question for our purposes is: “How
did that revolution have an impact on wealth and income levels of the entire popu-
lation?” Though surprisingly good, the quality of statistics on wealth and income
distribution in nineteenth-century England must necessarily be suspect. But even
allowing for that, the flowering of the Industrial Revolution made the nineteenth
century “England’s century.” Table 9-1 on the following page shows statistics on
wealth and income during1700–1858. According to most accounts, progressive
increases in aggregate income were translated into equally dramatic increases in
per capita national income. Robert Dudley Baxter (National Income) claims that
national income (from all sources) expanded threefold between 1801 and 1858.
Leone Levi (Taxation) asserts that per capita income increased from £14.7 to
£20.15 in the same interval.2 However, per capita income statistics tell nothing of
1
Using brilliant deduction, Snow plotted the incidence of cholera cases around the “potable” water
pumps in London, finding a significantly higher incidence of the disease around the pump at
Broad Street, thereby concluding that the disease was waterborne.
2
Using statistics collected in France, Levi contrasted Britain’s progress (£20.15 per capita in 1858)
with that of France (£15 per capita) and Russia (£5 per head).
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214 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

income distribution. The best statistics on income distribution tell a far different
story, justifying the concern among economic and social reformers for the working
poor and impoverished.
We acknowledge the data limitations inherent in such sources, but official
accounts of the comparative income distributions of Great Britain (England and
Scotland) in 1801 and again in 1848 are enlightening in several respects. Consider
the following Lorenz curves3 in figure 9-1, constructed from data collected by Wil-
liam Farr (British Parliamentary Papers, pp. 462–463). A persistent complaint

Table 9–1 Wealth and Income Estimates in United Kingdom (1700–1858)

Population Wealth Per-Capita Percentage Income
Year (Millions) (Millions) Wealth Increase (Millions)
1700 8 £0,600 £ 75 —
1801 16 1,800 112 300 £220
1811 18 2,100 116 16 250 (1822)
1841 27 4,000 150 94 450
1858 29 6,000 206 50 600
Sources: Wealth estimate for 1700 by Gregory King, as reported by Evans (“Law of Demand”); other wealth
estimates by Levi (Taxation, p. 6). Income estimates by Baxter (National Income, p. 66).

120

100

80
Income (%)

60

40
1801

20
1848

0
0 10 20 30 40 50 60 70 80 90 100 110
Population (%)

Figure 9-1 As a measure of income distribution, these Lorenz curves show that
incomes in the United Kingdom were less equal in 1848 than in 1801—despite an
increase in average income over the period.

3
A Lorenz curve plots the actual cumulative distribution of income in percentages; usually com-
pared with a curve showing a perfectly even distribution of income (the diagonal in figure 9-1).
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Chapter 9 ■ Economic Policy in the Classical Period 215

among observers and compilers of tax statistics well into the nineteenth century
was that income data is self-reported, leading to huge discrepancies between esti-
mates of the number of returns reported and the income-earning population in vari-
ous classes.4 The dramatic inequality in income distribution among the self-
reporters is obvious at a glance. By 1848, approximately 60 percent of the popula-
tion earned just over 10 percent of the income of Great Britain. The lowest 22.5 per-
cent earned only 1.3 percent of income while the upper 3 percent earned 45.5
percent of reported income. Reported income data was also affected by the fact that
wages earned by manual labor was exempt from taxation and thus not recorded on
income tax returns. Moreover, skewness of income distribution does not accurately
reflect wealth distribution. Morton Peto presents evidence of massive undervalua-
tions of property in addition to underreporting of income (Taxation, pp. 45–46).
Baxter shed additional light on the nature of income distribution in the United
Kingdom in a paper read before the Statistical Society in 1868. Baxter divided
income recipients into upper and middle class on the one hand and manual labor on
the other. He further segmented each stratum into “independent” and “dependent.”
The latter included nonworking wives, homebound children and relatives, scholars,
paupers, prisoners, vagrants, and manual laborers over 65 years old (National
Income, p. 81). His population estimates are shown in table 9-2. Upper and middle
classes (nonwage earners) comprised approximately 23 percent of Great Britain’s
population in 1867, whereas manual laborers made up approximately 77 percent.
On this basis, wage earners in the United Kingdom outnumbered nonwage earners
by approximately 3.5 to one. Drawing on Levi’s companion data on wages and earn-
ings of the working classes Baxter presented an estimate of income distribution for
the year 1867.
The primary advantage of the Levi-Baxter calculations is that they incorporate
the wage incomes of the working classes and the salaried incomes of the middle
and upper income groups. By modern standards income distribution in England in
1867 was comparable to that of a developing country. By our calculations, taxes on

Table 9-2 Population Estimates by Class: United Kingdom (1867)

Upper and Middle Classes
With Independent Incomes 2,759,000
Dependent 3,859,000
Subtotal 6,618,000
Manual Labour Class
Earning Wages 10,961,000
Dependent 12,130,000
Subtotal 23,091,000
Total Estimated Population 29,709,000
Source: Baxter, National Income, p. 16.

4
J. S. Mill argued that income taxes led to fraud and moral degeneration. Many others complained
of cheating. The Draft Report to the Income Tax Committee of 1861, quoted by Baxter (National
Income, p. 32), described the income from the trades and professions as dependent “on the con-
science of the tax-payer, who often, it is feared, returns hundreds instead of thousands, and who is
certain to decide any question that he can persuade himself to think doubtful, in his own favour.”
Also see Peto’s elaboration and documentation of enforcement problems (Taxation, p. 49).
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216 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

large incomes of £5,000 or more were assessed on 8,500 individuals, who received
average income of £14,842. Those whose incomes fell below the minimum taxable
amount (£100 in 1867) numbered 12,458,000 individuals, with average annual
income of less than £33!
For the most part, the classical economists were acquainted with these facts.
Even allowing generous room for error, British income distribution appeared, on its
face, to be highly skewed in favor of the upper (aristocratic) class. (There wasn’t
much of a middle class yet in England, but some highly skilled workers and agricul-
turalists were moving toward that status.)
Apocalyptic predictions soon emanated from Marx and other heterodox writers
of the mid-nineteenth century, forcing attention on the economic status of the labor-
ing population. “Romantics,” like novelist Charles Dickens, held the Industrial Rev-
olution responsible for the denigration of the working class and, took to the literary
stump to reform the economic system. Because economics was associated with the
Industrial Revolution, economics itself became suspect and was often rejected out-
right by the zealots of reform. Classical economics, as we have seen, offered little
room for reform because it emphasized, following Ricardo, “iron laws” and station-
ary (stagnant) equilibria. Adherence to Say’s Law counseled patience in the face of
temporary crises, because it established a self-correcting mechanism that would
restore the economy to health in the long run. Laborers, in this theoretical frame-
work, had little to look forward to, as they were relegated to a subsistence wage
despite their best efforts. As a consequence, cries for reform grew ever louder.
Prominent economists, like Mill, Chadwick, and Senior, were not swept away by the
rising tide of criticism but rather sought to find solutions to social problems within
the “orthodoxy” of the classical canon.

■ EARLY REFORMS: THE POOR LAWS AND FACTORY ACTS

Conscious attempts to mitigate poverty in Great Britain were undertaken as
early as 1601, when Parliament began to enact a series of “Poor Laws” designed to
relieve the economic stress on the poor. By John Stuart Mill’s time the nation had
more than two centuries of legislative experience confronting the problem. Relief
was organized at the local level, with churches given responsibility for administer-
ing poor relief on a parish-wide basis. Revenues were initially raised by an income
tax on parish inhabitants, but over time the system came to be funded by property
taxes instead. Sir Edward Knatchbull’s Act of 1722–23 enabled workhouses to be
established either singly or in combination with other parishes.
The actual running of workhouses was not necessarily undertaken by the par-
ish itself. Management could be, and sometimes was, contracted out to a third party
who would undertake to feed and house the poor, charging the parish a weekly rate
for each inmate. The contractor would also provide the inmates with work and
could keep any surplus income generated. This system was known as “farming” the
poor. The contract was usually awarded to the bidder offering the best price for the
job, which might take a variety of forms: comprehensive maintenance of all the pau-
pers in a parish; managing just the workhouse or just a particular group of paupers,
such as infants and children; keeping lunatics under control; or providing medical
relief. In 1796, eager to promote his system of “contract management,” Jeremy Ben-
tham (chapter 6) promulgated a grandiose scheme for “Pauper Management”—an
early example of privatization that proposed the formation of a National Charity
Company that would construct a chain of 250 enormous workhouses, financed by a
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Chapter 9 ■ Economic Policy in the Classical Period 217

large number of small investors. Each workhouse would hold around two thousand
inmates who would be put to profitable work and fed a Spartan diet. Like many of
Bentham’s privatization schemes, this one, too, was not undertaken.
The condition of the laboring poor was a special concern of J. S. Mill; he
devoted two chapters of Book II of his Principles to remedies for the low wages of
workers. His laissez-faire convictions, belief in the allocative merits of economic
incentives, and concern for social justice are clearly evidenced in his opinions on
the Poor Laws. He thought it “right that human beings should help one another; and
the more so, in proportion to the urgency of the need” (Principles, Robson [ed.], p.
960). He supported the findings of the Royal Commission on Poor Law Reform
(whose members included Senior and Chadwick) on the grounds that the absence
of relief would have grave social consequences for the disabled poor—the blind, the
aged, the sick, the very young, and so forth. The problem was to design a system of
relief that would care for the destitute but discourage the able-bodied from becom-
ing wards of the state. This was clearly a matter of structuring economic incentives.
Mill wrote in the Monthly Repository of 1834:
The condition of a pauper must cease to be, as it has been made, an object of
desire and envy to the independent labourer. Relief must be given; no one must be
allowed to starve; the necessaries of life and health must be tendered to all who
apply for them; but to all who are capable of work they must be tendered on such
terms, as shall make the necessity of accepting them be regarded as a misfor-
tune. . . . To this end, relief must be given only in exchange for labour, and labour
at least as irksome and severe as that of the least fortunate among independent
Labourers. (“Proposed Reform,” p. 361)

Implicit in Mill’s statement is the assumption that subsidies would make the
working poor indolent and unproductive, a result that policy must guard against.
Efficiency of this able-bodied army of paupers could only be obtained within the
workhouses, since the decentralized program of parish relief was fraught with inef-
ficiencies and outright bribery. Mill felt that the parish relief system imposed “fatal
consequences” on the industry and prudence of the poor, whereas the workhouse
offered “the means by which society may guarantee a subsistence to every one of its
members, without producing any of the fatal consequences to their industry and
prudence” that the outdoor parish relief system provided (“Lord Brougham’s
Speech,” p. 597). Despite his concern for social justice and his support of the Poor
Laws, Mill did not take a leading role in their establishment. He was, however, defi-
nitely concerned with the design of an optimum system to alleviate, and ultimately
eliminate, poverty. His writings and correspondence on this issue, as we will see in
this chapter and the next, reflect a lifelong concern with the means of achieving
three interrelated goals pertaining to poverty and income distribution: aid for the
destitute, provision of the right kind of work incentives for the able-bodied unem-
ployed, and use of government policy as a vehicle for altering income distribution.
Whether anyone today would defend Mill’s means to attain these goals is less
important than the fact that he attempted to blend a concept of social justice with
market economics. He did not, however, advocate improvement based merely on
environmental changes, as some other reformers did.
After 1802 the British Parliament passed a series of increasingly stringent acts
regulating the employment of children, adolescents (those under eighteen years of
age), and adult women. Early legislative efforts were modest, but in 1833 the first
effective act was passed under the sponsorship of Lord Althorp. Althorp’s Act
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218 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

banned employment of children under nine years of age and restricted the hours
and conditions of work for those between the ages of nine and eighteen. The act
also provided an enforcement mechanism, which had been missing from earlier fac-
tory acts. Reformers generally hailed Althorp’s Act as a great step forward in social
policy. Nassau Senior, economist and consultant administrator, was at the center of
the discussion concerning this early capitalist reform measure, and his role in this
timely debate gives us insight into the policy implications of classical economics.
Senior was called into government service to assess the economic implications
of the Factory Acts. He accepted the general provisions of Althorp’s Act but argued
that the cost structure of the typical textile mill (England’s chief industry of the
period) was such that further reductions of hours worked would eliminate the mill’s
margin of profit. His argument proceeded along the following lines: The average net
profit per firm in the competitive cotton industry was 10 percent, which Senior took
to be the normal rate of return in the industry. His research showed that the average
firm in the industry was spending £4 on fixed capital (plant and equipment) for
every £1 on working capital (raw materials). Thus, he argued that a reduction in the
workday by one hour would reduce variable costs (and output) but not fixed costs.
In effect, reduced hours of work would lower output, force plant and equipment
into idleness, and increase the fixed-cost burden per unit of output (because output
would fall but fixed costs would not). Senior felt that because of the disproportion-
ate share of fixed costs in the total costs of manufacturing, the increase in per-unit
costs by reducing the workday would wipe out the normal rate of return of the tex-
tile mills.
Until recently, Senior’s argument has been evaluated chiefly on the quality of his
empirical research, which has been questioned by many writers. But there is a sound
analytical principle in Senior’s analysis that has sometimes been overlooked. He
argued that restrictions on labor contracts that render capital idle reduce the mar-
ginal efficiency of capital, thereby diminishing the efficiency of resource allocation.
Writing in 1843, Senior made it clear that a legislated reduction in the marginal effi-
ciency of capital (which lowers the rate of return on capital investment below what
could be earned in other industries) would cause higher-cost producers to leave the
industry, thereby reducing employment and granting a competitive advantage to for-
eign producers who were not subject to the same restrictions (Industrial Efficiency,
p. 309). In other words, Senior advised Parliament that the Factory Acts served to
hand foreign competitors an increased share of the domestic textile market, an
important lesson that is no less meaningful for contemporary debates about global
competition. Therefore even though Senior’s argument is incorrect that eliminating
the “last hour” of work would destroy normal profit—indeed, it has often been the
subject of ridicule by later writers—there is nevertheless merit in his analysis.
The Poor Laws and Factory Acts represent early attempts to address poverty
among the indigent and working poor. They may be viewed therefore as a kind of
“laboratory experiment” designed to utilize the self-interest, natural-law axiom of
Adam Smith in order to channel the “natural” incentives of the poor toward desired
ends. These natural incentives were taken as given by human nature. With few
exceptions, there was no clear plan for altering the “natural” incentives of the poor
and the laboring classes; nor was there any mechanism for improving class mobil-
ity. Fundamentally, most of the classical writers accepted the profile of labor that
changed little from the mercantilist period, although most writers rejected Mandev-
ille’s characterization of them as “brutes.” Eventually, more enlightened views of
labor began to emerge.
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Chapter 9 ■ Economic Policy in the Classical Period 219

The Force of Ideas: Senior’s Interest-Group Theory of Economics

A more subtle aspect of Senior’s analysis of the Factory Acts has been largely ignored, and
this aspect seems to foreshadow a basic principle of the contemporary theory of public choice
(see chapter 24). Senior recognized that Althorp’s Act imposed an economic loss on the parents
of children under nine who were prohibited from working in the textile mills and a similar loss
on the parents of children between the ages of nine and thirteen whose hours were restricted
by the act. He also noted a corresponding gain on the part of workers (or their parents) over
thirteen whose hours were not restricted by the act. This led him to question the motives of
those seeking to restrict the length of the workweek. He concluded that the Factory Acts were
not inspired by the “public interest” so much as the interest of the (adult male) factory opera-
tives who sought to raise their own wages. In a closely reasoned passage, Senior argued:
[The workers’] original object was to raise the price of their own labour. For this pur-
pose the spinners, who form . . . a very small . . . but a powerful body among them, find-
ing that they could not obtain a limitation of the hours of work to ten by combination,
tried to effect it through the legislature. They knew that Parliament would not legislate
for adults. They got up therefore a frightful, and (as far as we have heard and seen) an
utterly unfounded picture of the ill treatment of the children, in the hope that the leg-
islature would restrain all persons under 18 years old to ten hours, which they knew
would, in fact, restrict the labour of adults to the same period. (Selected Writings, p. 19)
At the heart of this issue is whether or not young workers and female workers were in
direct competition with adult male workers for jobs and pay. While this question has not been
settled by contemporary historians of economic thought, strong evidence exists to support
the notion that child labor and female labor were substitutes for adult male labor rather than
complements. (Senior himself treated them mostly as complements and probably erred in
doing so.) By reducing the physical exertion required on the job, technological advances (e.g.,
invention of the spinning mule, etc.) made it possible for adolescents and women to enter the
workforce. The same technological advances threatened job security of the spinners (mostly
adult males), who possessed the necessary brawn and had acquired the necessary skills under
earlier technology. Senior was alert to the self-interests involved and interpreted the move-
ment toward a ten-hour workweek on the basis of small-group interests. Threatened by grad-
ual reductions in wages and employment due to technological advances in the textile
industry, spinners supported “ten hours” legislation. Unable to get a ten hours bill passed,
they tried indirectly to reduce the elasticity of demand for their services by lobbying against
the employment of children, adolescents, and females.
For the historical record, the spinners were successful in achieving their objectives. The
Factory Act of 1833 led to a significant reduction in child labor. The number of workers under
fourteen years of age in the textile industry was reduced by 56 percent between 1835 and
1838, and this reduction occurred while overall employment within the industry was growing
rapidly. Flush with this success, the adult male textile operatives gained additional restrictions
on the hours and work conditions of females in the Factory Act of 1844. It goes without saying
that Senior showed that private incentives could work against the improvement of the poor
and laboring classes.*
*While the “correct” interpretation of this historical episode involving the British Factory Acts remains
controversial, Senior’s role in the policy debates of his day is enlightening in several respects. For one
thing, it reveals in a meaningful way how economic theory can be brought to bear on important social
issues. For another, it pits the informed economist against the less-informed (at least in economics) social
reformers who frequently agitate for change. Whether right or wrong in all parts of his analysis, Senior
showed that he was alert to the lessons of Adam Smith—namely that the self-interest axiom applies to
coalitions of private-interest groups and to politicians as well as to businesspeople. These ideas are
explored more fully in Anderson et al. (see references).
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220 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

■ LABOR AS A UTILITARIAN POLICY ISSUE

Owing to its downtrodden circumstances, the position of labor in the economy
became a critical and central issue of classical economics, both in its microeco-
nomic and macroeconomic conceptualizations. As part of a medieval inheritance
these views leeched into policy discussions of the nineteenth century and gave them
a peculiar shape. In chapter 3 we saw that certain mercantilists either took an
extremely dim view of human nature or succumbed to the interests of the moneyed
merchant class when dealing with the poor. That practice persisted into the nine-
teenth century. The “utility of poverty” idea is incipient in the wages-fund theory,
which postulated that if the laboring poor received wages in excess of the barest
subsistence, they would be lazy and slothful and little better than animals; if they
received less, they would not survive due to overpopulation and starvation. From
there it is a short step to postulating an “optimum” level of poverty. Mandeville
(chapter 3) even argued that poor and orphaned children should not be given an
education because it would “ruin” them for productive work. While these arguments
seem insensitive and backward today, they fit the tenor, and the class structure, of
the times.
This bleak assessment of progress for the poor and laboring classes was a stim-
ulant to growing awareness of labor and its role in production as well as a catalyst
to more enlightened economic policy. Poor relief was the first line of attack. Poor
relief at the parish level was widely considered a disaster. The program was haunted
by nagging questions without easy answers. Should social relief be “indoors” in
workhouses or “outdoors,” administered by government functionaries? Should
workhouses use the “carrot” (provide education, sanitary housings, and so on) or
the “stick” (punishment for sloth and/or malingering)? And the biggest question of
all haunted even the most considerate reformers: Can any reasonable measures to
change the plight of the poor have the intended effect?

■ THE BIG QUESTION: CAN THE POOR BE LIFTED OUT OF POVERTY?

Some classical writers like Adam Smith and John Ramsay McCulloch clearly
did not condemn the poor outright in the manner of Mandeville, but their analytics
left plenty of room for the self-interested attitudes held by the wealthier classes
toward the poor. The class structure of nineteenth-century England was fairly rigid,
but most of the classical writers did believe in a “bootstrap theory” of upward mobil-
ity. Few went beyond the idea that progress was possible only if workers and the
poor acquired (somehow) a “taste for capitalism.” One important exception was
Edwin Chadwick who, ironically, was vilified by the poor for his advocacy of the
workhouse under the Poor Laws.
Chadwick sometimes slipped backward into the mercantile view of labor, but he
ultimately adopted a very different perspective than most of the classical writers
regarding the possibilities for the laboring population and the dependent or indi-
gent poor. He was a thoroughgoing utilitarian (in the Benthamite sense), and all of
his reform proposals reflected that fact. But he also believed that man’s character is
strongly and effectively changed by environmental influences. In talking about
laborers engaged in railway construction, he wrote: “Many of the men are reckless,
but what is the cause? No man cares for them; they labour like degraded brutes;
they feed and lodge like savages; they are enveloped in vice as with an atmosphere;
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Chapter 9 ■ Economic Policy in the Classical Period 221

the sensual only is present” (Papers, p. 49). Elsewhere he said: “I do not deny the
force of hereditary conditions and habits which countenance such superficial gener-
alisations, but I have seen that those conditions and habits may be much sooner and
more effectually altered, than is commonly supposed” (“Improvements,” p. 77,
emphasis added).
Chadwick’s approach to reform, therefore, represents a combination of these
(empirically based) propositions into a theoretical structure that posited utility max-
imization subject to environmental and institutional constraints. His great familiar-
ity with the human condition convinced him that altered constraints were the key to
economic and social mobility, which, in turn, defined the potential for success of the
laboring and poor classes.5 He remonstrated those who promoted the idea that pov-
erty is inexorable: “The Mandevillians have brutalized millions of human beings,
and brought them to a state in which they are ready to rush on to the injury of them-
selves, and the destruction of all around them” (“Taxes,” pp. 246–247).6 He argued
instead that the state of the workers and the poor was due not to any inherited fail-
ure or character flaws but rather to environmental constraints. The solution to pov-
erty, therefore, was to develop social, economic, and political institutions designed
to foster bourgeois characteristics in the lower classes. John Stuart Mill became his
willing ally in the mission to improve the lot of the working poor.
Mill’s open rejection of the paternalistic view of class structure established a
corollary to Chadwick’s rejection of the mercantilist attitude toward the poor. Mill
cast the problem in terms of two opposing worldviews: “The one may be called the
theory of dependence and protection, the other that of self-dependence” (Principles,
Ashley [ed.], p. 759). The former takes the position that the upper classes have the
duty and responsibility to care for the lower classes (what the French call noblesse
oblige) and in return the lower classes owe allegiance to their employers. Mill
argued that this view was mutually destructive: “If the rich regard the poor, as by a
kind of natural law, their servants and dependents, the rich in their turn are
regarded as a mere prey and pasture for the poor; the subject of demands and
expectations wholly indefinite, increasing in extent with every concession made to
them.” This situation, he continued, leads to “the total absence of regard for justice
or fairness in the relations between the two, [which] is as marked on the side of the
employed as on that of the employers” (Principles, Ashley [ed.], p. 761). A more last-
ing solution, Mill thought, was to raise the working poor to the same footing as mid-
dle-class English society, although the scope of his policy program was less
ambitious than Chadwick’s.
Of course there are other ways to address the issues of poverty and skewed
income distribution, and we shall visit alternative approaches in chapters 11 and 12.
But it is worth noting at this juncture that many of the so-called “utopian socialists”

5 Despite his best efforts Chadwick was unable to rid himself completely of mercantile preconcep-
tions. In his later life he argued that “it may be maintained as a principle of political economy that
a poor man must make a poor master, and that he had better serve a rich one, a capitalist, i.e., a
work finder and a wage finder; that a poor man never works for so bad a master as when he works
for himself” (Evils of Disunity, p. 26). Chadwick had an unfortunate proclivity to moralize, which
is evident in his discussion of the use of “common labourers” as locomotive engineers in the con-
struction of railroads: “High wages, with such a class of men, only increase the danger [of con-
struction accidents]; for it generally leads to an increase in drinking” (Papers, p. 25).
6
As we noted in chapter 3, Mandeville (Fable, p. 311) is the best source of this extreme attitude:
“Abundance of hard and duty Labour is to be done, and coarse Living is to be complied with:
Where shall we find a better Nursery for these necessities than the Children of the Poor? none cer-
tainly are nearer to it or fitter for it.”
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222 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

shared Mill’s and Chadwick’s emphasis on environmental constraints, though not

their emphasis on the efficacy of economic incentives. Robert Owen, for example,
was the most forthright: “Any general character, from the best to the worst, from the
most ignorant to the most enlightened, may be given to any community, even to the
world at large, by the application of proper means; which means are to a great
extent at the command and under the control of those who have the influence in the
affairs of men” (“Address to the Inhabitants of New Lanark,” p. 14). But Owen may
more properly be considered a socialist, whereas Mill merely flirted with socialism,
and Chadwick did not believe that the government could run anything well.

■ TECHNOLOGY, LABOR, AND POVERTY: CLASSICAL PERSPECTIVES

The Industrial Revolution was at base a technological transformation that dom-
inated the nineteenth-century social and economic landscape. But for the most part,
the classical writers only dimly understood the long-term impact of technology.
They were aware that technology could “shock” the economic system, but their
analysis was mostly of a macroeconomic nature. They allowed that there would be
an “upward drift” in aggregate real wages through time—with cultural rather than
biological revisions to the notion of subsistence—but their main concern was the
impact of machinery on employment. When they considered the microeconomic
consequences they focused chiefly on the impact of machinery on labor in the short
and long run rather than on the social dimensions of poverty. The narrow analysis
of the employment effects of labor-saving machinery has become known as the
“Compensation Controversy,” which figured prominently in both classical and
Marxian economic doctrine. Chadwick took the position that the introduction of
machinery would result only in temporary unemployment, a view he shared with
McCulloch, Mill, and Malthus.
In the cotton industry, where mechanization was progressing swiftly, Malthus
argued that the end result of the introduction of machinery was likely to be an
increase in employment because the product was, in the contemporary vernacular,
one of elastic demand (see O’Brien, Classical Economists, p. 227). It followed, there-
fore, that new machinery could lead to a reduction of poverty for certain workers.
McCulloch maintained that machinery caused only temporary, “frictional” unem-
ployment (see O’Brien, Classical Economists, pp. 302–306). Mill’s analysis of the
Compensation Controversy was somewhat less, but he reached the same conclu-
sion. He wrote: “all increases of fixed capital, when taking place at the expense of
circulating, must be, at least temporarily, prejudicial to the interests of the labour-
ers” (Principles, Ashley [ed.], p. 93). He then detailed the circumstances wherein
laborers are injured by mechanization. From a practical standpoint, however, Mill
asserted that the substitution of fixed for circulating capital is not an ordinary
occurrence. Rather, “improvements are always introduced very gradually, and are
seldom or never made by withdrawing circulating capital (wages to hire labor) from
actual production, but are made by the employment of the annual increase” (Princi-
ples, Ashley [ed.], p. 97). Mill argued that in a growing economy, mechanization is
financed from the net increase in national output, leaving the wages-fund, and
hence, the demand for labor, unchanged (in a macroeconomic sense). On this basis
Mill was in agreement with Chadwick, Malthus, and McCulloch. He stated: “I do not
believe that, as things are actually transacted, improvements in production are
often, if ever, injurious even temporarily, to the labouring classes in the aggregate”
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Chapter 9 ■ Economic Policy in the Classical Period 223

(Principles, Ashley [ed.], p. 97). He was, however, like virtually all of the classical
writers, responding to a macroeconomic situation.7
The classical writers, almost without exception, encased their views on labor
within the abstract context of the wages-fund theory, a staple of classical macroeco-
nomics. Chadwick followed the other classical writers to a point, but also provided
a unique assessment of labor markets that featured actual empirical observations.
He observed the behavior of individuals who were technologically unemployed.
While investigating the direct effects of the institution of labor-saving machinery on
the pauper rolls and Poor Laws administration, Chadwick concluded that techno-
logical improvement was not a contributing factor to pauperism. He presented evi-
dence to back his claim, again drawn from relentless personal investigation.
According to Chadwick:
In one instance, where, by the introduction of Mr. Whitworth’s street-sweeping
machine into a large town district, the labour of the entire body of sweepers by
hand had been displaced. I confidently expected that that class, at least, who were
of the lowest labourers, and the least capable of changing the object on their
labour, would be found, as a class, on the destitute relief list; but as a class, they
were not there. (“Extracts,” p. 806)

With dogged determination, Chadwick tried to locate the displaced street-

sweepers. He found that 8 percent had since died (a percentage that Chadwick
noted was not significantly different from expected mortality), 6 percent were unac-
counted for, and the rest had found employment elsewhere. Chadwick attributed
their re-employment to the initiative of the individuals: “Under the stimulus of an
extraordinary necessity they had found for themselves miscellaneous services, for
which, under that stimulus, they qualified themselves, which services no one else
could have anticipated or found out for them . . . and none had fallen below their
former position, which indeed was scarcely possible” (“Extracts,” p. 806). Chadwick
also allowed that the uncontrolled effect of market pressures may result in laborers
actually improving their situation, hypothesizing that markets may be efficient in
making adjustments to equilibrium disturbances.
Chadwick also recognized another advantage to the introduction of labor-sav-
ing machinery: increased job security. He believed that mechanical operatives were
less likely to be subject to cyclical unemployment if displacing them was marginally
more costly than retaining skilled workers. His argument was that if workers can-
not be safely dismissed because of difficulty of finding suitable replacement, the

7 The Compensation Controversy began when Ricardo added a chapter entitled “On Machinery” in
the third edition of The Principles of Political Economy and Taxation, where he concluded that
mechanization might be prejudicial to labor. Explaining his change of heart from previous edi-
tions Ricardo wrote: “I am convinced that the substitution of machinery for human labor is often
very injurious to the interest of the class of labourers” (Principles, p. 388). Mark Blaug explained
Ricardo’s analysis as follows: “The basic argument is that if the introduction of machinery
involves the diversion of labor previously required to produce wage goods, if instead of new
machines being financed out of retained earnings they are financed by drawing down the wages
fund, then output may fall for a time and produce unemployment” (Economic Theory, pp. 137–
138). It should be noted that Ricardo based his analysis on the assumption that circulating capital
(the wages-fund) is converted into fixed capital, which J. S. Mill later rejected. Ricardo’s analysis
of mechanization was taken by Karl Marx and became a central element in Marx’s “Laws of Capi-
talistic Motion” (see chap. 12 of our text). Marx also made mechanization a driving force behind
his “Law of a Growing Industrial Reserve Army,” which posits that the permanent dislocation of
labor by machinery creates a growing unemployed class as technological improvement advances.
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224 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

costs of maintaining an idle machine (i.e., maintenance and interest on borrowed

capital) is a “penalty on the owner of the machine for every day he omits to find
work and keep the artisan employed at these high wages. Under these circum-
stances, the owner becomes, to a greater extent than may be supposed, the servant
of the operative” (“Extracts,” p. 804). He might have added that employers may be
less likely to temporarily discharge workers if the cost of rehiring them is high. As
usual, Chadwick’s investigations probed behind the obvious and superficial, shining
light on the complexity of many economic decisions.

Labor Conditions and the Business Cycle

Chadwick observed a close association between mechanization and the business
cycle, advancing the counter-intuitive belief that manufacturing distress was beneficial
to labor in the long run. Manufacturing distress, he argued, led to technological
improvements and the introduction of labor-saving capital, which in turn had net bene-
ficial effects on the laboring poor. Acknowledging detrimental short-run effects, he nev-
ertheless confidently argued that recessions often had a positive effect on innovation!
As always, for him it was a matter of submitting hypotheses to empirical investigation.
Commenting on the effects of the blockage of cotton shipments to British textile
manufacturers during the American Civil War, Chadwick noted: “It was an axiom of
the late Mr. John Kennedy, who was called the father of the cotton manufacture,
that no manufacturing improvements were ever made except on ‘threadbare prof-
its’” (“Improvements,” p. 3). Chadwick considered it axiomatic that when profits are
low, entrepreneurs have the greatest incentive to innovate; whereas, “When the
trade is doing well, the axiom is, that they cannot be better than well, and they
remain as they are” (“Opening Address,” p. 3). In a manner of speaking, Chadwick
adumbrated the “crucible theory” of entrepreneurship: When profits are falling and
inventories of unsold goods rising, the entrepreneur’s
nerves are strained, as much as any officer’s in a military command, and his mind is
tasked, even with the aid of new divisions of labor, of brokers to buy his raw mate-
rial, and of agents to have an outlook and sell his produce. Being under heavy penal-
ties for every day he fails to find work and wages for his corps, he is driven to his
wits’ end to exercise invention, and listens greedily to any which bids fair to cheapen
production, lower prices and stimulate consumption. (“Improvements,” p. 3).8

Labor, Technology, and Human Capital

As previously mentioned, Chadwick was aware of the temporary unemploy-
ment that resulted from manufacturing distress. However, since he predicted that
recessions led to higher wages and increased stability of demand by dint of entre-
preneurs’ adjustments, he was more concerned with alleviating the short-run costs
of the business cycle rather than eliminating them completely. Labor, too, can adjust
to the adverse consequences of recession. Chadwick suggested that laborers could
mitigate the short-run, personal disadvantages of recessions by investment in
human capital and diversification; or, in the broadest sense, education.

8
On the “crucible theory” see Janet Nixdorff and George Solomon (“Role of Opportunity Recogni-
tion”). We note here that Chadwick’s view of invention is opposed to that advanced by Schumpeter
(see chap. 23), who argued that product research and development takes its greatest stimulus
from monopoly profits (Capitalism, Socialism and Democracy, p. 106). Schumpeter’s thesis is
controversial and unverified, primarily because such empirical evidence that exists is inconclusive
as to which form of market structure is most conducive to effective market innovation.
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Chapter 9 ■ Economic Policy in the Classical Period 225

Chadwick was one of the earliest writers to understand that a general system of
education for the poor and laboring classes had both public and private benefits.
The public benefits are mostly in the nature of an externality. Education creates
public (human) capital, which benefits society in various ways: Raising society’s
general level of intelligence will result in greater social stability, he argued, through
encouragement of a lower propensity to violence and through generating more and
better informed voters. A critical aspect of the educational scheme should be to
improve public knowledge of the legal structure and the penalties entailed therein.
Hence, Chadwick lobbied for all manner of skill and literacy enhancements and
against what he called “taxes on knowledge,” that is, excise taxes on newsprint.
On the issue of diversification, he was very straightforward. Having warned cot-
ton manufacturers against dependency on only one source of a vital factor of pro-
duction (e.g., American cotton) Chadwick counseled laborers not to put too many
“eggs” in one basket: “There is a lesson on domestic prudence, on the like principle
[diversification], the expediency of which, for families of the wage classes, ought to
be strongly impressed upon them, namely to avoid, as much as they can, having all
the working members of the same family engaged in the same manufacture”
(“Improvements,” pp. 10–11). Thus, by spreading the family’s sources of income
across several industries, a household would be less susceptible to the vagaries of
manufacturing distress. The same principle, of course, is now widely recognized as
a principle of risk and portfolio management in the world of finance.
The pauper and lower classes were kept that way in part by ignorance, with the
complicity of the upper classes, which controlled government. Chadwick was scath-
ing in his criticism: “In fact, the measures of government, whether by design or not,
keep the immense mass of people in the state of ignorance which predisposes them
to extravagant action, while it fosters and gives power to the fanaticism which takes
the lead among them” (“Taxes,” p. 115). He thought a major, immediate corrective
would be “the entire removal of the obvious taxes on knowledge. The reduction of
the stamp duty, proposed by ministers, will benefit only the press and the middle
classes; as regards the labouring classes it is paltry; and will keep the larger channels
of public information as far out of their reach as before. Every penny of duty retained
is a bounty on ignorance.” Pressing further, Chadwick asserted: “There can be no
safety from the most fearful outrages against life and property but in the intelligence
and moral feelings of the labouring classes.” (“Real Incendiaries,” p. 116). But, more
than as a protection of life and property, Chadwick felt that a literate population
would provide a form of human capital that would mitigate poverty and encourage
economic growth. The poor and illiterate were dupes of the upper, ruling classes, he
said, whether by design or by accident. The antidote to this situation is knowledge:
A habit of reading the public journals, cannot fail to gradually loosen the authority
of a certain class of ignorant popular leaders, whose governing motives are less
sympathy for the sufferings of the people and a desire to advance social happiness
than insatiable vanity and love of power, and whose only claims to authority are
reckless confidence and incessant action, which never waits, or allows others to
wait, for evidence or deliberations. To such men as to the priests who sway an
ignorant people, divided attention is divided power. (“Taxes,” p. 246)

Despite the public benefits of improved education, Chadwick identified the

greatest benefits in private terms. He treated expenditures on education as a form
of capital investment necessary to the improvement of labor’s condition. Specifi-
cally, he expected education to increase wages and job security. On these two
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226 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

points, he was unequivocal. Discussing the effects of steam power on agriculture,

Chadwick blamed lapses in education as an obstacle to economic advance: “Unfor-
tunately, in the present state of education in the agricultural districts, if higher
wages were offered, the men were not to be found to do the work with the greatest
amount of economy, and in order to attain this end, their education must be
improved” (“Forces,” p. 63).
In other words, he viewed education as a vital component of economic effi-
ciency, especially when used in conjunction with (then) modern machinery. It might
be hard to sustain Chadwick’s enthusiasm today, when the quality of education in
many countries is questioned on all sides, but he was unswervingly confident in his
own judgment, declaring:
If the principles of economical and social science which I have indicated in their
relation with the means of intellectual, moral, and physical improvement, be duly
regarded and applied, the conditions of the manufacturing population, instead of
being deplorable, will, with the increased and increasing stages derivable by the
people from the extraordinary improvements in the mechanical arts for which they
are required as ministers and the servants, be brought up to a high state of moral
and social advancement. (“Opening Address,” p. 27)

In addition to increased employment opportunities generated by education, the

increased choice set of available jobs serves to lessen the effect of the business
cycle. Education breeds self-reliance, such that “the better educated, who can write
and inquire for themselves, and find out for themselves new outlets and sources of
productive employment which no one else can find out for them, and who can read
for themselves, and act upon written or printed instructions. The really well-trained,
educated, and intelligent, are the best to bear distress” (“Opening Address,” p. 12).
The comparative advantage at bearing distress comes about not only because of the
relative efficiency at job search but also because the worker is better suited to learn-
ing new manufacturing skills.
Mark Blaug said of the classical economists as a group that they “favored edu-
cation more for purposes of moral improvement than for the development of pro-
ductive skills” (Economic Theory, p. 226), but Chadwick had a broader vision that
laid primary stress on the human capital aspects of education. He and Mill were in
total agreement on this point. They shared a philosophical foundation, utilitarian-
ism, which can be traced to their mentor, Bentham. Despite occasional lapses into
the jaded propositions about workers that beset the mercantilist period, both Mill
and Chadwick took seriously the economic analysis of the condition of the laboring
poor. Where they differed was in the minor nuances that defined the relative impor-
tance of environment versus incentives in regard to human nature.

■ CONCLUSION
The multitalented and energetic John Stuart Mill was a giant in the develop-
ment of economic theory and is accorded his rightful place in that history. In his
own right, Chadwick was equally talented and energetic, but his contributions con-
sisted more in the elaboration of institutions and how they affected economic incen-
tives. When probed in full, the contributions of Mill and Chadwick to economic
policy convey a sharp and slightly kaleidoscopic “answer” to the sometimes shrill
and emotional criticisms of economics and industrialism launched by the “utopian
socialists” (chapter 11) and Marx (chapter 12). Recognizing lack of theoretical
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Chapter 9 ■ Economic Policy in the Classical Period 227

underpinnings in the popular criticisms of the former group, Marx tried to distance
himself from them. Though probably understood by few who read his works, and
despite its flaws, Marx’s theoretic apparatus surpassed that of the “utopians” in the
public arena.
This chapter has presented some dimensions of the “orthodox” (as opposed to
the Marxian) assault on the economic and social climate of the time. Some writers
in the classical tradition made a conscious effort through English politics to alter
the condition of the laboring poor. The first fruit of this effort was the early passage
of British Poor Laws and a series of Factory Acts, but these palliatives affected only
a part of the population and they contained, at least implicitly, a (fatalistic) view of
the poor and laboring classes that was noticeably beginning to wither under
increased scrutiny. The old view said that Providence created poor and rich, lower
and upper classes and little could be done about it, a view that was a holdover from
the medieval and mercantile periods when it was considered axiomatic that mainte-
nance of a large body of poor workers was necessary for a great nation to function.
The altered circumstances of labor and production introduced by the Industrial
Revolution provoked new concerns by economists and social thinkers. The effects
of technology on labor and wages could not be ignored in the new circumstances.
John Stuart Mill and Edwin Chadwick were in the vanguard of economists awaken-
ing to the economic transformations taking place. Mill was willing to flex economic
theory to make room for the heightened concerns. Edwin Chadwick held social and
economic institutions under a microscope in order to identify palliatives driven by
economic incentives. Both writers believed the nature and condition of the poor and
the working poor could be changed for the better by harnessing the power of eco-
nomic incentives. The rigid English class structure did not yield easily; conse-
quently the mobility of labor was retarded unnecessarily.
Nevertheless, once it was admitted that the poor were in nature like everyone
else, the door opened to means for changing their environment and for utilizing and
altering incentives to provide avenues for progress in income distribution. Mill and
Chadwick led the charge among classical economists in scaling the castle walls of
intellectual inflexibility. Their respective roles in this regard are discussed further in
the next chapter.

REFERENCES
Anderson, G. M., R. B. Ekelund, Jr., and R. D. Tollison. “Nassau Senior as Economic
Consultant: The Factory Acts Reconsidered,” Economica, vol. 56 (February 1989),
pp. 71–82.
Baxter, Robert Dudley. National Income: The United Kingdom. London: Macmillan, 1868.
Blaug, Mark. Economic Theory in Retrospect, 3rd ed., Cambridge: Cambridge University
Press, 1978.
British Parliamentary Papers, vol. I, Irish University Press Series of British Parliamen-
tary Papers, (Shannon: Irish University Press, 1968).
Chadwick, E. “The Real Incendiaries and Promoters of Crime,” The Examiner, no. 1203
(1831), pp. 114–116.
———. “The Taxes on Knowledge,” Westminster Review, vol. 20 (1831), pp. 238–267.
———. “Improvements in Machinery—Races of Workmen—Nominally Low-Priced
Labour,” Journal of the Royal Society of Arts, vol. 5 (1856), pp. 77–78.
———. “On the Forces Used in Agriculture,” Journal of the Royal Society of Arts, vol. 8
(1857), pp. 62–63.
Ekelund-Hebert 6E.book Page 228 Thursday, August 1, 2013 11:03 AM

228 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

———. “Opening Address of the President of the Department of Economy and Trade, at
the Meeting of the National Science, Held at York in September 1865,” Journal of the
Statistical Society of London, vol. 28 (1865), pp. 1–33.
———. On the Evils of Disunity in Central & Local Administration Especially with Rela-
tion to the Metropolis and Also on the New Centralisation for the People Together
with Improvements in Codification and in Legislative Procedure. London: Long-
mans, Green, 1885.
Evans, G. H., Jr. “The Law of Demand—The Role of Gregory King and Charles Dav-
enant,” Quarterly Journal of Economics, vol. 81 (1967), pp. 483–492.
Levi, Leone. On Taxation: How It Is Raised and How It Is Expended. London: John W.
Parker and Son, 1860.
Mandeville, Bernard de. The Fable of the Bees, B. F. Kaye (ed.). London: Oxford Univer-
sity Press, 1734 [1924].
Mill, J. S. “Lord Brougham’s Speech on the Poor Law Amendment Bill.” Monthly Reposi-
tory, vol. 7 (1834), p. 597.
———. “The Proposed Reform of the Poor Laws,” Monthly Repository, vol. 8 (1834), p. 361.
———. Principles of Political Economy, W. J. Ashley (ed.). New York: A. M. Kelley, Pub-
lishers, 1965 [1848].
———. Principles of Political Economy, J. M. Robson (ed.), Collected Works, vols. 2 and 3.
Toronto: University of Toronto Press, 1966 [1848].
Nixdorff, Janet and Solomon, George. “Role of Opportunity Recognition in Teaching
Entrepreneurship,” http://sbaer.uca.edu/research/icsb/2005/paper148.pdf.
O’Brien, Denis. J. R. McCulloch: A Study in Classical Economics. London: George Allen
& Unwin, 1970.
———. The Classical Economists. Oxford: Clarendon Press, 1975.
Owen, Robert. “An Address to the Inhabitants of New Lanark.” A New View of Society
and Other Writings of Robert Owen, G. D. H. Cole (ed.). London: Dent, 1821 [1927].
Peto, Morton. Taxation: Its Levy and Expenditure, Past and Future: Being an Enquiry
into Our Financial Policy. New York: D. Appleton, 1863.
Ricardo, David. Principles of Political Economy and Taxation. Volume I: The Works and
Correspondence of David Ricardo, Pierro Sraffa, (ed.). London: Cambridge Univer-
sity Press, 1969 [1817].
Schumpeter, J. Capitalism, Socialism and Democracy, New York: Harper and Row, 1942
[1962].
Senior, N. W. Industrial Efficiency and Social Economy, vol. 2. New York: Henry Holt, 1928.
———. Selected Writings on Economics. New York: A. M. Kelley, 1966.
Smith, Adam. An Inquiry into the Nature and Causes of the Wealth of Nations. New York:
Modern Library, 1776 [1937].

NOTES FOR FURTHER READING

Lionel Robbins’s The Theory of Economic Policy in English Classical Political Econ-
omy (London: Macmillan, 1965) provides a good general introduction to classical eco-
nomic policy. Robbins’s interpretations are pristine and get to the heart of important
matters. For example, on Mill’s so-called socialist leanings he writes: “Mill is very typi-
cal. It is this vision of the future, rather than that of central collectivism, which has usu-
ally captured the fancy of lovers of liberty who, for one reason or another, have wished to
transcend the society based on private property and the market” (p. 160). Also see Rob-
bins’s comments on the contrast between the precision suggested by Bentham’s “felicific
calculus” and the rough-and-ready marginal alterations in economic policies actually
recommended by Bentham’s disciples (p. 181). Another valuable introduction to classi-
cal economic theory is D. P. O’Brien’s The Classical Economists Revisited (Princeton, NJ:
Ekelund-Hebert 6E.book Page 229 Thursday, August 1, 2013 11:03 AM

Chapter 9 ■ Economic Policy in the Classical Period 229

Princeton University Press, 2004). Chapters 6, 9, and 10 are especially good, as are the
bibliographies that follow them. For the view that Bentham was a collectivist and Mill
essentially a Benthamite, see J. B. Brebner, “Laissez-Faire and State Intervention in
Nineteenth Century Britain,” Journal of Economic History, vol. 8, supp. (1948), pp. 59–73.
On the influence of economists on nineteenth-century legislation, see two contributions
by F. W. Fetter: “The Influence of Economists in Parliament on British Legislation from
Ricardo to John Stuart Mill,” Journal of Political Economy, vol. 83 (October 1975), pp.
1051–1064; and his longer treatment The Economists in Parliament, 1780–1868 (Durham,
NC: Duke University Press, 1979).
The medieval and philosophical origins of the concept of laissez-faire are discussed
by Jacob Viner, “The Intellectual History of Laissez-Faire,” Journal of Law & Economics,
vol. 3 (October 1960), pp. 45–69. Contributors to the Romantic and literary criticism of
economics that had some impact on Mill are reviewed by W. D. Grampp, “Classical Eco-
nomics and Moral Critics,” History of Political Economy, vol. 5 (Fall 1973), pp. 359–374.
There is an extensive literature dealing with individual policy issues in classical econom-
ics. On the Factory Acts in particular, see K. O. Walker, “The Classical Economists and
the Factory Acts,” Journal of Economic History, vol. 1 (1941), pp. 170–191; L. R. Soren-
son, “Some Classical Economists, Laissez-Faire, and the Factory Acts,” Journal of Eco-
nomic History, vol. 12 (1952), pp. 101–117; D. P. O’Brien, The Classical Economists
(supra), pp. 277–279; and Mark Blaug, “The Classical Economists and the Factory Acts—
A Reexamination,” Quarterly Journal of Economics, vol. 72 (May 1958), pp. 211–226. On
a related topic, see W. D. Grampp, “The Economists and the Combination Laws,” Quar-
terly Journal of Economics, vol. 93 (November 1979), pp. 501–522. In his analysis of the
Factory Act of 1833, H. P. Marvel, “Factory Regulation: A Reinterpretation of Early Eng-
lish Experience,” Journal of Law & Economics, vol. 20 (October 1977), pp. 379–402, con-
cluded that “this innovation in industrial regulation was not enacted and enforced solely
out of compassion for the factory children. It was, instead, an early example of a regu-
lated industry controlling its regulators to further its own interests.” Thus, Marvel
describes the very same process of rent seeking in representative democracy that we
elaborated in chapter 3. The implication is that other forms of early nineteenth-century
social controls may also constitute examples of rent seeking, although these other forms
have not yet been subjected to such analysis. For a similar conclusion, see Clark Nardi-
nelli, “Child Labor and the Factory Acts,” Journal of Economic History, vol. 15 (1980), pp.
739–755.
The public-choice ramifications of Senior’s analysis of the Factory Acts are explored
by G. M. Anderson, R. B. Ekelund, Jr., and R. D. Tollison, “Nassau Senior as Economic
Consultant: The Factory Acts Reconsidered,” Economica, vol. 56 (February 1989), pp.
71–81. On the confused issue of Senior’s “last hour” analysis, see Orace Johnson, “The
‘Last Hour’ of Senior and Marx,” History of Political Economy, vol. 1 (Fall 1969), pp. 359–
369; J. B. DeLong, “Senior’s ‘Last Hour’: Suggested Explanation of a Famous Blunder,”
History of Political Economy, vol. 18 (Summer 1986), pp. 325–333; and the dialogue
between DeLong and J. M. Pullen in History of Political Economy, vol. 21 (Summer
1989), pp. 299–312. E. G. West has written extensively on education in classical econom-
ics, see West, “Private versus Public Education, A Classical Economic Dispute,” Journal
of Political Economy, vol. 72 (October 1974), pp. 465–475; same author, “Resource Allo-
cation and Growth in Early Nineteenth-Century British Education,” Economic History
Review, vol. 23 (April 1970), pp. 68–95. Also see Margaret O’Donnell, The Educational
Thought of the Classical Political Economists (London: University Press of America,
1985). On classical views of “appropriate” policy toward emergent corporate forms of
business organization, see C. E. Amsler, R. L. Bartlett, and C. J. Bolton, “Thoughts of
Some British Economists on Early Limited Liability and Corporate Legislation,” History
of Political Economy, vol. 13 (Winter 1981), pp. 774–793. Agrarian economic organiza-
Ekelund-Hebert 6E.book Page 230 Thursday, August 1, 2013 11:03 AM

230 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

tion and population incentives are examined by W. C. Bush, “Population and Mill’s Peas-
ant-Proprietor Economy,” History of Political Economy, vol. 5 (Spring 1973), pp. 110–120.
The critical distinction between Bentham’s “artificial” identity of interests and
Smith’s “natural” identity of interests is discussed by Elie Halévy, The Growth of Philo-
sophical Radicalism, Mary Morris (trans.) (Boston: Beacon Press, 1955). Chadwick’s role
in the history of public administration is well-known. The astonishing range of social
causes in which he was embroiled, highlighted in this chapter and the next, is outlined in
his massive vita. See R. A. Lewis, Edwin Chadwick and the Public Health Movement,
1832–1854 (London: Longmans, 1952), pp. 380–395. Chadwick’s actions on behalf of
Poor Laws reform made him one of the most hated public figures of his day, and his per-
sonality did not ease the situation. In what seems a majority opinion, Lewis described
him as follows: “He was a bore, a really outstanding specimen of bore in an age when the
species flourished. He was too keenly aware of his own merits; while, on the other hand
he had no patience with fools, and his definition of a fool was a very wide one, taking in,
as it did, nearly everybody who disagreed with him. With a wholesome suspicion of
power wielded by others he managed to combine a boundless confidence in the benefits
of power in his own strong hands, and every scheme drawn up by Edwin Chadwick
seemed to contain a provision at some point for giving more power to Edwin Chad-
wick. . . . He stirred up a great deal of mud, and it is a tribute not a reproach that so
much of it was thrown back at him by his critics.” For another biographical treatment of
Chadwick, see S. E. Finer, The Life and Times of Sir Edwin Chadwick (London: Methuen,
1952). Additional secondary sources on Chadwick and his pregnant ideas can be found
in “Notes for Further Reading” at the end of chapter 10.
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10

J. S. Mill and Edwin Chadwick

on Taxation and Public Economics

Major economic transformations like the Industrial Revolution usually wind up as a

mixed blessing. We saw in the last chapter that despite the tremendous spur to eco-
nomic development by technological advance, adverse side-effects inevitably fol-
lowed, creating a dilemma for economists and policy makers alike. The old order of
mercantilism was sustained by strong centralized government and authoritarian
market controls. The new order, industrialism, required a liberating philosophy that
allowed market-based incentives relatively free sway. Adam Smith supplied the phi-
losophy of limited government that the new industrial order required. But second-
generation classical economists were constantly balancing the need to limit govern-
ment, on the one hand, with the practical necessity to use it as a vehicle for socio-
economic improvement, on the other. This chapter examines those areas in which
Mill and Chadwick performed a delicate balancing act between proactive and reac-
tive government action in the emergent market economy.
The second half of the nineteenth century was a victory for laissez-faire and
economic freedom inasmuch as public institutions were gradually and progres-
sively constrained in a way that provided marginal gains for free trade, both domes-
tically and internationally. Two especially noteworthy constraints on government
typified the age of nineteenth-century laissez-faire. The first was a fairly rigid
adherence to a monetary gold standard, which denied the central government
access to the printing press (fiat money), thereby limiting the amount of govern-
ment spending for war or social programs. The second was the limits placed by a
conservative government (then led by Prime Minister Robert Peel and Chancellor of
the Exchequer William Gladstone) on the amount and types of taxation the govern-
ment could levy. Gladstone in particular promoted a number of policies designed to
produce a balanced withdrawal of government from the private sector. Among them
were the repeal of the Corn Laws (finally accomplished in 1846), the reduction of
income taxes, and the prohibition of sales and excise taxes. The calculated effect of
Gladstone’s policies of public finance was less government and a practical realiza-
tion of laissez-faire, but in this context laissez-faire consisted mainly of legal limita-
tions on the tax base available to the government.1 The straightforward policy was
1 Baysinger and Tollison (“Chaining Leviathan”) argue that the implementation of Gladstonian
financial and economic policies in mid-nineteenth-century England marked the official end of
mercantilism. The question of when mercantilism actually declined, however, depends on how the
terms “mercantilism” and “laissez-faire” are defined and understood.

231
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232 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

to “starve the beast.”2 The state would necessarily be kept small in terms of its
sphere of influence because it could not “afford” to intervene on a large scale.
Against this backdrop of shrinking government, Mill and Chadwick agitated for
improvement of the working class. They clearly understood the value of open, com-
petitive markets (although Chadwick would have attenuated private property rights
along with a competitive bidding system) and the actual and potential gains from
trade. But they were also attuned to the negative impacts of the Industrial Revolu-
tion. Problems of income inequality, urbanization, and especially urban poverty of
the working and dependent segments of the population were much on their minds.
Following Bentham, they understood that “incentives mattered” and that while lais-
sez-faire had produced marvels in terms of aggregate economic growth, the gener-
ally low condition of labor was a drag on a healthy economy. The question then was:
Can the mobility of labor and its well-being be altered by changing tax structures,
the physical environment of the poor, and public policy? Both Mill and Chadwick
thought so, but each invoked a different modus operandi.

■ SOCIAL AND ECONOMIC POLICIES OF J. S. MILL

John Stuart Mill, economist, philosopher, humanitarian, and Member of Parlia-
ment, was in the vanguard of those espousing progressive policies regarding educa-
tion, welfare, trade unions, and the equality of women. He and Chadwick alike
adopted the Benthamite model of social reform, namely proper arrangement of
incentives to achieve desired ends. Mill’s sociological and philosophical treatment
of society’s “ends” underwent considerable change over time, but his reform pro-
posals were consistently grounded in “market” measures. That is to say, Mill recog-
nized the nature and importance of economic incentives as a guide to human action.
We will see that Chadwick espoused the same objectives but was far more apt to
invoke government intervention than his great friend Mill.

Nature and Scope of Economic Policy

An ardent defender of liberty, Mill nevertheless kept an ever-watchful eye on
the conditions of the poor. Committed to both commercial and individual freedom,
he would sometimes countenance exceptions to the former in order to nurture the
latter. In his view, personal liberty required equality of opportunity, not equality of
income or talents. Thus, he noted that
many, indeed, fail with greater efforts than those with which others succeed, not from
difference of merits, but differences of opportunities; but if all were done which it
would be in the power of a good government to do, by instruction and by legislation,
to diminish this inequality of opportunities, the difference of fortune arising from peo-
ple’s own earnings could not justly give umbrage. (Principles, Robson [ed.], p. 811)

To Mill the essential element of liberty is that individuals “all start fair,” and he con-
ceded to government the basic role of establishing social and economic policies that
promote equality of opportunity.
2
This does not mean that certain artifacts of the mercantile system did not remain. Internal mer-
cantilism began to decline as early as the seventeenth century due to institutional change (see
chapter 3), but external control of international trade and the associations with empire building
were a large part of the British economy. Particularly in the agricultural sector, Mokyr establishes
that rent-seeking interest groups influenced trade subsidies and restrictions into the twentieth
century (Enlightened Economy).
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Chapter 10 ■ J. S. Mill and Edwin Chadwick on Taxation and Public Economies 233

Mill divided government interventions into two types: (1) “authoritative” inter-
ventions that prohibit or restrict market forces and (2) “supportive” interventions
that augment market forces. These two types of interventions might also be thought
of in terms of the concepts of ex ante and ex post. Ex ante equality refers to those
interventions designed to ensure that individuals start fairly, for example, all run-
ners begin at the same mark. Ex post equality refers to those interventions such as
taxation that attempt to impose some criterion of fairness in the actual outcome of
social processes involving risk and uncertainty. Ex ante in this context relates to
prospects. Ex post relates to results. Both types of equality may result from the
same social policy, but in general this division is useful for analyzing Mill’s several
policy positions. In golf, for example, handicapping is used to equalize competition
in the sense of making the contest more level and “fair” at the start, but the data for
handicapping are derived from average scores in previous contests. In the same
sense, taxation over time blends the ex ante and ex post concepts of equality.

Taxation and Poverty

As we learned in chapter 8, Mill was sensitive to the distinction between income
distribution and wealth distribution. He did not wish to interfere greatly with the
former because of the adverse effect that income redistribution has on incentives.
However, wealth was a different matter. Inherited wealth, in particular, represented
a means to perpetuate unequal distribution among the classes. Mill looked, there-
fore, to various means of taxation to eliminate wide disparities in wealth and allevi-
ate the meager condition of the working class. Like Smith, Mill was a general
advocate of proportional taxation. He stressed “equality of sacrifice,” but he also
expressed concern for the effects of taxation on the condition of the poor. He spon-
sored three different tax policies aimed at alleviating poverty: The first involved a
minor adjustment to the income tax; the second involved a graduated inheritance
tax; and the third involved certain sumptuary restrictions.
Income Tax. To Mill, the least objectionable of all taxes was a “fairly
assessed” income tax. He wanted tax rates to be proportional at all income levels,
with a built-in exemption for all incomes below a certain amount. In 1857 he sug-
gested that this minimum be set at £100, although he allowed that the controlling
factor must be whatever amount is required to purchase the “necessaries of the
existing population.” At the time, the vast majority of the English population earned
well below that amount (see chapter 9). Mill supported his argument by defending a
low tax rate on the next increment of income (between £100 and £150) on the
grounds that existing indirect taxes were regressive and fell hardest on individuals
earning between £50 and £150 (Principles, Robson [ed.], p. 830).
Although he believed that, in principle, proportional income taxes would be the
most equitable, Mill thought it inadvisable to rely solely on income taxes as a source
of government revenue. Attempts to strictly enforce income taxes would inevitably
lead to tax evasion, fraud, and collection irregularities, in his view. “Commercial
dishonesty,” he pointed out, was “the certain effect of Sir Robert Peel’s income tax;
and it will never be known for how much of that evil product the tax may be
accountable, or in how many cases a false return was the first dereliction of pecuni-
ary integrity” (Essays, p. 702). Despite these weighty objections, Mill justified an
income tax so that the rich would pay their share of taxation.
Mill did not have in mind a minimum-income program because his income tax
proposal did not guarantee everyone an income of £100; it merely exempted from
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234 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

taxation those whose incomes fell below this level. He wanted to build into the tax
system individual incentives to work; hence, the exemption was important in
removing marginal disincentives to earn among the poorest classes of society. As
for the rich, proportional taxes were preferable to progressive income taxes for the
same reason. Mill noted: “To tax the larger incomes at a higher percentage than the
smaller, is to lay a tax on industry and economy; to impose a penalty on people for
having worked harder and saved more than their neighbors. It is not the fortunes
which are earned, but those which are unearned, that it is for the public good to
place under limitations” (Principles, Ashley [ed.], p. 808).
Inheritance Tax. Adam Smith was opposed to the inheritance tax not only
because it did not conform to his canons of taxation, but also because it transferred
capital to the state, which generally proved inept at the use of capital. Mill parted
ways with Smith by denying any right of inheritance, and he contended that both
individuals and society would be better off if no one received large fortunes that
freed them from the necessity of working. He took the view that, except for near rel-
atives, inheritances should be abolished, the amount of bequests should be limited,
and rates should be progressive. Mill believed that inheritances were the chief
impediment to greater income equality over time, and inheritance taxes should be
used to redress extreme inequalities of wealth and to encourage a situation in which
all start fairly. As always in matters of taxation, the key for Mill was the impact of
any tax on incentives. Whereas he favored proportionality in income taxation for
reasons mentioned above, he did not object to progressively higher rates on inheri-
tances, because incentives are not adversely affected in the case of bequests and
because the tax base is comprised of unearned rather than earned wealth.
Mill’s reasoning was borrowed from Bentham, who rejected “natural law” in
favor of utilitarianism. Declaring natural law “sheer nonsense,” Bentham expressed
utter contempt for those who would use it as the foundation for public policies.3
Bentham always focused on incentives, and in this he was followed by his two
famous protégés, Mill and Chadwick. He favored inheritance tax because he
thought it would produce revenue with minimum sacrifice. He defended the (virtu-
ally) painless inheritance tax on collateral legatees (distant relatives) because he
reasoned that those who received unexpected “windfalls” would not see their utility
diminished if they did not receive the unexpected. At the same time, inheritance
taxes could be used to lighten the burden of taxes on the poor and working classes
of society (Supply without Burden). Death, in other words, constituted a limitation
on property rights unlike deprivations of the living.4
On occasion Mill has been labeled a “socialist” for his views on inheritance tax-
ation, but he only countenanced limits on individual property rights after a person’s

3 Bentham wrote: “Who is this . . . Queen ‘Nature,’ who makes such stuff under the name of laws? . . .
In what year of her own, or any body else’s reign, did she make it, and in what shop is a copy of it to
be bought, that it may be burnt by the hands of the common hangman. . . . It being supposed, in point
of fact, that the children have or have not a right, of the sort in question, given them by the law, the
only rational question remaining is, whether, in point of utility, such a right ought to be given them or
not? To talk of a Law of Nature, giving them, or not giving them a natural right, is so much sheer
nonsense, answering neither the one question nor the other” (Supply without Burden, pp. 93–94).
4
A similar argument was advanced in another connection—the rights to one’s burial plot—in Chad-
wick’s appendage to the 1842 Sanitary report (Report on the Sanitary Conditions, 1843). Chad-
wick, the utilitarian practitioner, appended a brief exposition of the English law with respect to
perpetuities in public burial grounds. A ruling judicial interpretation proclaimed that rights con-
sisted in a balancing between those of the dead and those of the living.
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Chapter 10 ■ J. S. Mill and Edwin Chadwick on Taxation and Public Economies 235

death. He relied on population control and strict rules regarding inheritance limits
to redistribute wealth and to provide for ex ante equality in British society, resisted
politically by a hereditary aristocracy. Nevertheless, changes were slow in coming.
Legacy and succession duties remained low in Britain throughout the nineteenth
century. The Stamp Act of 1815 set the basic rates of inheritance duties, until it was
amended by the Finance Act of 1910. Moreover, real-estate wealth remained beyond
the reach of these “stamp duties,” which included a (regressive) probate tax on all
inheritances and a legacy (and succession) duty that varied by kinship between
legator and legatees.5 Gladstone tried to levy new death duties on freehold and
hereditary landed properties in 1853, but according to Morton Peto the results were
minimal in a statistical sense (Taxation, pp. 118–120). Factors contributing to the
failure of reforms included assessment problems and ease of tax evasion and the
political resistance of the landed aristocracy.
As a percentage of property bequeathed, large increases and massive levies of
death duties did not occur until the twentieth century. Nevertheless, the revenue
raised by death duties rose during Mill’s lifetime and afterward, due in part to popu-
lation growth, increased coverage, more accurate reporting, and persistent govern-
mental emphasis on direct versus indirect taxation. According to Peto death-duty
receipts from probate and bequests grew from about £2 million in 1851 to £3.4 mil-
lion in 1859 (Taxation, pp. 135–136). Alfred Soward and W. E. Willan report that
dramatic increases in the gross capital value of properties subject to estate duties
pushed the tax “take” to more than £31.7 million in 1918 (Taxation of Capital, pp.
338–339; 343). Death duties as a percentage of total government revenue also rose
over the last half of the nineteenth century, indicating that the kind of redistribution
Mill envisioned was actually underway prior to the massive expansion of the state
in England at the turn of the century. At this point many landed estates were dis-
persed and reformers of various stripes (as we will see in the following two chap-
ters) were successful in greater government participation in the British economy.
Excise and Sumptuary Taxes. According to Mill indirect taxes bore dispro-
portionately on the poor, especially since many excise duties were on “necessities.”
He advocated selective discrimination in setting import duties and excise rates so
that the burden of taxation would not fall unduly on the poor. He did not object to
the appropriateness or legitimacy of these levies but to their relative burden:
The duties which now yield nearly the whole of the customs and excise revenue,
those on sugar, coffee, tea, wine, beer, spirits, and tobacco, are in themselves,
where a large amount of revenue is necessary, extremely proper taxes; but at pres-
ent grossly unjust, from the disproportionate weight with which they press on the
poorer classes. . . . It is probable that most of these taxes might bear a great reduc-
tion without any material loss of revenue. (Principles, Robson [ed.], p. 872)

Mill’s concern for equality of opportunity among the poor also explains his sup-
port of sumptuary taxes, especially those on luxury goods. He singled out “snob”
goods for special attention, declaring that expenditure by the rich not “for the sake
of the pleasure afforded by the things on which the money is spent but from regard
to opinion, and an idea that certain expenses are expected from them, as an
5
Despite some variations, rates prior to 1910 were as follows: husband or wife (0%); lineal ances-
tors or issue (1%); brothers or sisters or their descendants (3%); brothers or sisters of the father or
mother or their descendants (5%); brothers or sisters of a grandfather or grandmother or their
descendants (6%); other collaterals or strangers (10%). In 1910 rates rose, with a charge (1%)
added to husband and wife (see Soward and Willan, Taxation of Capital, pp. 323–324).
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236 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

appendage of station . . . is a most desirable subject of taxation” (Principles, Ashley

[ed.], p. 869).
Taking all these proposals together and recognizing the financial requirements
of the state, Mill sought to promote equality of opportunity by providing incentives
to work, by reducing the regressive burden of indirect taxes on the poor, and by off-
setting the remaining burden on the poor with a high and progressive inheritance
tax. His integrated approach to economic policy thus suggested an antipoverty pro-
gram based on tax relief. Income distribution consistent with equality of opportu-
nity could and should be altered, in Mill’s view, by legislative power. But indirect
support through tax relief was not sufficient in itself. Mill designed a more direct
form of support as well.

Income Redistribution in Theory and Practice

Mill’s 1845 essay “The Claims of Labour” (see Essays) outlined a program for
public policy that exemplified clearly the distinction in economics between “norma-
tive” and “positive” that he made in his earlier work, On Logic. Noting the gathering
momentum of socialist agitation for income redistribution, Mill affirmed the desir-
ability of policies that redistribute income to the poor. Once again, however, he
insisted that the question was one of means, not ends. Mill was unimpressed by the
proposals of the socialists and the Romantics. For the most part, they sought to
improve the condition of the poor by merely raising wages—a program Mill found
dangerous because its advocates refused to attach population limits to their wage
proposals. Good Malthusian that he was, Mill concluded that an increase in the
birthrate would wipe out the gains in wages advocated by the socialists. What was
needed was a change in the living habits of the working class. He wrote: “If the
whole income of the country were divided among them in wages or poor-rates, still,
until there is a change in [laborers] themselves, there can be no lasting improve-
ments in their outward condition” (Essays, p. 375). Mill had nightmarish visions of
large classes of people becoming dependents of the state, citing the Irish and
French experiences in this regard (Later Letters, p. 44). He regarded welfare depen-
dence as a most pernicious form of evil and, unhappily, a lesson that the poor learn
more easily than any other.
Having rejected socialist and Romantic proposals for income redistribution as
being at odds with the nature of human beings, Mill championed instead a system
of self-help based on education and proper economic incentives. Like Bentham, he
advocated public education. He supported Chadwick’s proposal that government
pay for the education of pauper children, but the measure was defeated by the
House of Lords in 1834. Mill conceived education as learning in the broad sense,
and he customarily backed changes that would cultivate “a taste for capitalist val-
ues” among the laborers. One such measure was a plan of government loans to the
poor for improving their living accommodations. Certain programs, Mill felt,
needed government impetus to get off the ground but, once established, should be
capable of sustaining themselves without further help.
Indeed, this idea is consistent with Mill’s support of a minimum income for the
laboring poor. He stressed that public assistance should always be a tonic rather
than a sedative. Public assistance should never dispense with, or replace, self-help.
Care must always be taken in designing programs to allow a person’s own labor,
skill, and prudence to flourish, thereby affording each worker a better hope of
attaining success by legitimate means. This, in fact, became a test to which all plans
of philanthropy and benevolence should submit, Mill argued, whether intended for
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Chapter 10 ■ J. S. Mill and Edwin Chadwick on Taxation and Public Economies 237

the benefit of individuals or of classes, and whether conducted on the voluntary or

on the government principle (Principles, Robson [ed.]). He was unwilling to rely
entirely on private charity, however, because Mill considered it uneven in its
bestowal of benefits. Besides, he argued, poverty has external effects (i.e., costs) on
the wider community (e.g., crime, beggary) and so should be solved by public policy
rather than by private charity.6
The above mentioned measures provide positive inducements to raise up the
poor, but Mill also recommended the removal of present discouragements to the
lower classes. He chided government for failure to build the right kind of economic
and legal incentives into the social structure, arguing that it was the government’s
responsibility to remove every impediment that legal and fiscal systems place on
attempts of the poor to better themselves. For example, he advocated removal of
defects in the common law of partnership, which restrained the poor from experi-
menting with joint-stock companies. Even more interesting is Mill’s proposal to
revamp the tax system on land transactions. The Stamp Office taxed land transac-
tions of even the smallest amount, whereas legal fees were the same regardless of
the size of transaction. The result was to suppress incentives to invest on the part of
the poor peasant. Should the poor manage to save, Mill argued, economic con-
straints within the legal system shut off investment outlets for their savings. The
land tax system was therefore of negative value in establishing opportunities for
redistribution. In sum, Mill wished to use government policy to implement a mini-
mum-income plan that utilized market forces to maintain work incentives. He
clearly believed that the “low moral condition” of the poor could be improved by
public assistance, provided that “while available to everybody, it leaves to everyone
a strong motive to do without it if he can” (Principles, Robson [ed.], p. 961).

A Brief Summary of Mill’s Approach

Mill’s approach to social reform was closely aligned with his overall view of
“justice.” Justice meant equal opportunities “at the start” but not (necessarily) equal
results “at the finish.” This maxim makes very good sense in the abstract, but it is
difficult policy to put into practice. The problem is an intergenerational one. How, in
an ever-growing and changing population, could a beginning and an end be identi-
fied? Mill’s answer to this question was to reward earners and entrepreneurs who
produced value for society and to tax away “unearned incomes” from hereditary
fortunes, many of them originating in medieval fiefdoms from a bygone era and
passed down to successive generations. To Mill, property rights ended at the coffin.
However one views Mill’s argument respecting inheritance as a means to dis-
tributive justice, he could never abandon his “Ricardian” roots. He clearly defended
incentives, free markets, and innovation as the essential goads to progress. He
believed that minimal government, generally of the Gladstonian type, was preferred
but that incentives to progress could be built into programs. Government had a role,
especially in redressing the “opportunity disparities” in a class-structured society,
but that role was “indirect” and minimalist in character. His good friend Edwin
Chadwick went much further than Mill was willing to go in his quest to change the
constraints affecting the poor. Chadwick had few reservations about extending the
power of centralized authority.

6
Moreover, a “free-rider” problem would exist when no private individual has any incentive to pro-
vide charitable contributions because he or she assumes that others would. This is, for instance,
the classic argument for government’s provision of national defense.
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238 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

■ THE POLITICAL ECONOMY OF SIR EDWIN CHADWICK

There is some disagreement about the extent to which J. S. Mill was a collectiv-
ist, owing mainly to his views on inheritance, but it is clear that he was greatly influ-
enced by the political thought of Jeremy Bentham and the economic analysis of
David Ricardo. He defended private property, personal liberty, and decentralized
government, even though he sometimes seemed willing to compromise these ends
to the utilitarian ethic of the greatest good for the greatest number. His friend and
ally, Edwin Chadwick, bowed more deeply at the utilitarian altar, and his persis-
tence as the quintessential bureaucrat had a far-reaching impact on British social
and economic policy. As one writer said of him, Chadwick had his insistent fingers
in practically every interventionist pie during his administrative career.
Chadwick’s domineering personality made him hated by many and feared by
some, but his boundless energy was evident to all. Actively involved in the design and
implementation of English social and economic legislation for over thirty years, Chad-
wick is credited as the driving force behind improvements in the Poor Laws, munici-
pal water supply, drainage, sewage treatment, public health, civil service, school
architecture, education of pauper children, and many other programs considered pro-
gressive in his day. With Bentham, he was also the leading proponent of a “competi-
tive principle” that has found resurgence in our own day. Unlike Mill, however, he had
few credentials as a serious economist, although he understood and accepted the four
macroeconomic cornerstones of the classical system. In keeping with this, his biogra-
phers have represented him as a lawyer and civil servant. Be that as it may, it would
be almost impossible to find anyone in the nineteenth century who saw more clearly
the variety and kinds of economic problems that confront the modern policy maker or
who was more at home in “classical” economic theory than Chadwick.

Law, Economics, and the Artificial Identity of Interests

Chadwick was trained in law, but he gave up the life of a barrister for a career
in civil service. He was sympathetic to Bentham’s “worldview” and, in particular, to
his belief in legislation grounded in utilitarianism. He was also versed in Ricardian
economics, though not as steeped in the subject as Mill. This combined intellectual
heritage of Bentham and Ricardo reinforced Chadwick’s conviction that individual
initiative is the mainspring of social progress. Throughout his life he remained a
vocal defender of this principle and often advocated change in the existing social
structure that would preserve and/or enhance the free play of individual initiative.
What Chadwick brought to Benthamism was administrative genius that strad-
dled utilitarian theory and bureaucratic practice. Bentham rejected Adam Smith’s
doctrine of the natural identity of private and public interests and sought to replace
it with an artificial identity of interests, achieved through administrative arrange-
ments. His public policy goal was to arrange obligations and punishments in such a
way that the incentive to cause public harm through private action was removed, or
at least blunted. But the practical implementation of this idea required a clear con-
ception of the public interest. Bentham’s personal view that the public interest is the
summation of individual interests was fraught with analytical difficulties because it
involved grandiose assumptions and interpersonal utility comparisons (see chapter
6). Chadwick simplified the idea of public interest by redefining it in terms of eco-
nomic efficiency: Anything that reduced economic waste was found to be in the
public interest. Under this banner, Chadwick advocated sweeping administrative
reforms in the provision of both private and public goods.
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Chapter 10 ■ J. S. Mill and Edwin Chadwick on Taxation and Public Economies 239

One famous example will serve to illustrate Chadwick’s approach to institu-

tional reforms through incentive manipulation. Confronted with the problem of
reducing the mortality of British criminals transported to Australia, Chadwick noted
that on embarkation from a British port the British government paid a flat fee to the
ship’s captains for each convict transported. The captains, of course, found that
they could maximize profits by taking on as many prisoners as could be carried
safely without endangering the ship and by minimizing expenditures (for food and
drink, etc.) on the prisoners en route. Survival rates among the prisoners under this
incentive system were as low as 40 percent, and English clerics complained bitterly
about the inhumanity of the system. After a quick assessment of the situation,
Chadwick changed the payment system so that the ships’ captains received a fee for
each live convict that disembarked in Australia. Within a short time the survival rate
increased dramatically to 98.5 percent (Chadwick, “Opening Address”). All that was
needed was to give the ships’ captains an incentive to protect the health of their
human cargo—thus creating an artificial identity between the public interest (i.e.,
the health of the prisoners) and the private interests (i.e., the shipper’s profit). This
same principle guided all of Chadwick’s policy research.

Economics of Crime and the “Preventive Principle”

In England the poor were not only perpetrators of crime but the primary victims
of a badly constructed administration of criminal justice. Chadwick saw an opportu-
nity to induce social reform by engaging the combined elements of Bentham’s utili-
tarianism and Ricardo’s economics. As usual he focused on incentives, which he
traced to existing institutional arrangements.
The Common-Pool Problem. A common-pool resource (also called a com-
mon-property resource) presents special problems for economists because the size
or characteristics of the resource make it costly (but not impossible) to exclude
potential (nonpaying) beneficiaries from its use. Unlike pure public goods, in which
individuals cannot be effectively excluded from use, and use by one individual does
not reduce availability to others, common-pool resources face problems of conges-
tion or overuse, because they are subtractable. A common-pool resource typically
consists of a stock variable, or core resource (e.g. water or fish), and a flow variable
(i.e., extractable, renewable, noncore units that can be consumed without decimat-
ing the core resource). The object of public policy in this regard is to protect and pre-
serve the core resource in a way that allows for continuous harvest and consumption
of the noncore units. Chadwick’s analysis of crime and criminal behavior empha-
sized the open-access, common-pool aspects of the enforcement and prosecutorial
sides of the British criminal justice system. He recognized free-rider problems
within the system and lobbied Parliament to change received institutions in a man-
ner that would prevent crime and encourage more efficiency in law enforcement.
At the beginning of the eighteenth century, law enforcement in England was
conducted by unpaid parish constables and magistrates or justices-of-the-peace
(JPs). Larger towns added night watchmen and the beadle (i.e., constable’s assis-
tant). This system soon broke down under increases in population and human mobil-
ity; as a result, metropolitan parishes moved to a system of pay to encourage more
people to work as night watchmen. But Chadwick believed that the change ignored
serious supply-side problems, such as time, transactions, and information costs.
Chadwick’s Preventive Principle. In 1829 Chadwick released his study of a
proposal to establish a municipal police force in the city of London. Prepared for Sir
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240 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

Robert Peel’s7 Select Committee, his report on police was a brilliant application of
Benthamite principles and an effective means of emphasizing Chadwick’s “preven-
tive principle,” which became a key element of so many of his later reforms. This
principle maintains that the surest way to reduce waste is not to alleviate inefficien-
cies after the fact but to keep them from occurring beforehand. Chadwick was a
fanatic on the principle of prevention, and he always implied that preventive mea-
sures were generally accompanied by large pecuniary economies, most particularly
in the areas of crime and police.
An avid believer in the primacy of statistical research, Chadwick commonly
conducted “field inquiries” on problems that required administrative solutions. His
direct questioning of criminal offenders produced the following behavioral profile:
Thieves, he learned, are impatient with steady labor, dislike physical exertion, enjoy
leisure, are not easily deterred by the threat of punishment, and value the prospect
of uninterrupted success. He learned that criminals make rational “career” choices
based on pecuniary gain. Typical of the responses Chadwick got from his interviews
was the retort of one Frenchman to the question of why he chose a life of crime. The
perpetrator replied: “I keep myself within bounds of moderation: yet as a thief, I
realise eighteen francs a day. But at my trade as a tailor I only earn three. I put it to
you—would you be honest only on that?” (“Préçis,” p. 391).
Chadwick concluded that individuals calculate the expected benefits and costs
of committing crimes against property, and that for any given booty obtained, the
expected gain will be greater the higher the probabilities of apprehension and con-
viction. He did not reject earlier claims by Bentham and others that there are trade-
offs between the severity of punishment (for example, death for stealing food) and
its certainty, but Chadwick’s research indicated that severe punishment was a rela-
tively weak deterrent. From his empirical studies he learned that: (1) existing police
administration and jurisprudence placed the risk-costs associated with crime at
very low levels, although the punishments were very severe, and (2) a high proba-
bility of capture and conviction was the stronger deterrent to crime.
In its basic approach and elements, Chadwick’s calculations find a modern
parallel in the writings of Isaac Ehrlich, George Stigler, and Gary Becker. He
argued that the (probability-adjusted) marginal benefits and costs of criminal
behavior could be altered by certain administrative actions that would deter prop-
erty crimes. In other words, property crimes could be deterred by lowering mar-
ginal benefits or raising marginal costs, or both. Some actions could be taken by
potential victims, such as arming themselves against thieves; installing locks, home
alarm systems, safes; and so forth. From the perspective of the perpetrator, how-
ever, Chadwick recognized that the marginal cost of crime was a compound proba-
bility of being apprehended, convicted, and punished. He therefore favored
administrative arrangements that would improve the probabilities of each of these
procedural elements.
Police Effectiveness. Chadwick maintained that crime prevention was the
joint responsibility of police and the public, but he identified disincentives for indi-
viduals to cooperate with public sector law enforcement that could be traced back
to the common-pool problem. Inasmuch as victims were denied compensation, it
was difficult to secure their cooperation, or that of witnesses. In a general sense,
existing institutional arrangements induced private individuals to underinvest in the

7
British police to this day are called “bobbies” in honor of Sir Robert, Britain’s prime minister who
successfully established a metropolitan police force in 1829—over many strenuous objections.
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Chapter 10 ■ J. S. Mill and Edwin Chadwick on Taxation and Public Economies 241

maintenance of public benefits and overinvest in the generation of private, internal-

ized benefits. Chadwick complained:
By allowing no compensation, and making parties pay the expense of all proceed-
ings for the recovery of stolen property, they are taught to view the crime as a mat-
ter with which they may act as best suit their own interests, without reference to
the public, which can claim of them no sacrifice, since, in this instance, at least, it
[the public] has failed to perform its first duty of giving protection. (“Preventive
Police,” p. 273)

For their part, the police had no incentive to collect or supply information on theft.
As Chadwick noted, in cities where “no reward can be hoped for, no exertion will
take place, and . . . no profit can be derived by them [police] from the prevention of
the great mass of depredation” (“Preventive Police,” p. 277). Crime is encouraged,
Chadwick concluded, by the rational behavior of victims and police, when jointly
confronted by the common-pool problem.
In order to make the police a more efficient preventive force, Chadwick focused
on police compensation and administrative economies. He found a close connection
between the quality of law enforcement and the compensation of enforcers. His
research indicated that police wages were so low in Britain as to encourage as many
thefts of high-valued property as possible, “in order that large rewards may be
offered for its recovery” (“Preventive Police,” p. 254). A solution to the wage prob-
lem was to base police wages on productivity, but inability to measure the real ser-
vices of prevention barred a “final” solution. As a second-best solution Chadwick
suggested an adjustment of wages based on the comparison of crimes committed in
one police jurisdiction with those committed in other jurisdictions where property
was similarly situated. Distortions caused by discrepancies between actual and
reported crimes or in the rate of reporting crimes would, of course, remain in such a
system, and Chadwick recognized that only improvements in the collection and
accuracy of crime data could correct those deficiencies. For this reason he harped
on the desirability of a centralized bureau for collecting and disseminating crime
data, including descriptions of stolen property.
On most matters of administrative economy Chadwick was a centrist. He chal-
lenged specialization and division of labor as principles of preventive efficiency,
arguing that where deterrence is the objective, maximum efficiency is promoted by
the geographical dispersion of preventive “inputs.” Hence he argued for consolida-
tion of functions in cases where public benefits are likely to occur. For example,
because it is easier to extinguish fires (and thereby reduce property loss) if detec-
tion and extinction occur soon after combustion, Chadwick advocated the consoli-
dation of police and firemen, which places more preventive agents in the field and
consequently reduces the time lag in detecting and extinguishing fires. He drove
home his point with the force of a scientific rule: “The force of one man for fire ser-
vice at half a mile is worth four men at three quarters of a mile, worth six men at a
mile, and worth eight men at a mile and a half” (“Police and the Extinction of Fires,”
p. 426). An additional benefit of consolidation would be improved efficiency in the
detection of arson. Chadwick viewed this as no small consequence, since reliable
estimates put the number of intentional fires in the London metropolis at one-third
of the total.
The Economics of Justice. Among the costs faced by lawbreakers is not only
the probability of capture but also the probability of conviction. Again Chadwick
recognized that in each case the probability of punishment is not a single value but
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242 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

rather the compound result of a series of separate probabilities that arise at each
stage of the judicial procedure. Besides the chance of being discovered, pursued, or
detected, all governed by the state of police, Chadwick identified corresponding ele-
ments of judicial procedure; in particular: (1) the chance, if detected and appre-
hended, of being indicted; (2) the chance of error in framing the indictment; (3) the
chance of dismissal of a bill of indictment by the grand jury; and (4) a number of
contingent chances in the trial process, such as the exclusion of evidence; the qual-
ity of witnesses, lawyers, judges, and juries; etc.
Chadwick’s most vicious attack on existing institutions was on the grand jury
system, which he labeled “the stronghold of perjury,” a system that gives to delin-
quents “all the chances (of escape) arising from the ignorance and want of skill both
in the jurymen and the witness” (“Preventive Police,” p. 298). He estimated that crim-
inals go free more often because of a lack of expertise among jurors than because of
improper action taken by judges, and he called for the elimination of the grand jury
system as one way of raising costs to the guilty without simultaneously endangering
the innocent. In addition to reforms that would streamline court procedures, Chad-
wick favored institutional arrangements that would lower the individual costs of
prosecuting crimes or of providing information necessary to court proceedings.
Chadwick’s centralization schemes did not find a sympathetic reception among
segments of British society. Fearing loss of individual liberties, the English were
highly suspicious of a centralized police. Some feared that a highly centralized
police would lead to a replication of the much despised French system of spies in
the service of police. Past experience with a judiciary tightly linked to the monarchy
also fed resistance. Fear that the police would be used to enforce workhouse incar-
ceration in new versions of the Poor Laws was a major concern among the workers.
And many entrenched narrow-interest groups did not want to change the status
quo. Politicians and magistrates of the landed gentry opposed Chadwick’s plan
because it would transfer the “contractual powers” and wealth of the proprietors to
a centrally managed national police force. The sharpest opposition, which Chad-
wick belatedly identified, came from the entrenched, rent-seeking interests of the
local JPs, their associated bureaucracies, and the legal profession.
Ultimately, a public police force was adopted in England. By 1900, 179 separate
police forces had been established in England and Wales, but there was little consol-
idation of police administration until the twentieth century, when rising crime levels
followed armistice from wars, and union agitation helped to break down resistance
to change. However, the retention of judicial procedures that made private partici-
pation in the justice system costly then, remains to the present day, despite techno-
logical improvements and the institution of regular, paid police.
The institutions Chadwick described and attempted to change are imbedded in
the modern U.S. system of law enforcement and jurisprudence, making his analysis
timely even at this late date. Although technology has reduced information costs,
the incentive problems in policing, in prevention, and in the legal system itself are
essentially the same. The same rent-seeking interest groups that resisted Chad-
wick’s reforms continue to coalesce against contemporary legal and jurisprudential
reforms. In some respects, Chadwick was a man for all seasons.

Disease, Sanitation, and Living Conditions of the Poor

The consensus view is that sanitation reform was Chadwick’s greatest achieve-
ment. But rather than considered independently, the most striking element of Chad-
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Chapter 10 ■ J. S. Mill and Edwin Chadwick on Taxation and Public Economies 243

wick’s legacy was how the roles that sanitation reform and his prior investigations
into English poverty shaped Chadwick’s analysis of the entire structure of the Brit-
ish economy, especially concerning the environmental constraints that determined
the conditions and behavior of the poor. Chadwick’s goal of “sanitizing” England
was far from an isolated event; moreover, his efforts in this regard had implications
beyond the narrow concerns of public health.
Building on his long involvement in matters of socioeconomic reform, especially
regarding the condition of the poor, Chadwick championed sanitation in a concerted
attempt to enhance the economic condition and productivity of labor and hence the
overall economy. In short, sanitation reform and centralized control were for him
the keys to improvement of labor productivity, the elimination of poverty, and, ulti-
mately, economic growth. As before, his argument for centralized provision of sani-
tation and other social and economic projects was premised on his belief, after
diligent study, that local governments were unable to promote productive activities.
Chadwick was alert to the many dimensions of poverty. His early investigations
on the condition of the working poor convinced him of the value of human capital—
investments in education in particular—as one means to improve the permanent
condition of labor and the poor. He also noted that nineteenth-century improve-
ments in medical science had actually improved life expectancy among middle- and
upper-class citizens from the previous century. This conundrum—increased life
expectancy on average, but wretched conditions and early death amongst the low-
income working poor and the destitute (the “dependent class”)—was a major moti-
vation for Chadwick’s research into sanitation and its effects.
Chadwick’s 1842 sanitary report investigated every corner of the United King-
dom and every facet of sanitary conditions. His research led him to the following
two generalizations: (1) life expectancies had increased, and (2) substantial benefits
would be realized through restructuring sanitary provision and administration. As
proof of the first proposition, Chadwick cited insurance company life tables, com-
piled as early as 1828 (“On the Means of Insurance, pp. 384–421). He compiled and
compared statistics from Northampton and Sweden. For more than three decades,
most British insurance companies used life expectancy from Northampton as the
basis for calculating insurance premiums. Statistics on life expectancies in other
regions were based on more current data compiled by medical and governmental
authorities and a major insurance company (the Equitable table). Chadwick recog-
nized that in almost every category, life expectancy had increased.
Chadwick’s campaign for sanitary reform gathered steam after he became
aware that there were apparent differences in life expectancies for individuals in
different circumstances, which led him to question the underlying circumstances
that promote sickness and death. As was his custom, Chadwick compiled a moun-
tain of data on the matter.8 He began by separating the death statistics by county
and by source (disease vs. nondisease, the former considered preventable). Then,
using his general knowledge of the physical conditions of the counties, he con-
cluded that a substantial portion of all illness was caused by environmental factors.
Areas with the highest death rate from disease were those with the most deplorable
physical conditions, such as inadequate supplies of fresh water, excess ground
moisture, and inadequate waste removal. He found that the number of deaths due
to respiratory problems and epidemics of various kinds dwarfed the number from
8
In this connection Chadwick argued that the poor might take extra measures in the presence of
moral hazard created by insurance. (See the box, “Force of Ideas: “Chadwick on Insurance and
Infanticide as Moral Hazard.”)
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244 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

other sources. Most importantly, the number of deaths from these two sources alone
produced the greatest number of orphans, imposing a high social cost on the state,
and a detriment to labor productivity and to economic growth.

The Force of Ideas: Chadwick on Insurance and Infanticide as Moral Hazard

Because death is an obvious certainty for everyone in all classes and in all ages, many peo-
ple tend to “put away” something during their lives to cover funeral expenses when they inev-
itably occur. The laboring poor and middle class in mid-nineteenth-century London were no
exception. But Chadwick found burial “insurance” sold by undertakers to be riddled with
fraud. And in analyzing the situation he discovered an important and modern economic prin-
ciple: moral hazard.
Chadwick marshaled available statistics to bolster his claim that, from an actuarial perspec-
tive, and regardless of the age group involved, burial insurance premiums were excessive. But
he looked beyond mere monetary consequences. In his day, workers typically congregated in
“public houses” (drinking establishments), which became the logical place to promote burial
“clubs” or the sale of burial “insurance.” Sensing a profit opportunity, the owners of such estab-
lishments became sponsors of burial insurance, sometimes offering a weekly beer allowance to
patrons in return for their dues.* Chadwick quickly concluded that monetary incentives of this
sort created deviations from acceptable behavior, the most egregious of which was infanticide.
As was his practice, Chadwick conducted field studies. In Manchester he found that chil-
dren, especially (less valued) females, were put at risk by multiple registrations in burial clubs.
The actual cost of burying a child was between 30s. to £1, but the death benefits in Manches-
ter were set at £3–5. Perverse incentives and the high cost of acquiring information (about
multiple registrations) led to moral hazard, and unintended consequences. The clerk of the
Manchester Union gave testimony regarding seven children in a particular family who died by
starvation. Sordid evidence from other English locales confirmed more starvations, poison-
ings, and maltreatment. Hoping to collect more than once, parents insured their children in as
many as nineteen clubs and societies, a practice that proved difficult to limit and/or police.
Some of these societies adopted rules that alleviated moral hazard (and adverse selection),
much as life insurance companies later adopted the common exclusion for suicide. “Yet,”
Chadwick said, “frauds are occasionally committed by persons who much know that they
have not long to live” (Report on Sanitary Conditions, p. 68).
Life insurance coverage up to but not exceeding the amount of insurable interest was the
rule among the best life insurance companies, and Chadwick thought that the principle—
stated legislatively during the reign of George III—should be applied to burial insurance as
well. Ever the economist, Chadwick thought that a collateral means of preventing infanticide
was to lower the expense of funerals, which would, in turn, reduce “the temptations to crime
constituted by the apparent expedience of the insurance of the payment of large sums to
meet that expence” (Report on Sanitary Conditions, p. 69). In other words, perverse incentives
could be addressed by changing rules and regulations affecting specific markets.
*Death announcements were often signals of a forthcoming “celebration.” As part of his investigation
Chadwick directed a question to the secretary of one of the better organized burial societies regarding
how the insurance proceeds were used. Mr. Gardner, the secretary, answered: “‘The family provide them-
selves with drink, and the friends coming also drink. I have known this to be to such excess, that the
undertaker’s men, who always take whatever drink is given them, are frequently unfit to perform their
duty, and have reeled in carrying the coffin. At these times it is very distressing. The men who stand as
mutes at the door, as they stand out in the cold, are supposed to require most drink, and receive it most
liberally. I have seen these men reel about the road, and after the burial we have been obliged to put
these mutes and their staves into the interior of the hearse and drive them home, as they were incapable
of walking. After the return from the funeral, the mourners commonly have drink again at the house. This
drinking at the funeral is a very great evil” (Report on Sanitary Conditions, p. 60).
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Chapter 10 ■ J. S. Mill and Edwin Chadwick on Taxation and Public Economies 245

The same official testified that the child of a laboring family “had been entered in at least ten burial
clubs; and its parents had six other children, who only lived from nine to eighteen months respectively.
They had received £20 from several burial clubs for one of these children, and expected to receive at least
as much on account of this child” (Report on Sanitary Conditions, p. 64). Testimony was given in a criminal
proceeding from an acquaintance that “she was a fine fat child shortly after her birth” but that she soon
became quite thin and did not get a sufficiency of food. In spite of the testimony, the case was dismissed by
the jury due to a lack of evidence concerning the exact cause of death (Report on Sanitary Conditions, p. 65).

Chadwick proposed changes in sanitary engineering and administration to

reduce these costs and eliminate disease-promoting factors. His favored solution
was to establish an integrated water and sewer system to which every house was
connected, a system that he sought to show was privately profitable as well as
socially efficient. The old system allowed all manner of water contamination. Much
illness could be traced to water-borne and air-borne contaminants generated from
existing burial practices (i.e., “graveyard externalities”). Disposal of human excre-
ment, primitive by modern standards, was another source of disease and contami-
nation. Chadwick believed that renovated and modernized water delivery systems
would work to eliminate disease and water-borne epidemics, and that the resulting
full price to consumers would constitute an incentive for these improvements.

Changing Economic Constraints

Chadwick’s investigations led him to conclude that the condition of the laboring
classes was being held in check by disease and debilitation caused by environmen-
tal factors that could be willfully changed by introducing proper sanitation and
hygiene. The problems to be corrected were not merely local but national in scope.
They included overcrowding, excessive dampness, and accumulation of the by-
products of human existence. To eliminate these problems, Chadwick proposed a
multidimensional program, all facets of which were designed to encourage the
development of sanitary habits by lowering the full cost of hygiene. The first matter
was to remove waste from the individual inhabitants and then to remove it from the
vicinity of the larger population. Next it was necessary to instill habits of personal
hygiene in every inhabitant. Finally, it was necessary to improve housing and work-
ing conditions. Chadwick put the onus for the first two squarely on the government.
The first public action consisted of the installation of a water and sewer system
with complete connectivity to every household. Chadwick was adamant on the
inclusion of a water supply to all buildings not only for personal use but also for the
immediate removal of waste. He noted that “it will be manifest that for an efficient
system of house cleansing and sewerage, it is indispensible that proper supplies of
pure water should be provided” (Report on the Sanitary Condition, p. 135). With the
installation of the water and sewer system, “the chief obstacles to the immediate
removal of decomposing refuse of towns and habitations,” namely “the expense and
annoyance of the hand labour and cartage requisite for the purpose” would be elim-
inated (Supplementary Report, p. 423). Chadwick estimated that costs would be
reduced to one-twentieth or one-thirtieth of the former costs and at the lower price,
a greater quantity of public hygiene would result.
Along with the reduced cost of removing waste, Chadwick asserted that the
delivery of water to every household would promote personal hygiene. Under the
old system of cisterns located in each neighborhood; “the minor comforts of cleanli-
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246 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

ness are of course foregone, to avoid the immediate and greater discomforts of hav-
ing to fetch the water” (Report on the Sanitary Condition, p. 141). Incentives matter,
of course, to individuals in every social class. “Even with persons of a higher condi-
tion, the habits are greatly dependent on the conveniences, and it is observed, that
when the supplies of water into the houses of the middle class are cut off by the
pipes being frozen, and when it is necessary to send for water to a distance, the
house-cleansings and washings are diminished by the inconvenience” (Report on
the Sanitary Condition, p. 141). In contemporary terms Chadwick was arguing that
the full-cost (including time costs) of cleanliness has an effect on the quantity of
cleanliness consumed. Chadwick recognized that the full-cost of water was the sum
of its purchase price plus the opportunity wage rate per hour times the number of
hours it took to fetch the water for home use. To provide the appropriate economic
incentive for improved personal hygiene he called for a reduction in the full-cost of
water by having it home-delivered. Once again, the solution to a public problem
required the creation of an artificial identity of interest. The desired (public) result
of home sanitation could be ensured by the proper structuring of economic incen-
tives. To this end he pointed out that “if the labourer or his wife or child would oth-
erwise be employed, even in the lowest paid labour or in knitting stockings, the cost
of fetching water by hand is extravagantly high” (Report on the Sanitary Condition,
p. 142).
Beyond the public provision of water and sewer systems, Chadwick saw oppor-
tunities where employers could greatly improve the conditions of the poor and the
working class simply by changing the constraints they faced. The provision of suit-
able housing is a case in point. Chadwick called for capitalists to undertake “the
erection of dwellings of a superior order” (Supplementary Report, p. 298). Although
he appealed to benevolence initially, his research led him to conclude that the bene-
fits to employers would in most cases exceed their costs. He cited as evidence the
experience of one entrepreneur who, strictly out of benevolence, invested in
improved housing and provided schools for the children of his employees. Yet, he
“was surprised by a pecuniary gain ground in the superior order and efficiency of
his establishment, in the regularity and trustworthiness of his work people” (Sup-
plementary Report, p. 301). Chadwick believed that proper housing would improve
worker productivity by providing greater proximity to place of work and by reduc-
ing “all the attacks of disease, occasioned by exposure to wet and cold and the addi-
tional fatigue in traversing long distances to and from his home to the place of
work” (Supplementary Report, p. 299).
Besides the provision of housing, Chadwick maintained that the health of the
working population was greatly affected by their work environment and that facto-
ries could be designed to promote the well-being of the workforce. He cited the case
of a cotton mill engineered with the health of the workers in mind. The factory was
designed to provide an abundance of fresh air and a means of controlling the cli-
mate. Moreover, the machinery was installed in a manner that maximized protec-
tion against industrial accidents. Ever mindful of costs and benefits Chadwick
observed that “the first expense of such a building is higher than a manufactory of
the old construction, but it appeared to possess countervailing economic advan-
tages to the capitalist” (Supplementary Report, p. 307). He clearly believed that the
laborers’ condition could be altered by changing the constraints faced by workers
and that promoting benevolence only goes so far, but appeals to the profit motive
can be ultimately effective.
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Chapter 10 ■ J. S. Mill and Edwin Chadwick on Taxation and Public Economies 247

Sanitation and the Economy

Chadwick clearly envisioned sanitation as a public good, to be supplied, when
possible, through the franchise-bidding process. His defense of the sanitary princi-
ple has had a lasting impact on advanced economies. Water supply and sewage dis-
posal systems are almost everywhere the consequence of public expenditure today,
sometimes with, and sometimes without, franchise bidding. Chadwick saw an eco-
nomic link between government outlays on improved sanitation and the benefits to
be expected from implementing sanitation reform. He thought that part of the social
benefit equation was a prolonged average life span. Although he investigated the dif-
ference in death rates between and within rural and urban districts, Chadwick based
his arguments concerning mortality, correctly as it turns out, on class differences.9
Chadwick considered it axiomatic that early mortality was preventable by
improved sanitation—in particular by providing means of pure water delivery and
reduced-cost waste disposal. Lower costs to the individual of personal hygiene
saved lives by preventing the creation and spread of disease. Among the lower
classes particularly, these improvements meant greater labor productivity and lower
death rates. But these private benefits had spillover effects on the public economy.
Lower death rates, as suggested in table 10-1 (on the following page), reduced the
number of widows and orphans that were destined to become wards of the state.
Thus, the cost of sanitation reform—at least partly provided by the government—
had to be weighed against the benefits to government (cost saving) from reduced
welfare and Poor Laws relief to the lower and destitute segments of society. When
private benefits—greater worker productivity and business profits (a net gain)—are
added to the social savings, Chadwick considered sanitation reform as a winning
proposition. Preventable early mortality clearly supported utilitarian goals. Criti-
cally, Chadwick, as had Bentham, appealed to private (net benefit producing) incen-
tives as well as to public provisions to promote these ends.

Public Goods and Institutional Forms of Competition

The idea that public policy consists of altering the institutional arrangements of
society so as to induce self-interested individuals to behave in a way conducive to
the public good is a decidedly Benthamite notion. But the practice of Benthamite
politics is facilitated best by concentrating the ownership and control of property
rights in the hands of a central authority, thus infusing this view with a certain “des-
potic” flavor.10 Chadwick almost seemed to view centralized control as a prerequi-
site for eliminating waste, and he was so committed to this principle that he
reformulated the notion of competition to accommodate it to the exigencies of cen-
tral authority.
After thirty years of investigating, designing, and reformulating myriad public
policies, Chadwick consolidated his views on the proper mode of government inter-
ventions and presented them in a “position paper” to the Royal Statistical Society.
Citing the coexistence of sound and unsound principles of competition, Chadwick
contrasted the orthodox view (which assumed large numbers of rival firms that
shared the market) with a “new” concept of competition that assumed rivalry

9
On the adequacy of the statistical component of Chadwick’s Report on the Sanitary Conditions,
James Hanley argues that Chadwick was correct in his conclusions, despite contemporary criti-
cisms to the contrary (“Edwin Chadwick”).
10
It is precisely on this point that Mill and Chadwick parted company on the matter of economic policy.
Chadwick was an avowed centralist, whereas Mill distrusted the centralized concentration of power.
Table 10-1 The Chief Causes of Death Producing Orphanage
Bethual Oakham- Alston, with TOTALS
Manchester Whitechapel Green Strand Upingham Garrigill Bath Avg. Age
Union Union Parish Union Unions Parish Union of No. of
Diseases, etc. Deaths Deaths Deaths Deaths Deaths Deaths Deaths Deceased Deaths Orphans
Respiratory 500 212 147 95 69 47 40 51 1,110 2,218
Epidemic, 146 65 73 28 34 9 4 46 359 862
Ekelund-Hebert 6E.book Page 248 Thursday, August 1, 2013 11:03 AM

Endemic,
Contagious
Other 129 68 104 32 36 7 8 54 384 694
Violent Deaths 94 44 20 16 23 13 5 46 215 508
Nervous 74 41 38 17 25 3 5 55 203 296
Undescribed 63 40 7 9 6 NA 2 47 127 171
Digestive 60 16 10 10 14 5 3 54 118 180
Old Age 84 104 46 13 47 5 NA 74 299 56
Total 1,150 590 445 220 254 89 67 53 2,815 4,985
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Chapter 10 ■ J. S. Mill and Edwin Chadwick on Taxation and Public Economies 249

among several bidders to win an exclusive right to serve the entire market. Chad-
wick labeled the orthodox notion “competition within the field” and his “new” prin-
ciple “competition for the field.” Describing his strong support for the latter,
Chadwick declared:
As opposed to that form of competition [within the field], I proposed as an admin-
istrative principle, competition “for the field,” that is to say, that the whole field of
service should be put on behalf of the public for competition—on the only condi-
tion on which efficiency, as well as the utmost cheapness, was practicable, namely
the possession, by one capital or by one establishment, of the entire field, which
could be most efficiently and economically administered by one, with full securi-
ties towards the public for the performance of the requisite service during a given
period. (“Results of Different Principles,” p. 385)

Possessed of an early notion of “public goods”—those that provide benefits

external to the immediate user—Chadwick vigorously sought to apply the principle
of competition within the field to this class of goods. He considered it wasteful to
implement or enforce a competitive system based on decentralized property rights,
so he proposed an alternative system in which government, representing society,
would buy out competing suppliers and bid out the exclusive right to supply the
public good. Chadwick called this principle “contract management.”
Illustrating Contract Management. Figure 10-1 sets out Chadwick’s principle
in more modern dress. The negatively sloped cost curves are those of a public util-
ity, transportation firm, or natural monopoly. An unrestrained profit-maximizing
monopolist would produce quantity Qp and sell it at price Pp . Chadwick’s point is
that given certain conditions and alternative property rights assignment, the exis-
tence of natural monopoly need not imply monopoly price and profits. Specifically,

Pp B

AC ‫׳‬

G F Pa
AC
Pm
MR MC
O Qp Qa Qm Q

Figure 10-1 In the absence of price and/or quantity contract specifications, average
cost will increase from AC to AC, resulting in a transfer of welfare from the monopolist
to society by GPpBF. If the government specifies some quantity Qa to be supplied, bid-
ding will continue until price reaches Pa .
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250 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

given that an elastic supply of competitive bidders exists and that the costs of collu-
sion among bidders are high enough, the government could purchase the small
number of competing firms and let out for bid the exclusive right to supply the good
or service in question.
A number of institutional and contractual arrangements are possible in this
context. The government may or may not provide fixed plant and capital equip-
ment. The contract period may be of fixed duration, or it may be reopened at the
discretion of the government. Certainty and/or perfect information may or may not
be assumed on the part of some or all parties. For example, treatment of windfall
gains and losses may be made part of the model. Solutions will, of course, vary
according to the nature of the assumptions made.
Some possible solutions may be shown with the aid of figure 10-1. Assume that
certainty and perfect information exist on the part of the government and bidders
and that the government supplies the fixed capital. The problem, then, is to investi-
gate how the nature of the contract specifications alters the solution. If price and/or
quantity are not specified in the terms of the contract, the maximum bid made by
suppliers to the government does not change the solution except for a transfer of
welfare from the monopolist to society. Such a transfer is depicted in figure 10-1 by
the amount GPp /BF. It would in effect raise the average cost to the successful sup-
plier to AC , resulting in a Chamberlinian “tangency solution” (see chapter 20)
between AC  and the demand curve at price Pp .
The more usual case—the one that Chadwick featured in the case of railroads—is
the situation in which the government contractually specifies some minimum quan-
tity (and/or quality) to be offered and lets potential suppliers engage in a bidding pro-
cess. If, for example, the government contractually specifies some quantity Qa to be
supplied, bidding will proceed to price Pa, at which only normal profits are being
earned. The important point is that Chadwick’s principle makes the attainment of a
“competitive” solution (where average revenue equals average cost and economic
profit is zero) a possibility through public ownership and private operation. Chad-
wick favored this approach, among other reasons, because he did not believe that the
government could operate anything efficiently. All this implies that the competitive
bidding process, given altered property-rights assignment, might approximate at
least some of the results of the orthodox model of competition, where competition is
defined as a market structure of many rival, independent firms. Whether or not this is
a practical result depends on numerous institutional forces, including the mode of
consolidation, design of contracts, cost of acquiring information, and so on.
Applications of Contract Management. In the 1860s, Chadwick became the
leading British proponent of the nationalization of railroads. His argument did not
support government operation of the railways but rather consolidation under the
principle of contract management. In Chadwick’s view, railroads were a natural
monopoly characterized by fractious management and wasteful competition. How-
ever, he did not think that government ownership and operation would be an
improvement. On the surface, he appeared to be in the best tradition of laissez-faire
when he argued that “the Government is utterly incapable of any direct manage-
ment of manufactures, or of anything else of an administrative character” (“Pro-
posal,” p. 202). Nevertheless, his proposal called for concentration of authority in
the hands of a central administration. By 1860, moreover, Chadwick could cite the
government’s successful implementation of a contract management scheme for the
provision of postal services.
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Chapter 10 ■ J. S. Mill and Edwin Chadwick on Taxation and Public Economies 251

Chadwick’s investigation into the conditions of water supply and public health
in London revealed that the problem was one of natural monopoly.11 Thus, he
regarded competition within the field as inappropriate. He found the field of service
currently divided among seven separate companies, several of which had become
multiform monopolies, duplicating one another’s facilities, so that two or three sets
of pipes ran down many streets, doling out insufficient supplies of water of inferior
and often unwholesome quality. Chadwick estimated that consolidation under the
principle of contract management could save £100,000 per year, which could then
be used for exploration and development of new water supplies.
Chadwick noted also that municipal gas companies in the city of Paris com-
peted initially under an almost identical situation of natural monopoly. A study by
the French government into the cost and supply conditions of several independent
gas companies found the charges excessive. The city then undertook consolidation
according to Chadwick’s principle, with the result that customer charges declined
30 percent, the quality of gas supplied improved, and the value of shareholders’
assets increased by 24 percent (“Results of Different Principles,” p. 388). Chadwick
presented additional evidence of two gas companies in northern England whose
prime cost of supplying gas dropped by almost two-thirds after the kind of consoli-
dation he championed.
Chadwick attributed the rejection of his proposed administrative reform of Lon-
don water to the vigorous protests of vested interests. Undeterred, he asserted that
the traditional form of competition over the decade of the 1850s burdened consum-
ers with higher prices, imposed more risk on stockholders, and inflicted on the pub-
lic inadequate water quality and delivery systems. He had little trouble coming up
with a never ending list of possibilities for contract management. The provision of
beer, bread, and public taxis were candidates. Importantly, however, he seems often
to have been describing markets in disequilibrium. In such circumstances almost
any market could be shown to contain inefficiencies, thus becoming a candidate for
subrogation of property rights. This is a severe deficiency in Chadwick’s theory of
“competition for the field” inasmuch as it may provide “efficiency” at the cost of free
enterprise and inviolable property rights.

A Brief Summary of Chadwick’s Approach

Clearly, sanitation reform—which in the West is appropriately credited to
Edwin Chadwick—was a central element of the utilitarian agenda in nineteenth-
century England. Other reforms—mostly financed by taxation and local assess-
ments—in the fields of education, health, and crime prevention rounded out the
program. Chadwick was an energetic, driving force spearheading all these reforms.
His favoritism for centralized authority to effect reforms was greeted with mistrust
in certain quarters, but inasmuch as his arguments were always empirically based
and innovative, he deserved to be taken seriously, as J. S. Mill, for one, did. Inven-
tion and application of the concept of franchise bidding was only one example of
Chadwick’s innovativeness and perspicacity. He understood the principle and con-
sequences of asymmetric information, the nature of common-pool problems, time
costs, and many other “modern” microanalytic principles, which he applied to eco-
nomic issues and to the utilitarian agenda.

11
A natural monopoly is said to exist when it is technically more efficient to have a single producer
or enterprise. In some cases, the survival of a single firm is the natural outcome of competition
among several firms.
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252 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

■ CONCLUSION
Both Mill and Chadwick shared Bentham’s belief in utilitarianism, the critical
nature and importance of incentives, the efficacy of creating artificial identities of
interest, and the philosophic acceptance of the “opportunity” principle—best enun-
ciated by Mill as the proposition that “all start fair.” This last principle understood
that differences in genetics, ambition, and energy would allow for differential end
results but maintained that each generation should start out with equal access to
education, good health, and other opportunities. This idea of equal opportunity,
though enshrined in the United States Declaration of Independence, represented a
major departure for nineteenth-century Britain. Both writers believed that the goal
could be approached and the class system eventually dismantled. Mill advocated
high or prohibitive death taxes, for example, as a means to that end.
Despite agreement regarding the aims of economic policy, Mill and Chadwick
worked two different sides of the utilitarian street. Mill defended inter vivos gifts
but essentially argued that property rights cease upon death. He therefore sup-
ported a high and progressive inheritance tax on the estates of the dead. Like Chad-
wick he was keen to build incentives into government programs, but he rejected the
kind of centralization espoused by his friend and colleague. Mill championed
income distribution supportive of a strong middle class that functioned within a
market-oriented, private-property system. He based his support of the Poor Laws on
social justice, but he worried that income assistance, without an adequate quid pro
quo extracted from its recipients, would inevitably “enslave” a segment of society in
a permanent, counterproductive welfare system. Chadwick had similar concerns
regarding “outdoor” relief for the poor but burrowed into the underlying prob-
lems—education and sanitation—which helped create the demand for poor relief.
Empirical investigations were a core practice of Chadwick’s utilitarianism but
made little impact on Mill’s agenda. Mill always deferred to Chadwick on matters of
fact, as we have already mentioned. His early education in Ricardian economics
channeled his mind toward abstract deduction, not empirical investigations. He
reviewed and admired Chadwick’s voluminous writings and offered advice to his
friend along the way, but his reluctance to endorse Chadwick’s plan to nationalize
industries (railroads) or socialize property rights (for example, funeral and cabrio-
let markets) was not deterred by Chadwick’s evidence. Although neither writer was
a socialist in any traditional sense, Chadwick did countenance market interventions
when his studies indicated a positive net utility outcome from designated policies.
He wanted to eliminate waste from many particular markets, believing that a trans-
fer of property rights from open competition to a government-created contract-let-
ting body of “experts” could and would maximize utility.

REFERENCES
Baysinger, Barry, and Tollison, R. D. “Chaining Leviathan: The Case of Gladstonian
Finance,” History of Political Economy, vol. 12 (Summer 1980), pp. 206–213.
Bentham, Jeremy. Supply without Burden: or Escheat vice Taxation. London: J. Debrett,
1795.
Chadwick, Edwin. “On the Means of Insurance,” Westminster Review, vol. 9 (1828), pp.
384–421.
———. “Preventive Police,” London Review, vol. 1 (1829), pp. 252–308.
———. On an Inquiry into the Sanitary Condition of the Labouring Population of Great
Britain. London: W. Clowes and Sons. Reprinted as Report on the Sanitary Condition
Ekelund-Hebert 6E.book Page 253 Thursday, August 1, 2013 11:03 AM

Chapter 10 ■ J. S. Mill and Edwin Chadwick on Taxation and Public Economies 253

of the Labouring Population of Great Britain, M. W. Flinn (ed.). Edinburgh: Edin-

burgh University Press, 1965 [1842].
———. Report on the Sanitary Conditions of the Labouring Population of Great Britain: A
Supplementary Report on the Results of a Special Inquiry into the Practice of Inter-
ment in Towns. London: W. Clowes and Sons, 1843.
———. “Results of Different Principles of Legislation and Administration in Europe; Of
Competition for the Field, as Compared with Competition within the Field of Ser-
vice,” Royal Statistical Society Journal, vol. 22 (1859), pp. 381–420.
———. “Opening Address,” Journal of the Royal Statistical Society of London, vol. 25 (1862).
———. “On the Proposal That the Railways Should Be Purchased by the Government,”
Journal of the Society of Arts, vol. 9 (February 1866), p. 203ff.
———. “The Police and the Extinction of Fires,” in B. W. Richardson (ed.), The Health of
Nations: A Review of the Works of Edwin Chadwick, vol. 2. London: Longmans, 1887.
———. “Précis of Preventive Police,” in B. W. Richardson (ed.), The Health of Nations: A
Review of the Works of Edwin Chadwick, vol. 2. London: Longmans, 1887.
Hanley, James. “Edwin Chadwick and the Poverty of Statistics,” Medical History, vol. 46
(2002), pp. 21–40.
Mill, J. S. Principles of Political Economy, W. J. Ashley (ed.). New York: A. M. Kelley, Pub-
lishers, 1965 [1848].
———. Principles of Political Economy, in Collected Works of John Stuart Mill, J. M. Rob-
son (ed.), vols. 2 and 3. Toronto: University of Toronto Press, 1966 [1848].
———. Essays on Economics and Society, in Collected Works of John Stuart Mill, J. M.
Robson (ed.), vols. 4 and 5. Toronto: University of Toronto Press, 1967.
———. The Later Letters of John Stuart Mill, 1848–1873, in Collected Works of John Stu-
art Mill, F. E. Mineka and D. N. Lindley (eds.), vols. 14–17. Toronto: University of
Toronto Press, 1972.
Mokyr, Joel. The Enlightened Economy: An Economic History of Britain, 1700-1850. New
Haven, CT: Yale University Press, 2010.
Peto, Morton. Taxation: Its Levy and Expenditure, Past and Future: Being an Inquiry into
our Financial Policy. New York: D. Appleton, 1863.
Soward, Alfred W. and Willan, W. E. The Taxation of Capital. London: Waterlow and
Sons, 1919.

NOTES FOR FURTHER READING

J. S. Mill’s many policy views are featured in the masterful and very accessible col-
lection of his writings in the Toronto series. See especially Mill’s Essays on Economics
and Society (see references). There is some debate as to whether Mill was in the van-
guard of those supporting progressive policies regarding income distribution, the equal-
ity of women, trade unions, public education, and welfare programs. On this matter see
Pedro Schwartz, The New Political Economy of J. S. Mill (Durham, NC: Duke University
Press, 1972); and R. B. Ekelund, Jr., and R. D. Tollison, “The New Political Economy of J.
S. Mill: The Means to Social Justice,” Canadian Journal of Economics, vol. 9 (May 1976),
pp. 213–231. A contrasting view is presented by E. G. West, “J. S. Mill’s Redistribution
Policy: New Political Economy or Old?” Economic Inquiry, vol. 16 (October 1978), pp.
570–586, who asserts that Mill was a Victorian moralist, a blatant Malthusian with regard
to the prospects of the poor, and an elitist supporter of labor unions; but see the rejoin-
der by Ekelund and Tollison that follows West’s article.
For more on Mill’s policy views, see Samuel Hollander, The Economics of John Stu-
art Mill, vol. 2 (Toronto: University of Toronto Press, 1985). Hollander (pp. 897–899)
lends his support to the idea that Mill was motivated by concern for the working poor. In
Hollander’s wake, some curious and idiosyncratic interpretations have floated to the sur-
face, especially one advanced by Oskar Kurer: “John Stuart Mill and the Welfare State,”
Ekelund-Hebert 6E.book Page 254 Thursday, August 1, 2013 11:03 AM

254 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

History of Political Economy, vol. 23 (Winter 1991), pp. 713–730, in which Mill is
advanced as a champion of “modern welfare-state legislation.” See also, same author,
“John Stuart Mill: Liberal or Utilitarian?” The European Journal of the History of Eco-
nomic Thought, vol. 6 (Summer 1999), pp. 200–215, in which Kurer states that Mill was
not a liberal in the classical sense; rather he linked the theory of government interven-
tion to the principle of utility through a social welfare function.
Semantics are of limited interest, but Mill’s view of tax policy as a tool to effect
short-term and long-term economic reform is an issue of far greater importance. In this
regard, even though Mill devised his views in the context of nineteenth-century British
economic and social conditions, they are clearly and distinctly “modern,” which is the
position advanced by R. B. Ekelund, Jr., and Doug Walker, “J. S. Mill on the Income Tax
Exemption and Inheritance Taxes: The Evidence Reconsidered,” History of Political
Economy, vol. 28 (Winter 1996), pp. 559–581. The issues regarding inheritance that Mill
raised are still debated and unresolved. See, for example, John Cunliffe and Guido
Erreygers, (eds.), Inherited Wealth, Justice and Equality (New York: Routledge, 2012).
Notwithstanding the debate over the “newness” of Mill’s policy views, Pedro
Schwartz (The New Political Economy) has made a very good case for his conclusion that
the critiques of laissez-faire by Cairnes, Sidgwick, Marshall, and Pigou would have been
unthinkable without Mill’s earlier efforts. Schwartz concludes: “From Mill stemmed the
neoclassical (one might say, the Cambridge) tradition of critical evaluation of the work-
ing of the market” (p. 151). More than once Mill argued that interventions were neces-
sary in the case of natural monopoly. As an advocate of government ownership of
waterworks (production and distribution) and gas companies, Mill argued for municipal
purchase and administration of these companies where possible. As Schwartz has shown
with respect to Mill’s views on the regulation of the London water supply, however, Mill
was very concerned that a centralized board not be given power to consolidate water ser-
vices; see P. Schwartz, “John Stuart Mill and Laissez-Faire: London Water,” Economica,
vol. 23 (February 1966), pp. 71–83. In spite of his earlier advocacy of centralization in the
case of the Poor Laws administration, Mill (under the possible influence of de Toc-
queville) came to distrust centralized concentration of authority. Provision of telegraph
and railway services may have been an exception, however; see the appendix to R. B.
Ekelund, Jr., and E. O. Price, “Sir Edwin Chadwick on Competition and the Social Control
of Industry: Railroads,” History of Political Economy, vol. 11 (Summer 1979), pp. 213–239.
Although Chadwick was the quintessential economic policy maker of the nineteenth
century, relatively little has been written of his policy exploits by economists. Some nota-
ble exceptions are R. A. Lewis, “Edwin Chadwick and the Railway Labourers,” Economic
History Review, vol. 3 (1950), pp. 107–118; and R. F. Hébert, “Edwin Chadwick and the
Economics of Crime,” Economic Inquiry, vol. 16 (October 1977), pp. 539–550. Some of
Chadwick’s policy views were presented by E. O. Price, “Contributions of Sir Edwin
Chadwick to Economic Policy,” unpublished PhD dissertation (College Station: Texas A
& M University, 1979). Chadwick’s policy and theoretical arguments have now been col-
lected and extended by Robert B. Ekelund, Jr. and Edward O. Price, III, The Economics of
Edwin Chadwick: Incentives Matter (Cheltenham: Edward Elgar, 2012).
Two recent papers address particular gaps in our knowledge of the extent of Chad-
wick’s utilitarian approach to economic policy. For a survey of the breadth of Chadwick’s
approach see A. W. Dues, “The Scope of Chadwick’s Bidding Scheme,” Journal of Institu-
tional and Theoretical Economics, vol. 150 (September 1994), pp. 524–536. See also, R.
B. Ekelund, Jr., and G. S. Ford, “Nineteenth Century Urban Market Failure? Chadwick on
Funeral Industry Regulation,” Journal of Regulatory Economics, vol. 12 (July 1997), pp.
27–52, which underscores Chadwick’s enduring ability to combine rhetoric and eco-
nomic argument in support of a regulatory apparatus aimed at controlling funeral ser-
vices and cemetery plots.
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Chapter 10 ■ J. S. Mill and Edwin Chadwick on Taxation and Public Economies 255

After a long hiatus, the Bentham–Chadwick plan of contract management has been
recast as the “Chicago Theory of Regulation.” Harold Demsetz, “Why Regulate Utili-
ties?” Journal of Law & Economics, vol. 11 (October 1968), pp. 55–65, explicated a prin-
ciple of competition whose origin he attributed to Edwin Chadwick; but see W. M. Crain
and R. B. Ekelund, Jr., “Chadwick and Demsetz on Competition and Regulation,” Journal
of Law & Economics, vol. 19 (April 1976), pp. 149–162. It is important to note that practi-
cal implementation of the “Chadwick plan” may engender many problems not antici-
pated by Chadwick or his modern defenders. Critics argue that the design and
implementation of optimal contracts may present as many or more difficulties than those
found in more traditional forms of regulation. The problems of contract management
vary with the technical and competitive characteristics of the industry and must be
developed in the context of a case study. For an interesting example of the latter, see O.
E. Williamson, “Franchise Bidding for Natural Monopolies—In General and with Respect
to CATV,” Bell Journal of Economics, vol. 7 (Spring 1976), pp. 73–104.
Despite possible impediments and misgivings, the “Chadwick plan” of franchise bid-
ding for the exclusive right to service is alive and well. Strong and vigorous support for
such plans has emerged in Europe, Asia, and the United States. With respect to water-
works in particular, see Steven H. Hanke and J. K. Walters, “Privatizing Waterworks:
Learning from the French Experience,” Journal of Applied Corporate Finance, vol. 23
(2011), pp 30–35. More generally see Steve H. Hanke (ed.), Prospects for Privatization.
New York: The Academy of Political Science, 1987.
An appreciation of Chadwick’s incredible foresight and creativity in the policy anal-
ysis of economic problems can be gleaned from the comparison of his views on crime
with the “latest word” by economists on the subject. See Hébert, “Chadwick and the Eco-
nomics of Crime”; G. S. Becker, “Crime and Punishment: An Economic Approach,” Jour-
nal of Political Economy, vol. 76 (March/April 1968), pp. 169–217; G. S. Becker and G. J.
Stigler, “Law Enforcement, Malfeasance, and Compensation of Enforcers,” Journal of
Legal Studies, vol. 3 (January 1974), pp. 1–18; and G. J. Stigler, “The Optimum Enforce-
ment of Laws,” Journal of Political Economy, vol. 78 (May/June 1970), pp. 526–536.
On the common-pool problem and how Chadwick’s recognition of it fit into his
reform scheme, see Bruce Benson, “Are Public Goods Really Common Pools? Consider-
ations of the Evolution of Policing and Highways in England,” Economic Inquiry, vol. 32
(April 1994), pp. 249–271; and R. B. Ekelund, Jr., and Cheryl Dorton, “Criminal Justice
Institutions as a Common Pool: The 19th Century Analysis of Edwin Chadwick,” Journal
of Economic Behavior and Organization, vol. 50 (March 2002), pp. 1–24. In some areas of
thought Chadwick was neither unknown nor elusive. So linked was he in the public
mind with sanitation reform that he became known to his contemporaries as “Drains”
Chadwick. For a discussion of his sanitation reforms from the standpoint of engineering
and public health, see Maurice Marston, Sir Edwin Chadwick, 1800-1890 (Boston: Small,
Maynard and Company, 1925); Anthony Brundage, England’s “Prussian Minister”:
Edwin Chadwick and the Politics of Government Growth, 1832–1854 (University Park,
PA: Pennsylvania State University Press, 1988). Christopher Hamlin, Public Health and
Social Justice in the Age of Chadwick, Britain: 1800–1854 (Cambridge: Cambridge Uni-
versity Press, 1998), provides an engaging and stimulating perspective on the politics
surrounding Chadwick’s public sanitation campaign and the rise of science as an appar-
ent neutral authority in policy making. Hamlin carefully retells the story of the founda-
tions of public health in Industrial Revolution Britain not as the triumph of responsible
government over urban filth but as a politically savvy choice to undermine the potential
of public medicine to provide a basis for radical criticism of laissez-faire capitalism.
Although cloaked in controversy, Chadwick’s role in the development of public
health in the United Kingdom is prodigious. The one hundredth anniversary of his death
(1990) and the one hundred and fiftieth anniversary of the first Public Health Act (1998)
was an occasion for serious and deserved plaudits for him in the U.S. and abroad.
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11

Nineteenth-Century
Heterodox Economic Thought

In previous chapters we saw how classical economics was previewed by Richard

Cantillon and the Physiocrats, formed by Adam Smith, and reshaped by Bentham,
Malthus, Ricardo, Say, Senior, and J. S. Mill, among others. By the middle of the
nineteenth century “political economy” was a reasonably unified, coherent body of
analysis that represented a fledgling science. As part of its maturation process, clas-
sical economics became an orthodox discipline. But from the very beginning it was
subject to many attacks. This chapter surveys some of the dissident voices raised
against classical economic orthodoxy. Even though strident and diverse in nature,
criticism did not defeat or replace classical political economy and its central doc-
trines of economic development and income distribution. Nevertheless, the writers
surveyed in this chapter had an impact on the formation of economic thinking.
Indeed, the tradition of heterodox thought within the corpus of economic theory
and analysis continues to this very day.
Between the major accomplishments of Smith (1776) and Mill (1848) momen-
tous events of social, economic, and political significance transpired on both sides
of the Atlantic. In North America, the Declaration of Independence signaled the
birth of a new nation in the same year that Smith published The Wealth of Nations.
Peopled mainly by European emigrés, the new nation faced many problems in its
initial drive toward decolonization and economic self-sufficiency. But the United
States of America was rich in territory and natural resources, requiring only a
steady stream of people, which turmoil in other parts of the world promoted. In
Europe, the French Revolution led to social and economic reorganization, as the
ancien régime melted away. Great Britain oversaw the incubation of industrialism
and the rise of the factory system—what historians refer to as the Industrial Revolu-
tion. These transformations posed different challenges to different nations and pro-
voked different criticisms by different writers.
In England an early protest against the dire predictions of Ricardo was raised
by Thomas Hodgskin and William Thompson, leaders of a group that came to be
known as “Ricardian Socialists.” This group offered an antidote to classical eco-
nomics, which was able to withstand the assault of the dissenters by virtue of the
theoretical elegance of the Ricardian system. In France, the early promise of the
French Revolution was severely tested by the Reign of Terror that followed. Those
who heralded the passing of the old regime as the triumph of reason over privilege

256
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Chapter 11 ■ Nineteenth-Century Heterodox Economic Thought 257

saw their hopes dashed by the aftermath of the revolution. And in Germany, a coun-
try splintered by numerous political and economic boundaries, philosophical forces,
quite distinct from the British or French variants, were at work. For its part, the
United States of America, though flush with the reality of its recent independence,
remained a net importer of ideas.
Global social and intellectual ferment was fanned by several philosophic winds.
On the one hand British industrialism was propelled by a high degree of pragma-
tism, which led to practical augmentations of productive capacity. On the other,
Continental society was entrenched in Cartesian rationalism, which rejected mate-
rial things in the search for inner truth. In contrast to their British counterparts
European philosophers placed more emphasis on group than individual activity.
Rousseau, for example, though aware that property rights are conducive to individ-
ual and social progress, argued that there are desirable social uses of property. And
Hegel viewed freedom, not in the Lockian sense as a relation between individual
and group, but in terms of associations with others, such as family, church, and
state. The major attacks on classical economics came from Continental writers,
though not exclusively.

■ ROMANTICISM
Romanticism arose to smite classic rationalism. Its themes were exalted fan-
tasy, unrepressed passion, and depth of feeling. It found adherents throughout
Europe, and in England it was targeted mainly against utilitarianism. Occasionally
cloaked in individualistic guise, Romanticism mainly fostered a collectivist outlook.
As the favorite form of collectivism, socialism arose initially from a combination of
three factors: the pre-Romantic conception of the bourgeoisie and its class struggle
against privileged groups, the supposition of common ownership of land and tools
in primitive society, and Rousseau’s idea of the equality of men.
With the exception of Rousseau, all the great philosophers of the French
Enlightenment viewed history as a steady progression of humans toward reason
and truth. In the economic arena, this view seemed to be affirmed by the rapid
expansion of production and productive capacity in the first half of the nineteenth
century. But many people considered economic development uneven. The working
class generally received low wages, worked long hours, and toiled under adverse
factory conditions. This led throughout the nineteenth century to “unorthodox”
attempts (i.e., opposed to the efforts of Mill and Chadwick) by champions of the
working class to “socialize” economics. These attempts ranged from the paternal-
ism of Robert Owen (1771–1858), a wealthy British industrialist, to the fantasies of
Charles Fourier (1772–1837), a French visionary who advocated free love and com-
munal living. Some of these socialist schemes were not easily distinguishable from
capitalism—such as Saint-Simon’s (1760–1825) program of industrial administra-
tion—whereas others, such as P. J. Proudhon’s (1809–1865) proposed reforms, bor-
dered on anarchy. All of these early plans for social and economic reorganization,
however, had one thing in common—they relied on a voluntary appeal to human
nature. In this sense, they were all products of the Enlightenment. And in this sense
also, they were to Karl Marx, all “utopian.”
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258 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

The Force of Ideas: Romantic Critiques of Classical Political Economy

The system promulgated by Adam Smith and his followers that championed markets, eco-
nomic growth, and the progress spawned by the Industrial Revolution was attacked passion-
ately by critics and naysayers in the nineteenth century. A leading source of criticism came
from the so-called “Romantics.” The Romantic Movement, so beautifully expressed in litera-
ture by the likes of Byron, Keats, Coleridge, and Shelley, emphasized the power of nature to
transform humanity, which was itself part and parcel of nature.
Essayists picked up these ideas. Perplexed by the complexity of the industrial age, Henry
David Thoreau (who was both anticapitalist and antigovernment), advised: “We may believe it,
but never do we live a quiet, free life . . . but are enveloped in an invisible network of specula-
tions. Our progress is only from one such speculation to another, and only at rare intervals do
we perceive that it is no progress” (Writings, p. 61). To Thoreau and others, the practical effects
of the Industrial Revolution were unpleasant: increased urbanization and overcrowding; more
poverty, filth, disease; and lack of public services. But rather than emulate John Stuart Mill’s
focus on trying to establish the ex ante conditions for equality of opportunity (or what we now
call “access”), the Romantics mounted an ex post attack on the progenitors of wealth and
“injustice.” They regarded the wicked capitalists and greedy bankers as enemies of the poor.
One of the Romantics, John Ruskin, reacted to political economy on two fronts: (1) he
changed the focal point from production to consumption; and (2) he made the science nor-
mative instead of descriptive. Ruskin the moralist opposed Mill the theorist. He claimed that
his principles of political economy were summed up thusly: “Government and co-operation
are in all things and eternally the laws of life; anarchy and competition eternally and in all
things, the laws of death” (“Modern Painters,” p. 207). Some of the Romantics did not believe
any sort of ultimate equality was possible. They often equated white “wage slavery” with
Negro slavery*
The Romantics closed their eyes and minds to the prospect that capitalism in a democratic
society could and would supply antidotes to the problems they identified. Charles Dickens, a
great novelist but a poor social scientist, refused to acknowledge that a market system could
provide means to lift people out of poverty. Moreover, he failed to compare the plight of the
rural poor of the past with the urban poor of his day. Opportunities still exist for “rags to
riches” experiences to unfold within capitalist societies. Moreover, Thoreau’s choice to
“become one with nature” is a choice that is routinely made even under conditions of modern
capitalism. (The westward movement of many U.S. citizens in the nineteenth century can be
explained in part by the “lure of nature”).
Foundationally the Romantics emphasized the costs of progress while ignoring or mini-
mizing its benefits. In the main, change is always unsettling because it imposes costs on some
and benefits on others. Those who endure new costs will protest and attempt to maintain the
status quo—through government (or even violence) if possible. The real questions are nettle-
some: What is the alternative to change? Should we obstruct scientific and technological
progress in an attempt to lower “social costs”? Are comparisons meaningful between earlier
medieval forms of rural poverty and the conditions faced by lower classes in an expanding
urban and industrial environment? In the end, it would appear that the “Romantics” failed to
understand the possibilities of how advancing economies would deal with social and eco-
nomic problems, especially under democratic forms of government.
*Recent research contends that those who tagged economics as “the dismal science” were themselves
racist. Ruskin believed in the “impossibility of equality” and Dickens (in his seldom- read classic Hard
Times) argued that slavery was a tool to increase blacks’ intellectual development and make them fit for
freedom. By contrast, virtually all economists of the time were egalitarians in this regard. So, it is an open
question whose philosophy was more “dismal” (see the provocative book by David M. Levy, How the Dis-
mal Science Got its Name).
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Chapter 11 ■ Nineteenth-Century Heterodox Economic Thought 259

■ EUROPEAN EVOLUTIONARY THOUGHT

The idea that society evolves through a succession of stages, each more
advanced than the former, is a historical strand of thought woven through much
Western philosophy. This evolutionary idea was evident in Smith’s vision of a natu-
ral, societal progression through three stages: agricultural, industrial, and finally,
“trading” (commercial). Whereas Smith used the stadial theory to establish the ben-
efits of atomistic markets, socialists used it to justify collectivism.
The idea of progressive “stages” of historical and economic development was
the centerpiece of several socialist doctrines. Here we explore the ideas of Nicolas
de Condorcet (French), Henri Saint-Simon (French), J. C. L. Simonde de Sismondi
(Swiss), and Friedrich List (German). Taken together, these writings provide a
cross-sectional illustration of the historical, evolutionary approach to economics.

Condorcet and the Laws of History

One of the earliest proponents of the evolutionary approach in Europe was the
French philosopher Condorcet (1743–1794), who believed that historical develop-
ment is subject to general laws and that the task of the historian is to discover these
laws by which humans progress “toward truth and well-being.” Condorcet called for
a new science, based on history, that would “predict the progress of the human spe-
cies . . . direct it and . . . accelerate it” (Esquisses, p. 4). The French Revolution,
motivated by the rationalist philosophy of the Enlightenment, demonstrated in its
bloody aftermath that social perfection was not the result of reason alone, as had
been optimistically assumed. Thus, Condorcet regarded the revolution as part of the
errors of the past, a mere transitional stage on the road to ultimate social perfection.
His new science of history relied on empiricism in place of rationalism. “Observa-
tions on what man has been and what he is today,” wrote Condorcet, “lead immedi-
ately to the ways of assuring and accelerating the further progress for which man’s
nature permits him to hope” (Esquisses, p. 4).
Condorcet understood that the development of social progress is more uneven
than the perfection of human knowledge. He attributed the lag in social develop-
ment to the fact that history, until his day, had always been the history of individuals
rather than the history of the masses. As a result, the needs and well-being of soci-
ety had been sacrificed to those of a few people. He sought to rectify this by recast-
ing history as the study of the masses. Condorcet therefore originated two
important themes that in some measure underlie almost all nineteenth-century crit-
icism of capitalism: the idea of “natural” laws of historical development, and the
“collectivist” view of history as the study of the masses.

Saint-Simon: Pixilated Prophet of Industrialism

Claude Henri de Rouvroy, Comte de Saint-Simon (1760–1825), was a member
of the French nobility who renounced his title during the early stages of the French
Revolution but was nevertheless imprisoned as an enemy of the state during the
Reign of Terror. He somehow escaped execution and gained his freedom after the
fall of Robespierre in 1794. Like another famous Frenchmen—the Marquis de
Lafayette—he fought on the side of the colonists in the American Revolution. By vir-
tue of his contribution to the defeat of General Cornwallis at Yorktown, Saint-Simon
boasted: “I can thus consider myself as one of the founders of liberty in the United
States, because it was this military operation which determined the peace and
established irrevocably the independence of America” (Oeuvres, vol. 18, p. 140).
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260 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

Egotistical and possibly delusional, Saint-Simon nevertheless was a visionary in

many respects.1 He was a leading advocate of canals, proposing to the Viceroy of
Mexico in 1783 a canal to join the Atlantic and the Pacific, and another to connect
Madrid to the Atlantic in 1787. One of his disciples led the construction of the Suez
Canal in Egypt and attempted, but failed, to replicate that success in Panama. (The
Panama Canal was completed in 1913 by the United States after the French aban-
doned the project.) He inspired a number of followers, often described as techno-
crats, and he influenced a number of important philosophers, including Auguste
Comte, John Stuart Mill, and Karl Marx.
Saint-Simon’s utopian vision of society reflected the influence of the French
Enlightenment, which extolled reason. The refinement of reason, and its ability to
direct economic production, was, in his view, a product of the evolutionary progress
of history. According to Saint-Simon history moved through ascending stages of
development. The first stage, typified by prerevolutionary France, was based on mili-
tary force and the uncritical acceptance of religious faith. During this stage, the mon-
arch and the Church dominated the production and distribution of wealth. The
second stage, characterized by post-revolutionary France, was based on industrial
capacity and scientific knowledge. The third stage was based on science and indus-
try, which Saint-Simon extolled as the hallmarks of the modern age. He devoted his
efforts to social reorganization schemes that would remove impediments to the
development of both. In Saint-Simon’s bold new world, science became the hand-
maiden of industry—a means to provide better living conditions for all. Indeed, he
blurred the distinction between science and industry by talking more and more about
the science of industry, by which he meant directing science and technical expertise
toward ever-increasing amounts of production. The “production of useful things,” he
wrote, “is the only reasonable and positive end that political societies can set them-
selves” (Oeuvres, vol. 18, p. 13). According to Saint-Simon the old order must be
swept away in order for society to reach the highest level of economic progress:
The prosperity of France can only exist through the effects of the progress of the
sciences, fine arts and professions. The Princes, the great household officials, the
Bishops, Marshals of France, prefects and idle landowners contribute nothing
directly to the progress of the sciences, fine arts and professions. Far from contrib-
uting they only hinder, since they strive to prolong the supremacy existing to this
day of conjectural ideas over positive science. (Oeuvres, vol. 20, p. 24)

Saint-Simon proposed to reorganize government so that industrial administra-

tion replaced existing forms of social control. He opposed government in the tradi-
tional sense, in which a privileged few exercised power over the unprivileged many.
“Government always harms industry when it mixes in its affairs,” he wrote, “. . .
even in instances where it makes an effort to encourage it” (Oeuvres, vol. 18, p.
186). Saint-Simon wanted to replace traditional government (monarchy) with an
industrial parliament. Details were not lacking in Saint-Simon’s fertile imagination.
His industrial parliament, patterned in part after the British system, consisted of
three bodies. The first—the Chamber of Invention—would be made up of 300 mem-
bers: 200 civil engineers, 50 poets, 25 artists, 15 architects, and 10 musicians. Its pri-
mary duty would be to draw up a plan of public works that would be designed and

1
Saint-Simon claimed that his ancestor, Charlemagne, appeared to him while he was imprisoned
and gave him the task of saving the French Republic from the excesses of the revolution. Once
freed from prison, he claims to have instructed his servant to awaken him each day with the same
phrase: “Arise, Monsieur le Comte, you have great things to do today.”
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Chapter 11 ■ Nineteenth-Century Heterodox Economic Thought 261

undertaken to increase France’s wealth and improve the conditions of its inhabit-
ants. The second—the Chamber of Examination—would likewise be made up of 300
members, the majority consisting of mathematicians and physical scientists. Its job
would be to draw up a master plan for education and to evaluate the desirability and
feasibility of projects proposed by the first chamber. The third body—the Chamber
of Execution—would consist of an unspecified number of representatives of each
branch of industry. It would levy taxes and exercise veto power over all projects
proposed and approved by the first two chambers.
Saint-Simon’s goal was to displace the parasitic class by raising the productive
class. But he did not identify or explain the process by which this transformation
was to take place. He seemed unconcerned about how power would be transferred
from the ruling class to the ballot box. He ignored deep-seated antagonisms among
different social classes, insisting instead that as civilization advanced, different
interests would be drawn together into a common zeal for social and economic bet-
terment. He did not share Adam Smith’s trust in self-interest and limited govern-
ment to accomplish economic growth and development. In place of the invisible
hand he advocated the loose fist of mutual cooperation. At base, Saint-Simon’s new
society rested on cooperation. Naively, he trusted the advance of reason to enlighten
individuals to their true interest. It is this aspect of Saint-Simon’s system that pro-
voked Karl Marx to refer to his system and others like it as “utopian.”
Some later writers interpreted Saint-Simon’s industrial parliament as a blue-
print for a fully planned economy. However, in Saint-Simon’s new industrial society
central planning was confined to the production of public works—which does not
represent a radical departure from Adam Smith’s notion of limited government. As
we saw in chapter 5, Smith justified certain government functions; in particular,
those public institutions and those public works, which, although they may be in
the highest degree advantageous to a great society are, however, of such a nature,
that the profit could never repay the expense to any individual or small number of
individuals, and which it therefore cannot be expected that any individual or small
number of individuals should erect or maintain. (Wealth of Nations, p. 681)

There is, nevertheless, a major difference between Smith and Saint-Simon. Smith
envisioned a harmony of (class) interests springing from the natural order of a mar-
ket economy. Saint-Simon envisioned an identity of interests evolving from enlight-
enment and reason. His optimism was undeterred by the messy clash of individual
or class interests. He persisted in the belief that all people had a stake in the out-
come of the production process, hence all new forms of social organization “must
conform directly to the interests of the greatest majority of the population; they
must be considered as a general political consequence deduced from the divine
moral principle; all men must regard themselves as brothers; they must concern
themselves with helping one another” (Oeuvres, vol. 22, pp. 116–117). In the final
analysis, Saint-Simon put his trust in education, broadly speaking; whereas Smith
relied on human nature and the predictability of economic incentives. A cynic might
say that Saint-Simon called on people’s higher nature to guide economic develop-
ment, whereas Smith relied on people’s lower nature to produce the same result.
While unfolding his stadial view of history, Saint-Simon maintained that the
hallmark of the “modern age” is the displacement of religious thought by science
and reason. However, in the third, most advanced stage of history he argued that
religion reappears in a higher form, which he called “physicism.” Physicism rejects
deism, somehow unifies mind and matter, and treats all phenomena, mental as well
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262 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

as material, as explicable by scientific laws. In this manner Saint-Simon completed

the formulation of his “Law of Three Stages” (i.e., polytheism, theism, physicism)—
that his secretary, Auguste Comte, later claimed as his own. For Saint-Simon, as for
Comte, the stadial theory was a way of explaining how the sciences pass from the
conjectural to the positive.2 He accurately charted the future direction of capitalism
in many important respects. The concept “technocracy,” if not the term, traces back
to him. He anticipated the successive development of specialization and expertise—
backed by one scientific advance after another—and its transformative effect on
modern corporations. His ideas and influence are readily traceable in the works of
the twentieth-century economist John Kenneth Galbraith (see chapter 19).
In his later years, Saint-Simon’s writings wandered aimlessly into physics and
physiology,3 which induced his followers to espouse a kind of bizarre mysticism.
Some of his disciples became notorious for their socially “radical” views, and they
modified Saint-Simon’s doctrine almost beyond recognition. Nevertheless, their
perversion came to be known, however inappropriately, as Saint-Simonism.

Simonde de Sismondi Rejects Say’s Law

Born in Geneva as J. C. L. Simonde, this Swiss economist changed his surname to
Simonde de Sismondi (1773–1842) in 1800 after learning that he was descended from
a noble Italian family by that name. He is therefore known to history as Sismondi.
Though trained as a historian, Sismondi acquired practical experience in business and
finance in France while he was young. His first venture into economics, De la richesse
commerciale (1803) was intended as a systematic exposition of the ideas of Adam
Smith combined with an “absolutely new” way of looking at changes in aggregate out-
put. Applying arithmetic and algebra to the task, Sismondi represented output in any
given year as a function of investment in the previous year. He then showed how out-
put varied in a closed economy (without international trade) versus an open economy
(with international trade); and how an open economy produced different results when
it had an export surplus as compared to an import surplus. But the book drew little
notice, so it made no direct contribution to the development of economics. Sixteen
years later, Sismondi presented his own theory of aggregate equilibrium income in his
major economic work, Nouveaux principes d’économie politique (1819). This work
marks his entry into the controversy over Say’s Law and the theory of market gluts.
According to Sismondi, the utility of output must be balanced against the disu-
tility of work, an idea that W. S. Jevons later transformed into a microeconomic the-
ory of labor supply (see chapter 15). Sismondi argued that whenever the disutility of
labor exceeds the utility of output in a given period, output will subsequently
decline until balance is restored. When the discrepancy between utility of output
and disutility of labor is reversed, output in subsequent periods will increase until
balance is again restored. In a complex economy, however, different people make
balancing decisions in isolation from one another, so that aggregate balance is not
always assured. The germ of this theory can be found in physiocratic literature (see
chapter 4), but Sismondi transformed the idea into a theory of aggregate equilib-
rium, thus challenging the prevailing view (i.e., Say’s Law) that there could not be a
general glut in the aggregate economy.

2
Turgot (see chapter 4) sketched out, briefly, a three-stage theory of history before Smith (in 1750)
and Condorcet followed suit in 1795. But Saint-Simon was the first to adumbrate the version that
led to Comte’s “positive” program based on historical evolution.
3
He argued at length, for example, that the industrious beaver, not the idle monkey, is the highest
creature next to man.
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Chapter 11 ■ Nineteenth-Century Heterodox Economic Thought 263

Sismondi’s view was attacked immediately by the reigning British economic

orthodoxy, but the following year, another maverick, T. R. Malthus (see chapter 6)
entered the fray on his side. In his Principles of Political Economy (1820), Malthus
expressed ideas he had long defended in correspondence with Ricardo; so Marx’s
portrayal of Malthus’s book as simply the “English translation” of Sismondi is not
fair. The debate over Say’s Law raged on for a decade or more, and was resurrected
in the twentieth century after a period of dormancy. More recent debates on Say’s
Law revolve around macroeconomic monetary controversies, however, which were
not Sismondi’s concern. British classical economists of the nineteenth century acted
as if Sismondi and Malthus were arguing about secular stagnation rather than tem-
porary disequilibrium, and the distinction between short-run and long-run effects
became blurred until revisited by Keynes in the 1930s. Along with Malthus, Sis-
mondi may rightfully be considered a precursor of Keynes (see chapter 21). He may
also be considered a precursor of Marx (see chapter 12), who appropriated (without
acknowledgement) Sismondi’s emphases on “proletarians,” increasing concentra-
tion of capital, recurring business cycles, technological unemployment, and eco-
nomic dynamics in general.
The Flaws of Capitalism. Like other children of the Enlightenment, Sismondi
was affected by the dramatic social and economic shifts brought about by the
French Revolution. To his way of thinking, the new era aroused conflicts of interest
between capital and labor, thus displacing the economic cooperation of the guild
system with a new, less stable industrial regime. Improvements in living conditions
lagged seriously behind the increases in wealth ushered in by the machine age.
Rather than serve to increase social welfare Sismondi believed that unrestrained
competition produced universal rivalry, large-scale production, and oversupply.
Overproduction, in turn, precipitated commercial crises and economic depression.
Some fifty or so years before Marx, Sismondi anticipated the class struggle
between labor and capital that Marx emphasized in Das Kapital. Whereas Saint-
Simon believed that economic cooperation and organization were the inevitable
outcomes of economic progress, Sismondi blamed the class struggle on the very
institutions of capitalism. But unlike Marx, he did not regard the class struggle as a
permanent feature of the new economy. Inasmuch as the class struggle was a conse-
quence of existing institutions, he believed it could be eliminated by appropriate
institutional amendments. What escaped Sismondi, however, was the realization of
precisely which factors constitute the driving force of historical change.
One of Sismondi’s most telling attacks on classical economics concerned
machinery. On balance, classical economics viewed the introduction of machinery as
beneficial because it lowers average costs of production and product prices, and thus
increases consumer welfare. Sismondi felt that the benefits of machinery were more
than offset by the technological unemployment that followed its introduction on a
large scale. It is self-evident that the introduction of labor-saving machinery displaces
workers. Sismondi argued that each worker so displaced finds his or her income
drastically reduced even as output is increased by the same machinery that displaced
him or her. He therefore argued that overproduction and economic crisis inevitably
follow the widespread introduction of machinery. Moreover, because machinery is
expensive, only the largest firms can afford it; hence the accumulation of machinery
in large firms gives them a decided advantage over small firms and tends to drive
many small manufacturers out of business, causing unemployment on a second
front. The adverse effects foretold by Sismondi are not inevitable, however. The use
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264 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

of machinery has the capacity to increase the demand for labor as well as decrease it.
Sismondi was either unwilling or unable to see that the growth of output brought
about by machinery sometimes creates additional employment opportunities.
Machinery evoked many violent emotions among workers in the nineteenth cen-
tury. The infamous Luddite Revolts—in which workers attacked and destroyed the
“evil” machines that stole their jobs—shows just how passionate, and wrongheaded,
reactions could be.4 In this regard it is important to note that Sismondi’s criticism
was not aimed at machinery per se but at the social organization that subjected work-
ers to the vagaries of competition. His summary statement on this matter is explicit:
Every invention in the arts, which has multiplied the power of man’s work, from
that of the plough to the steam engine, is useful. . . . Society had made progress
only through such discoveries; it is through them that the work of man has sufficed
for his needs. . . . It is not the fault of the progress of mechanical science, but the
fault of the social order, if the worker, who acquires the power to make in two
hours what would take him twelve to make before, does not find himself richer,
and consequently does not enjoy more leisure, but on the contrary is doing six
times more work than is demanded. (Nouveaux principes, p. 349)

Theory and Method. Sismondi’s complaint against classical economics was

based less on theoretical principles than on its method, aims, and conclusions.
Unlike Nassau Senior (see chapter 7) who strove to make economics more scientific
by removing normative elements from it, Sismondi treated economics as a subset of
the science of government. Whereas Saint-Simon wanted to replace government
with industrial administration, Sismondi held that government and economics are
inseparable. He considered economics a moral science:5 “The physical well-being of
man,” he declared, “insofar as it can be the work of his government, is the object of
political economy” (Nouveaux principes, p. 8). A science that concerns itself solely
with the means of increasing wealth without studying the purpose of such wealth
was, in Sismondi’s view, a false science.
In a subtle attack on the theory of self-interest, Sismondi pointed out that in the
struggle to achieve personal gain, not every individual force is equal. Hence, “Injus-
tice can often triumph . . . being backed by public force which is believed to be
impartial, but which, in fact, without examining the cause, always places itself on
the side of the stronger” (Nouveaux principes, p. 408). In a phrase, exercise of indi-
vidual self-interest does not always coincide with the general interest.
It is to the interest of one to rob his neighbor, and it is to the interest of the latter to
let him do it, if he has a weapon in his hand, in order not to be killed; but it is not to
the interest of society that one should use force and the other should give in. The
entire social organization presents to us at every step a similar compulsion, not
always with the same sort of violence, but always with the same danger of resis-
tance. (Nouveaux principes, p. 200)

Sismondi especially rejected the abstract, deductive method of Ricardo and his fol-
lowers, preferring instead the comparative, historical method. In his telling descrip-
tion of economics he indicts classical political economy and defends his own method:
4
The Luddites—who took their name from (mythical?) leader, Ned Lud—were armed rebels who
clandestinely attacked textile mills in England and destroyed textile machinery during 1811–1812.
While the motivation for these attacks was complex and multifaceted, historians agree that a
major source of discontent was unemployment caused by machines displacing labor.
5
Many nineteenth-century writers, from Bentham onward, did not see a contradiction in fusing the
terms “moral” and “science.” This was especially true in France.
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Chapter 11 ■ Nineteenth-Century Heterodox Economic Thought 265

[Economics] is not founded on dry calculations, nor on a mathematical chain of

theorems, deduced from some obscure axioms, given as incontestable truth. . . .
Political economy is founded on the study of man and men; human nature must be
known, and also the condition and life of societies in different times and in differ-
ent places. One must consult the historian, and the travelers; one must look into
one’s self; not only study the laws, but also know how they are executed; not only
examine the tables of exportation and importation, but also know the aspect of the
country, enter the bosom of families, judge the comfort or suffering of the masses
of the people, verify great principles by observation of details, and compare cease-
lessly science with daily practical life. (De la richesse commerciale, I, p. xv)

Sensing the complexity of the industrial era, Sismondi felt that the abstract the-
ories propounded by the classical economists were inadequate for the modern age.
He blamed the reigning orthodoxy for drawing too many loose observations that
applied only to England, and for misleading people by declaring principles univer-
sal when they are, in fact, rooted in weak foundations. Sismondi also protested the
tendency of the abstract theorists to reduce habits and customs to mere calcula-
tions; and he criticized “those who wished to see man isolated from the world, or
rather who considered abstractly the modifications of his existence, and always
arrived at conclusions that are belied by experience” (Études, p. 4).
Sismondi the historian was interested in those periods of transition that charac-
terize the passing of one regime and the beginning of another. In practice he was
concerned with ameliorating the condition of the proletariat (a term Marx borrowed
from him) during this transition. He was particularly influential in France where he
originated the line of inquiry that the French call économie sociale (social econ-
omy). Sismondi influenced a number of writers who were not outright socialists but
who protested the evils of unrestrained laissez-faire. Along with him, these writers
sought some happy halfway house between capitalism and socialism that would
retain the principle of individual liberty as much as possible. In retrospect his criti-
cism of the classical school may have been justified by historical experience, but his
theoretical reasoning was marred by a logical flaw. Marx revived his theory of eco-
nomic crises and his concern for the working class, but in his theory of overproduc-
tion, which posited that useful production must always be preceded by increased
demand, Sismondi did not admit the possibility that increased production could
itself create additional demand.

List and National Political Economy

History, coupled with nationalism, also rallied a distinct group of German econ-
omists in the nineteenth century. The peace treaty that ended Germany’s participa-
tion in the Napoleonic Wars left the country divided into thirty-nine different states,
most of which were individual monarchies acting more or less independently. A
complex system of interstate tariffs that impaired the free and easy exchange of
goods internally produced economic isolation and retarded economic development.
Yet, the German states imposed no import duties on foreign goods, thus inviting
British surplus products and those of other countries to enter German markets
where they were sold at extremely low prices. These circumstances threatened the
very existence of German manufacturing and commercial interests so badly that by
the 1830s a general clamor arose for economic unity and uniform tariffs.
Unification of the German states was the goal of many German nationals. One
of the earliest advocates of nationalism was Friedrich List (1789–1846), the son of a
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266 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

German leatherworker who gave up an academic career to become active in Ger-

man politics. In 1819 he became the leader of the General Association of German
Manufacturers and Merchants, a group seeking to confederate the disunited Ger-
man states. He subsequently became the face of the movement to develop a system
of national economy and was the forerunner of a peculiar Germanic strain of eco-
nomic thought that eventually formed the German Historical School (see below).
List strenuously objected to those aspects of classical economics that stressed
absolutism and universalism. He rejected the idea that classical economic principles
hold for all time and for all countries. Principles that might apply to England were
not relevant to Germany, which stood at another level of development and faced dif-
ferent economic problems. In the final analysis, List subordinated economics to pol-
itics, but he bequeathed to Marx the view that industry is more than the mere
combination of labor and capital—it is primarily a social force that itself creates and
improves capital and labor. Industry not only shapes present production, but gives
direction and form to future production. In other words, there is a dynamic about it
that was missing from classical economics.
Protectionism and Economic Development. List applied a method of inquiry
originated by Saint-Simon: the idea that an economy must pass through successive
stages before it reaches maturity. The historical stages of development identified by
List were: (1) barbaric, (2) pastoral, (3) agricultural, (4) agricultural-manufacturing,
and (5) agricultural-manufacturing-commercial. Like Saint-Simon and Sismondi,
List focused more on the transition between stages of economic development than
on the end result. He argued that free trade would speed passage through the first
three stages of development but that protection was required to facilitate transition
between the last two. Once the final stage was reached, free trade is warranted once
again. The system of protection that List advocated was designed to be temporary
and remedial, because not every nation advances at the same pace. He gave elo-
quent expression, for example, to the argument for protection of “infant industries”:
In nations . . . which possess all the necessary mental and material conditions and
means for establishing a manufacturing power of their own, and of thereby attain-
ing the highest degree of civilization, and development of material prosperity and
political power, but which are retarded in their progress by the competition of a
foreign manufacturing Power which is already farther advanced than their own—
only in such nations are commercial restrictions justifiable for the purpose of
establishing and protecting their own manufacturing power; and even in them it is
justifiable only until that manufacturing power is strong enough no longer to have
any reason to fear foreign competition, and thenceforth only so far as may be nec-
essary for protecting the inland manufacturing power in its very roots. (National
System, p. 144)

By List’s reckoning Great Britain was the only country to have attained the final
stage of economic development. While the Continental and American nations strug-
gled to reach this level, cheap British imports were thwarting the development of
domestic manufacturing. According to List international competition could not exist
on an equal footing until all nations reached the final stage of development. Hence
he advocated protective tariffs for Germany until it could reach its final stage. It is
important to note that List was not an outright protectionist. He felt that protection
was warranted only at critical stages of history. His writings are replete with exam-
ples borrowed from history and experience showing that economic protection is the
only way for an emerging nation to establish itself. He pointed to America’s experi-
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Chapter 11 ■ Nineteenth-Century Heterodox Economic Thought 267

ence as vindication of his views. Not surprisingly he found ready support among
U.S. protectionists, particularly Alexander Hamilton and Henry Carey.
The Flaws of Classical Economics. List rejected the absolutism and cosmo-
politanism of classical political economy. Against the classical view he argued that
economic principles do not hold for all nations at all times. His own method was
historical and nationalistic. His stadial theory of economic development, for exam-
ple, was calculated to demonstrate the inability of classical economics to recognize
and reflect the variety of conditions existing in different countries, and most espe-
cially, in Germany.
Like Sismondi, List subordinated economics to politics in general. He main-
tained that it was not enough for the statesman to know that the free interchange of
products will increase wealth (as demonstrated by the classical economists); he
must also know the ramifications of such action for his own country. Consequently
he held that free trade is undesirable if it harms domestic workers or industries.
Moreover, he was not willing to sacrifice the future for the present. He argued that
the crucial economic magnitude in economic development is not wealth—as mea-
sured by exchange value—but productive power. “The power of producing wealth,”
he said, “is infinitely more important than the wealth itself” (National System, p.
108). Therefore economic resources must be safeguarded in order to assure their
future existence and development. This view was used by List to further justify his
protectionist arguments. It also lies at the root of the popular “infant-industry” argu-
ment in support of protective tariffs.
List’s originality in economic theory and method consisted in his systematic use
of historical comparison as a means of demonstrating the validity of economic prop-
ositions, and in his persistent emphasis on the social character of economic activity.
In this respect he not only influenced Karl Marx but provided a methodological ral-
lying point for the economists of the German Historical School.

■ THE UTOPIAN SOCIALISTS

Although socialism remains an active force in many areas of the globe, the con-
cept itself is very vague. The word socialism conjures up a number of meanings:
public ownership of economic enterprise, subjugation of individual freedom to col-
lective interests, elimination of private property, redistribution of wealth from rich
to poor, centralized direction of economic activity, and so on. In practice, socialism
is rarely the clear-cut alternative to capitalism it is reputed to be. Every capitalist
economy today possesses some socialist elements and vice versa. Moreover, many
past writers who are deemed socialist today can be distinguished from one another
by significant philosophical and/or methodological differences. Nevertheless, there
is sufficient common ground among nineteenth-century writers to group them out-
side the orbit of the classical economists. This is particularly true of that coterie of
writers that Marx called “utopian socialists.”6
The utopian socialists regarded capitalism as irrational, inhumane, and unjust.
They repudiated the idea of laissez-faire and the doctrine of the harmony of inter-
ests. They believed in the perfectibility of humans and society through the proper
construction of the social environment. And they all developed reform schemes that

6
Marx used this phrase to distinguish his brand of socialism from other theories not based on dia-
lectical materialism. It is debatable whether Marx’s own theory was significantly less utopian than
the theories he disdained; nevertheless, the phrase is useful in a categorical sense.
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268 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

appealed to voluntary action rather than inexorable historical “laws.” In this section
we will examine the ideas of Robert Owen (Welsh), Charles Fourier (French), and
Pierre Joseph Proudhon (French).

Owen’s Grand Experiment

Born in obscurity to Welsh parents, Robert Owen (1771–1858) worked his way
up the ladder of success in the textile industry to achieve fame and fortune by his
thirtieth year. Owen was especially alert to the changes in economic and social life
brought about by the introduction of machinery. The mechanical marvels of Ark-
wright (spinning frame), Crompton (spinning mule), and Hargreaves (spinning
jenny) transformed the textile business in England and helped make Owen a
wealthy man, but their impact on the working class was not so apparently benefi-
cial. Owen repudiated the popular social view that poverty is the just consequence
of the sins of the working class. In A New View of Society (1813) he turned tradi-
tional social theory upside down by asserting that an individual’s character is
formed for him, not by him. In other words, rather than accept the conventional wis-
dom that the wretched are poor because they are wretched, Owen argued that the
poor are wretched because they are poor! Improve a man’s social environment, he
argued, and you improve the man. This single precept lay at the center of his social
philosophy. He embellished it by stating his “true principles” which he set forth in
his “Report to the County of Lanark” in 1821 (in Morton, pp. 58–59):
1. Character is universally formed for and not by the individual.
2. Any habits and sentiments may be given to mankind.
3. The affections are not under the control of the individual.
4. Every individual may be trained to produce far more than he can consume,
while there is sufficiency of soil left for him to cultivate.
5. Nature has provided means by which population may be at all times maintained
in the proper state to give the greatest happiness to every individual, without
one check of vice or misery.
6. Any community may be arranged, on a due combination of the foregoing princi-
ples, in such a manner as not only to withdraw vice, poverty, and, in a great
degree, misery from the world, but also to place every individual under such cir-
cumstances in which he shall enjoy more permanent happiness than can be given
to any individual under the principles which have heretofore regulated society.
7. That all the assumed fundamental principles on which society has hitherto been
founded are erroneous, and may be demonstrated to be contrary to fact.
8. That the change which would follow the abandonment of these erroneous max-
ims which bring misery to the world, and the adoption of principles of truth,
unfolding a system which shall remove and forever exclude that misery, may be
effected without the slightest injury to any human being.

Shortly after his marriage to the owner’s daughter in 1800, Owen began to
manage New Lanark Mills in Scotland, which served as a proving ground for his
social theories. The workforce at New Lanark was an intemperate and immoral
bunch, given to frequent bouts of drunkenness and debauchery. It was a tough task
for a young, new manager, but Owen approached his job with reformist zeal. He set
out to prove his theory that a worker’s character is determined by his social envi-
ronment. He wished to test the premise that a contented workforce was a more effi-
cient workforce. At New Lanark he restricted the labor of children and devoted
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Chapter 11 ■ Nineteenth-Century Heterodox Economic Thought 269

much time and money to their education. He improved housing conditions for the
workers and their families, raised wages, shortened work hours, and made other
provisions to enrich the lives of the community’s inhabitants.
To the amazement of his skeptical fellow industrialists, the mills that Owen
managed continued to earn substantial profits after his reforms were introduced.
Nevertheless, his success was short-lived. He was eventually forced out of New
Lanark by business partners who resented his program. This bitter experience con-
vinced him that private initiative could not be relied on to bring about lasting social
and economic reform. He therefore advocated a larger role for government. He
sought laws promoting factory reforms, aid to the unemployed, and, eventually, a
national system of education. He lived to see a second social experiment launched
at New Harmony, Indiana, but it failed within three years of its establishment.
Although many of the reforms he championed are now commonplace in industrial
societies, Owen did not live to see his suggested reforms legislated into action.

Fourier’s Shattered Dream

In his saner moments Charles Fourier (1772–1837) was more than a little eccen-
tric; in his wilder moments he was probably more than a bit insane. In between
these poles, he displayed a mastery of the smallest detail and an uncanny power of
prediction. Like Saint-Simon and List, he believed that civilization passes through
certain stages of development. However, his vision of the world was so fanciful
almost no one took him seriously. He asserted that nineteenth-century France was
in its fifth stage of advance, having passed already through (1) confusion, (2) sav-
agery, (3) patriarchalism, and (4) barbarity. He predicted that after passing through
two more stages, society would approach the upward slope of harmony—the final
stage of utter bliss—which would endure for eight thousand years. Then, history
would reverse itself and descend back through each stage to the beginning.
In apocalyptic fashion Fourier detailed the earthly changes that would accom-
pany the final stage of harmony: six new moons would replace the one in existence;
a halo, showering gentle dew, would circle the north pole; the seas would turn to
syrup (e.g., oceans of Coca-Cola?); and all violent and repulsive beasts of the earth
would be replaced with their opposites, which would be tame and serviceable to
humanity—anti-lions, anti-whales, anti-bears, anti-bugs, and anti-rats, for example.
To top it all off, the life span of humans in the final stage of history would stretch to
144 years, of which 120 years would be devoted to the unrestrained pursuit of sex-
ual love.
It is tempting to dismiss all this as the pure frenzy of a madman—except for one
thing: Despite its fantastic nature Fourier devised a plan for reorganizing society that
captured the imagination of others who shared his distress over the evils of capital-
ism. His plan was a forerunner of the twentieth-century commune. He proposed mul-
tiple “garden cities” (phalanstères) modeled after a grand hotel, where ideally fifteen
hundred people would live in common. No restrictions would be placed on individual
liberty, nor would income be forcefully redistributed. Fourier did not believe in
income or wealth redistribution of the leveling kind; he maintained that poverty and
income inequality “are of divine ordination, and consequently must forever remain,
since everything that God has ordained is just as it ought to be” (Nouveau monde
industriel, 1848, in Gide and Rist, p. 256). He did not object to private property per se,
only to its abuse, as when income is earned without work. Residents of the pha-
lanstère would be able to purchase hotel-like accommodations suitable to their indi-
vidual tastes and pocketbooks. Individual property would not be confiscated but
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270 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

transformed into fully participating common-stock shares of the phalanstère. Coop-

eration would replace self-interest so that economic production would be undertaken
collectively. Fourier promised high returns to wealthy capitalists who invested in his
scheme but was ultimately disappointed. It is said that in his old age he stayed home
at appointed times each day to receive potential investors, but no one ever came.
Fourier regarded the conflict of individual interests as the main evil of capital-
ism. Hence, he designed the phalanstère to eliminate conflicts of interests by mak-
ing each member a cooperative owner as well as wage earner. Hence, each member
was to be given an active voice in the management of the phalanstère. As worker/
investor/owner, each resident would receive income from three sources: wages of
labor, interest of stock, and salary of management. Fourier posited the precise divi-
sion of profits: four-twelfths to capital, five-twelfths to labor, and three-twelfths to
management. Because he foresaw economies through communal living Fourier’s
phalanstère promised maximum comfort at minimal cost. Collectivity was the rule.
Even unpleasant household tasks were to be undertaken collectively, thereby elimi-
nating much individual drudgery. Fourier would assign such tasks to children, who,
perversely, but by their very nature, delight in getting themselves dirty. Adults
would restrict themselves to work they enjoyed, and Fourier mused that a kind of
friendly competition would emerge in the form of contests to see who could do his
or her job best. It is easy to see how Fourier’s plan could appeal to dreamers, espe-
cially after Owen’s more practical ideas bore little fruit. It is also easy, among the
more sober-minded, to dismiss Fourier out of hand. Fantasy notwithstanding, how-
ever, he was a pioneer of the cooperative movement.

Proudhon: “Scholastic Anarchist”

Pierre Joseph Proudhon (1809–1865) is usually considered a French socialist
even though he criticized socialism as vehemently as he did capitalism. It is more
appropriate to represent him as a libertarian in the extreme. The most distinguish-
ing features of his thought were a rejection of all authority and an almost medieval
concern for economic justice in exchange. Because these combined themes pervade
his work, we have tabbed him a scholastic anarchist.
Criticism of Authority. Proudhon railed against all forms of authority. In 1840
he published a sensational essay entitled “What is Property?” His answer—“property
is robbery!” His inflammatory pamphlet brought him notoriety not only for its radical
views, but also because he was charged with conspiracy by the French government.
Proudhon refused to back down. He stubbornly defended his position in this passage:
If I were asked the following question: What is slavery? and I should answer in one
word, It is murder, my meaning would be understood at once. No extended argu-
ment would be required to show that the power to take from a man his thought, his
will, his personality, is a power of life and death; and that to enslave a man is to kill
him. Why then to this other question: What is property? may I not likewise answer,
It is robbery, without the certainty of being misunderstood; the second proposition
being no other than a transformation of the first. (“What is Property,” in Manuel
and Manuel, p. 363)

In actuality what Proudhon renounced is not ownership of property per se but

the consequences of private property in a market economy. He was opposed to cer-
tain attributes of property, namely what he considered unearned income in the form
of rent, interest, or profit. In the next chapter we shall see a similar strain in Marx’s
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Chapter 11 ■ Nineteenth-Century Heterodox Economic Thought 271

thought. Like Saint-Simon, Proudhon felt strongly that everyone should work. Like
Marx (who also spent his life in abject poverty), he had little choice.
Proudhon complained that the French Revolution of 1789 had lost its direction.
Rather than focus on sweeping the political system away, the heirs to the revolution
merely sought to reform it. Aware that political powers always tended toward con-
centration and centralization, he argued that tyranny was inevitable. Proudhon had
a passion for liberty—he wanted liberty to be absolute, everywhere, and forever. Of
the tripartite values of the French Revolution, “liberty, equality, fraternity,” it is clear
that liberty was uppermost in his mind. In places he sounds almost Saint-Simonian,
even though he generally deprecated Saint-Simon’s ideas. In discussing industrial
organization, a favorite theme of Saint-Simon, Proudhon expressed a mutual desire
to eliminate government functionaries:
To live without government, to abolish all authority, absolutely and unreservedly,
to set up pure anarchy seems to [some] ridiculous and inconceivable, a plot
against the Republic and against the nation. What will these people who talk about
abolishing government put in place of it? they ask.
We have no trouble in answering. It is industrial organization that we will put in
place of government. . . . In place of laws, we will put contracts. . . . In place of polit-
ical powers, we will put economic forces. In place of the ancient classes of nobles,
burghers, and peasants, or of business men and working men, we will put the gen-
eral titles and special departments of industry: Agriculture, Manufacture, Com-
merce, etc. In place of public force, we will put collective force. In place of standing
armies, we will put industrial associations. In place of police, we will put identity of
interests. In place of political centralization, we will put economic centralization.
Do you see how there can be order without functionaries, a profound and
wholly intellectual unity? (“General Idea,” in Manuel and Manuel, p. 371)

Proudhon also shared Saint-Simon’s faith in a higher order of social unity than
what he saw around him in his day. He declared that truth and reality are essentially
historical and that progress is inevitable. Science rather than authority holds the
key to the future, he wrote, and it alone, rather than self-interest, is the chief moti-
vator of progress:
What no monarchy, not even that of the Roman emperors, has been able to accom-
plish; what Christianity, that epitome of the ancient faiths, has been unable to pro-
duce, the universal Republic, the economic Revolution, will accomplish, cannot fail
to accomplish. It is indeed with political economy as with the other sciences: it is
inevitably the same throughout the world: it does not depend upon the fancies of
men or nation: it yields to the caprice of none. . . . Truth alone is equal everywhere:
science is the unity of mankind. If then science, and no longer religion or authority,
is taken in every land as the rule of society, the sovereign arbiter of interests, gov-
ernment becoming void, all the legislation of the universe will be in harmony.
(“General Idea,” in Manuel and Manuel, pp. 374–375)

Paradoxically, Proudhon was attracted to the cosmopolitanism of classical polit-

ical economy and its opposition to excessive government intervention. Above all
else, he sought protection of individual freedom. He wished to preserve economic
forces and economic institutions, unlike the socialists he knew; at the same time,
like them, he wanted to suppress existing conflict between these forces. He did not
endorse the socialist plea to eliminate private property, but he did advocate its uni-
versal distribution. He wanted everyone to have property, which he considered the
greatest guarantor of liberty. However, he put no faith in the state to accomplish this
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272 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

end. He thought the widespread possession of property would be achieved through

a process of rationalization, or enlightenment. It is probably for this reason that
Marx considered his ideas “utopian.” In contrast to Marx, Proudhon’s thought was
evolutionary rather than revolutionary.
Justice and Exchange. Despite his affinity for the philosophy of classical
political economy, Proudhon refuted the arguments of the classical economists in
order to distance his position from theirs. He detected a false promise in classical
liberalism that defeated its conclusions. Proudhon was convinced that the price
mechanism—which classical liberalism relied on to accomplish social ends—was
just as oppressive as law and other government actions. In the final analysis, he
judged a major assumption of classical economics untenable—the premise that eco-
nomic power is more or less equally diffused in the marketplace. The law of supply
and demand, he claimed, is a “deceitful law . . . suitable only for assuring victory of
the strong over the weak, of those who own property over those who own nothing”
(cited in Ritter, p. 121). Presumably, if each market participant had an equal chance
to benefit from the vagaries of supply and demand, Proudhon would accept the
market as a method of organizing society. But he did not believe that all traders
were equally subject to the market; hence he thought the market incapable of fulfill-
ing its promise to protect each individual’s freedom to pursue his or her own goals.
In retrospect Proudhon’s criticism of economic liberalism is misplaced, since
what he objected to was monopoly, not competition. In fact, Proudhon gloried in the
notion of competition. Declaring the market oppressive, he nevertheless said that
competition is “the spice of exchange, the salt of work,” adding that “to suppress
competition is to suppress liberty itself” (cited in Ritter, p. 123). Proudhon acknowl-
edged that competition encourages creativity and on that account should be main-
tained. As he saw it, the task of the economist is to create a more appropriate
environment for competition so that its benefits could be realized.
In Proudhon’s ideal society the social fabric is held together by mutual respect
rather than authority. Economic exchange in his world “imposes no obligation on its
parties but that which results from their personal promise . . . it is subject to no
external authority. . . . When I bargain for some good with one or more of my fellow
citizens, it is clear that then it is my will alone that is my law” (cited in Ritter, p.
124). In order to protect bargainers from being exploited in market exchange,
Proudhon strove to equalize power among market participants. This is what lies
behind his proposals for the universalization of property and the creation of inter-
est-free loans for all customers. To protect against trade stalemates that might
result from the leveling of economic power, he encouraged social diversity, which
he thought would stimulate competition and, at the same time, be consistent with
individual liberty. Social diversity, he maintained, tends to prevent economic dead-
locks by increasing traders’ incentives to compromise. Nonmarket disputes (e.g.,
over ideology), moreover, cannot arise under true mutualism.
Proudhon’s mutualism offers yet another parallel to Saint-Simon. Neither
writer trusted the egoistic practice of self-interest to spontaneously establish social
harmony, as Adam Smith proclaimed. Saint-Simon suggested replacing traditional
government with a hierarchy of experts who are able to discern and promote the
public interest. Proudhon rejected all forms of law, government, and hierarchy in
favor of the mutualist principle of commutative justice. The duty of all traders in
Proudhon’s marketplace is to exchange goods with one another of equal, real value.
Thus, he imposed the same basic rule of trade as that of Aristotle or Aquinas (see
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Chapter 11 ■ Nineteenth-Century Heterodox Economic Thought 273

chapter 2). The problem with such maxims of trade, as we have seen, is that their
purely subjective nature does not guarantee the viability of mutual exchange. In
fairness to Proudhon, he recognized this shortcoming of his theory of exchange, but
he never could adequately resolve this issue in a manner consistent with his liber-
tarian principles.

■ GERMAN HISTORICISM
Although most of the critics surveyed in this chapter up to now anchored their
ideas to an evolutionary, progressive theory of history, we reserve the term histori-
cism for a different brand of heterodoxy that surfaced in the nineteenth century. In
this context, historicism refers to the role of history in defining the proper method
of economic inquiry, not necessarily its premises, theorems, and conclusions. There
were two nineteenth-century variants of historicism that encroached on economics,
a German variant and a British variant. In this chapter we focus on German histori-
cism. In a later chapter we introduce British historicism as a backdrop to neoclassi-
cal British economics and American institutionalism (see chapter 19). German
historicism, which in the nineteenth century constituted a somewhat milder form of
criticism than Marxist economics, appears here as a stage for Karl Marx’s singular
contribution to the social sciences, which is the subject of the next chapter.
The core question raised by historicists is whether economics can be legitimately
studied apart from its political, historical, and social milieu—an issue that is still
debated among social scientists. Both William S. Jevons (see chapter 15) and Alfred
Marshall (see chapter 16) made important concessions to the historicist point of
view. Moreover, a number of the organizers of the American Economic Association
(founded in 1886), especially its first secretary, Richard T. Ely, were educated in Ger-
many under the tutelage of the historicists. The significance of the historicist move-
ment, therefore, should not be taken lightly, even if major methodological issues
raised by them were sometimes based on a misunderstanding of logical processes.
The German Historical School is often divided into two groups of writers: the
“older,” less extreme school, and the “younger,” more dogmatic members who pro-
pounded rigid and extreme views on economic method. Members of the older
school include its founder, Wilhelm Roscher, as well as Karl Knies and Bruno Hil-
debrand. The younger school was dominated by the tenacious Gustav Schmoller.
Dating the precise origin of ideas is always difficult, if not impossible. Writers
who combined economics with historical research may be found throughout the his-
tory of ideas, but a distinctive grouping of them emerged in Germany around 1840.
Several reasons exist for the rise of historicists to supremacy in Germany. First, that
country provided a suitable and favorable environment for historical economics to
impose itself. Theoretical economics had not become entrenched in Germany. On
the contrary, Germany harbored something of a hostile attitude toward it. Second,
German philosophy had always stressed an “organic” rather than an individualistic
approach to economic and social problems. Thus, men of the caliber of Roscher,
Knies, and Hildebrand, spurred partly by the philosophy of Hegel and by the
organic jurisprudence of Frederick Karl von Savigny, were drawn into the search
for broad economic and cultural laws that would explain the world in which they
lived. Hegel’s emphasis on evolving ideas as the motive for changes in social organi-
zation is implicit in most German literature of the era, including the historicist
movement. Hegelian influence figures prominently in List’s doctrine of the succes-
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274 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

sion of states, for example, which he developed as early as 1845. In fact, Hegel’s
philosophy permeated practically all aspects of German social thought in the nine-
teenth century, including that of Marx and the Romantics.

Wilhelm Roscher
Time and a dubious reputation as extraneous cast a shadow over the mass of
historicist literature. Most historians of economics pass over the field in silence,
while others deride the famous (and some would say, pointless) methodenstreit (lit-
erally “battle of methods”) that pitted Gustav Schmoller against Carl Menger, leader
of the Austrian School (see chapter 14). This neglect is particularly regrettable in the
case of the founder of the “older historical school,” Wilhelm Roscher. Like his col-
leagues, Roscher incorporated Hegelian ideas on history in his work on economics.
Born at Hanover in 1817, Roscher studied jurisprudence and philosophy at the
universities of Göttingen and Berlin from 1835 to 1839. In 1848 he became profes-
sor of political economy at the University of Leipzig. Although he began his work on
economic history as early as 1838, his magisterial grasp of history and historical
methods was put on full display in 1854, with the publication of his major economic
treatise, System des Volkswirschaft (Principles of Political Economy). This encyclo-
pedic work matched the scope of J. S. Mill’s classic treatise and established Roscher
as a scholar of the first rank. He did not want to abandon Ricardian economics alto-
gether; he merely wanted to supplement and complete it. The historical method that
he outlined for this purpose sought to combine organic, biological analysis—the
study of living, breathing human beings—and statistics to discover the laws of eco-
nomics. In other words, economics could not be entrusted exclusively to the
abstract, deductive method. Roscher wrote:
That which is general in Political Economy has . . . much that is analogous to the
mathematical sciences. Like the latter, it swarms with abstractions. . . . It also sup-
poses the parties to the contract to be guided only by a sense of their own best
interest, and not to be influenced by secondary considerations. It is not, therefore,
to be wondered at, that many authors have endeavored to clothe the laws of Politi-
cal Economy in algebraic formulae. [But] . . . the advantages of the mathematical
model of expression diminish as the facts to which it is applied become more com-
plicated. This is true even in the ordinary psychology of the individual. How much
more, therefore, in the portraying of national life! . . . The abstraction according to
which all men are by nature the same, different only in consequence, is one which,
as Ricardo and von Thünen have shown, must pass as an indispensable stage in
the preparatory labors of political economists. It would be especially well, when an
economic fact is produced by the cooperation of many different factors, for the
investigator to mentally isolate the factor of which, for the time being, he wishes to
examine the peculiar nature. All other factors should, for a time, be considered as
not operating, and as unchangeable, and then the questions asked, What would be
the effect of a change in the factor to be examined, whether the change be occa-
sioned by enlarging or diminishing it? But it never should be lost sight of, that such
a one is only an abstraction after all, for which, not only in the transition to prac-
tice, but even in finished theory, we must turn to the infinite variety of real life.
(Principles, p. 105)7

7
This kind of cautionary signal about the dangers of abstraction continues to echo down through
the centuries; see, for example, Nobel laureate Wassily Leontieff’s “Theoretical Assumptions and
Nonobserved Facts,” in which it is argued that the weak and all too slow-growing empirical foun-
dations of economics cannot support the proliferating superstructure of pure economic theory.
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Chapter 11 ■ Nineteenth-Century Heterodox Economic Thought 275

History and the recording of it (data) were essential for Roscher because he
rejected the idea of economics as a set of normative, value-loaded prescriptions. He
set as his goals the faithful description of what has come to pass and the explana-
tion of how social and national life came to be as it is. He said:
Our aim is simply to describe man’s economic nature and economic wants, to
investigate the laws and the character of the institutions which are adapted to the
satisfaction of these wants, and the greater or less amount of success by which
they have been attended. Our task is, therefore, so to speak, the anatomy and
physiology of social or national economy. (Principles, p. 111)

Roscher expected the historical path of discovery to lead to broad laws of historical
(economic) development that would allow comparisons within and between nation-
states. He argued that classical economics—especially the Ricardian variant—did
not, and could not, provide the whole story. Underscoring the advantages of this his-
torical method, Roscher stressed that its use in economics would establish “a firm
island of scientific truth, as universally recognized as truth as are the principles of
mathematical physics by physicians of the most various schools” (Principles, p. 113).
Joined in this task by Karl Knies and Bruno Hildebrand, Roscher devoted his
lifework to establishing the historical method. In a prolific stream of publications
that included the one-thousand-page Principles, he set out to integrate economics
and other phenomena. But when it came to treating the theory of traditional top-
ics—money, wages, values, and so forth—Roscher accepted, in the main, the analy-
ses of John Stuart Mill. In later editions of his Principles, Roscher even incorporated
W. S. Jevons’s contributions to utility and statistics. What was different about
Roscher’s work was not any overt antagonism to classical political economy but his
incredible display of historico-statistical virtuosity aimed at enlarging and elucidat-
ing received economic theory. Roscher’s passion for history and statistics led him
into side excursions on the construction of price indexes and other topics including
population, international trade, and protectionism. The history of prices in turn led
to a study of economic institutions such as slavery, church, money, and insurance.
Many of these themes still repay careful reading, but in the end, despite his best
efforts, Roscher was unable—even with the assistance of Knies and Hildebrand—to
reorient the dominant method of economics. When the more extreme “younger”
school took over, the tide turned toward antagonism.

Gustav Schmoller
The younger historical school, led by the indomitable Gustav Schmoller, pushed
Roscher’s historicism to extremes. Schmoller argued that all received economic
analysis, especially Ricardo’s, was not only useless but downright pernicious.
Rather than repeat the errors of the abstract, deductive method, the younger histor-
ical school set out to study economics de novo as an organic subject. Schmoller seri-
ously proposed that due to the unrealism of its assumptions, its degree of
theoretical abstraction, and its neglect of interrelated and relevant facts, existing
economic theory be discarded completely. In its place he would substitute historical
laws of development, laws that Schmoller attempted to establish in numerous publi-
cations, including his compendious Grundriss der Allgemeine Volkswirtschaftslehre
(roughly translated as Outline of General Economic Theory), an ambitious attempt
to capture sweeping historical laws in a single, systematic treatise.
Published between 1900 and 1904, Schmoller’s Grundriss was described by
Wesley Clair Mitchell as a “treatise of beginnings” (Types of Economic Theory, p.
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276 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

574). For Schmoller and his followers economic laws were not discoverable by mere
logical deductions, but rather they were found in the study of society in the broadest
possible context. Thus, the younger historical school combined history and ethnol-
ogy (i.e., a branch of anthropology that deals with the study of cultures) to explore
such topics as medieval institutions (especially the guild system), urban develop-
ment, banking, and various industry studies. As Joseph Schumpeter remarked,
Schmoller was essentially a historically minded sociologist.
Thus, while the older historical school questioned the abstractedness and abso-
lutism of classical economic theory, the younger school rejected theory altogether.
Schmoller established sharp lines of demarcation in the ensuing debate over
method: He wished to replace the abstract-deductive method with the historico-
inductive method. Such theoretical antagonisms were bound to stir up controversy
sooner or later, and when it came, it is no surprise that the bitterness was hottest
and heaviest in Germany. The first blow came from neighboring Austria, where Carl
Menger (see chapter 14) was in the midst of reforming classical economics by pre-
serving its theoretical roots.
In 1883, Menger published a book on methodology (Investigations into the
Method of the Social Sciences with Special Reference to Economics) that launched a
frontal attack on Schmoller by vindicating the use of economic theory as a legiti-
mate procedural device in the social sciences. What followed was a protracted and
heated debate that has come to be known as the methodenstreit, or battle of meth-
ods. In retaliation Schmoller wrote an unfavorable review of Menger’s Investiga-
tions. Menger counterattacked in a pamphlet entitled Errors of Historicism (1884);
which elicited a predictable rebuttal from Schmoller, and so on. The bitter quarrel
that provoked these exchanges involved personalities and intellectual preferences
as well as methodological substance. Because the debate was largely a matter of
precedents and the relative merits of theory versus history, much of the fight
amounted to “tilting at windmills.”
The issue of the proper method to employ in economics, as in each social sci-
ence, is not a trivial one. But the extreme to which Schmoller took the historicist
doctrine made it antirationalist: It refused to derive any general rules from reason,
insisting instead on recording unique events in almost infinite historical variation.
No doubt facts are extremely important, but the jumble of facts that present them-
selves in everyday life must be steered by something if they are to be meaningful
and useful. Schmoller’s historicism offered no principles to guide or restrain human
action. Thus, it was a well without a spring to feed it. It may be that Joseph Schum-
peter—who was trained in the Austrian tradition opposed to Schmoller and his fol-
lowers—issued the last word on the matter. He said that “since there cannot be any
serious question either about the basic importance of historical research in a sci-
ence that deals with a historical process or about the necessity of developing a set of
analytic tools by which to handle the material, the controversy, like all such contro-
versies, might well . . . have been wholly pointless” (History of Economic Analysis,
p. 814).

■ HETERODOXY AND ENTREPRENEURISM

This chapter presents (non-Marxian) heterodox economic thought as it
emerged in England and Western Europe in the nineteenth century. The record
shows that France (and to a lesser extent England) provided fertile ground for early
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Chapter 11 ■ Nineteenth-Century Heterodox Economic Thought 277

socialist thought. The strain was more prevalent in France, probably because Eng-
land escaped the upheaval of the French Revolution. The entrepreneur is a key
actor in a market-exchange economy, which is antithetical to the aspirations of
socialist economies. Since socialism stresses collective action, its proponents are
not likely to be much concerned about the role and significance of entrepreneurism.
German historicism, however, presents another story. Despite the predominant
tendency among historians of economic thought to treat historicism as an unfortu-
nate detour in the development of economic science, one may justifiably expect to
find discussions of entrepreneurship in a discipline that emphasizes living, breath-
ing persons and historical experience. Roscher treated the subject in much the
same way as J. B. Say and J. S. Mill, representing entrepreneurial activity as a spe-
cial form of labor, and profit as a special form of wage. Earlier German economists
such as J. H. von Thünen and H. K. von Mangoldt hammered out theoretical innova-
tions in the treatment of entrepreneurism, but their ideas are reserved for chapter
14, where they fit into the backdrop of Carl Menger, founder of the Austrian School.
Schmoller’s contribution is easy to overlook because it is subtle, not wedded
closely to economic theory, and indiscriminately infused with normative proposi-
tions. He showed that entrepreneurship and leadership resemble each other—a
theme commonly associated with Wieser (see chapter 14), who impressed on
Schumpeter the importance of the “sociology of leadership.”8 Schmoller recognized
the creative role of exceptional individuals as an internal factor of the development
process. The major characteristics of entrepreneurship he identified—initiative,
risk, leadership—resemble common basics of a theory of entrepreneurship, but his
antagonism toward theory in the conventional sense did not incline him to invest
entrepreneurism with theoretical substance. He was content to emphasize that
those best endowed with will power and motivational drive, the “born leaders” of
society, would become the most successful entrepreneurs (Grundriss, vol. 2, p. 434).
He defined the entrepreneur in unambiguous terms as the person who is the center
and head of an enterprise, the one who takes the initiative and bears the risks
(Grundriss, vol. 1, p. 413).
Unfortunately Schmoller slipped easily into making normative statements,
whether due to his aversion to theory or his general character is uncertain. He por-
trayed entrepreneurs who manage the challenges of large enterprises as not only
highly energetic, but also ruthless (Grundriss, vol. 1, p. 430). On that account he
observed that economic improvements such as rising productivity and living stan-
dards attributable to entrepreneurism might be accompanied by the spread of anti-
social attitudes, such as greed. To safeguard the effects of entrepreneurship, he
argued that it needs to be embedded in a framework of political regulations and
customary institutions. Such statements were not grounded in a solid, theoretic
approach, since he did not explore the function of the entrepreneur by means of an
elaborate theory of entrepreneurship. But aside from his normative “errors”
Schmoller (and later, Werner Sombart) tilled the ground for Schumpeter’s influen-
tial perspective by emphasizing the institutional embeddedness of entrepreneurship
as a historical fact of the exchange economy.

8
Schmoller’s influence on Schumpeter’s treatment of entrepreneurial activity (see chapter 23) as
the central element in his theory of economic development has not been widely appreciated; but
see Ebner, “Institutional Analysis of Entrepreneurship.”
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278 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

■ CONCLUSION
Even as British classical economics was consolidating its position and becom-
ing an orthodox body of thought in the nineteenth century it was subject to various
criticisms from different quarters. Evolutionists, historicists, radicals, reformers,
and Romantics all weighed in against what historian Thomas Carlyle injudiciously
dubbed “the dismal science.” It is not easy to gauge the full effect of these criticisms
even as far removed as we are today. Yet, at least two things are clear from the his-
torical record: First, dissent has been part of the history of economics from its
beginning (and we shall encounter dissent of various kinds in later sections of this
book). Second, the missing element in nineteenth-century heterodox economic
thought was a truly scientific “engine of analysis” that could propel economics
toward the resolution of pressing problems. Near the middle of the century, Karl
Marx undertook to fill this void.
As we approach the next chapter it is worth noting that Hegelian philosophy
formed a common root of German historicism and Marxian economics. Hegel con-
sidered history the proper guide to the science of society, a theme echoed by Marx
and the historicists alike. However, Marx rejected Hegel’s peculiar view of liberty,
which involved submission to the state. For his part, Marx anticipated the withering
away of the state. Inasmuch as most of the German historicists exalted the nation
and the role of government they were better Hegelians than Marx in this regard. On
the practical side, German historicists promoted a social policy of ameliorating the
condition of the working class. They envisioned a kind of “people’s capitalism” in
which workers obtained a proprietary interest in industry. Their views were there-
fore compatible with the welfare state that Otto von Bismarck undertook to con-
struct when he came to power near the end of the century. The failures of the group
were not so much of the practical as the intellectual kind. Not only were they unable
to discover the universal laws of historical development, they also failed to convince
the next generation of theoretical economists to embrace the historicist method—a
method that has and continues to have gravitas in economics. They may have struck
a chord by extolling fact-finding, but their quantitative data were not assembled in a
manner that could verify economic theory. Because their facts had to speak for
themselves, they underestimated the extent to which meaningful measurement
depends on a theoretical framework to organize and interpret observations.
The issue of proper balance between theory and facts is a delicate one that
requires attention to context and detail. A clear lesson that can be drawn from the
historicist interlude in the history of economics is that some theories, though ele-
gant, may be “empty” in the sense that they have no empirical content or grounding
in fact. Although the younger historical school rejected Roscher’s moderate
approach to historicist economics, he was acutely aware of the symbiotic relation-
ship between theory and facts. He wrote:
It is evident that, of statistics in general, economic statistics constitute a chief part,
and precisely the part most accessible to numerical treatment. As these economic
statistics need to be always directed by the light of Political Economy, they also fur-
nish it with rich materials for the continuation of its structure, and for the strength-
ening of such foundations as it already has. They are, moreover, the indispensable
condition of the application of economic theorems to practice. (Principles, pp. 94–95)

This passage could be taken as a warning that contemporary economic theory may
yet have to pay dearly for ignoring the saner and less extreme messages of the his-
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Chapter 11 ■ Nineteenth-Century Heterodox Economic Thought 279

toricist doctrine. At the very least the historicist movement is an expression of the
desire to preserve basic insights into the historical and changing nature of eco-
nomic and social phenomena against the onslaught of oversimplified and mechanis-
tic views of the “laws” of rational behavior. In this sense, it was an important step in
the development of related disciplines, especially sociology.

REFERENCES
Condorcet, Marquis de Marie-Jean. Esquisses d’un tableau historique des progrès de
l’esprit humain. Paris, 1795.
Ebner, Alexander. “The Institutional Analysis of Entrepreneurship: Historicist Aspects of
Schumpeter’s Development Theory,” in J. G. Backhouse (ed.), Joseph Alois Schum-
peter: Entrepreneurship, Style and Vision, Boston: Kluwer, 2003.
Gide, Charles, and Charles Rist. A History of Economic Doctrines from the Time of the
Physiocrats to the Present Day, 2d ed., R. Richards (trans.). Boston: Heath, 1948.
Leontieff, Wassily. “Theoretical Assumptions and Nonobserved Facts.” American Eco-
nomic Review, vol. 61 (March 1971), pp. 1–7.
Levy, David M. How the Dismal Science Got its Name: Classical Economics and the Ur-
text of Racial Politics. Ann Arbor: The University of Michigan Press, 2001.
List, Friedrich. The National System of Political Economy, S. S. Lloyd (trans.). New York:
Longmans, 1928 [1841].
Morton, A. L. The Life and Ideas of Robert Owen. New York: Monthly Review Press, 1963.
Mitchell, Wesley Clair, Types of Economic Theory, vol. 2. New York: A. M. Kelley, 1969.
Proudhon, Pierre-Joseph. “What is Property,” in F. E. Manuel and F. P. Manuel, (eds.),
French Utopias: An Anthology of Ideal Societies. New York: Free Press, 1966.
———. “The General Idea of the Revolution in the Nineteenth Century,” in F. E. Manuel
and F. P. Manuel (eds.), French Utopias: An Anthology of Ideal Societies. New York:
Free Press, 1966.
Ritter, Allan. The Political Thought of Pierre-Joseph Proudhon. Princeton, NJ: Princeton
University Press, 1969.
Roscher, Wilhelm. Principles of Political Economy, vol. 1, J. J. Lalor (trans.). New York:
Henry Holt, 1877 [1854].
Ruskin, John. “Modern Painters,” in E. T. Cook and Alexander Wedderburn (eds.), The
Works of John Ruskin, vol. 5. London: George Allen, 1905.
Saint-Simon, C. H., and Prosper Enfantin. Oeuvres complètes de Saint-Simon et Enfan-
tin, 47 vols. Aaelen: Otto Zeller, 1963 (the writings of Saint-Simon are in volumes 15,
18–23, 37–40).
Schmoller, Gustav von. Grundriss der allgemeinen Volkswirtschaftslehre, vols. 1 & 2.
Munich and Leipzeig: Duncker & Humblot, 1900 and 1904.
Schumpeter, J. A. History of Economic Analysis, E. B. Schumpeter (ed.). New York:
Oxford University Press, 1954.
Sismondi, J. C. L. Simonde de. De la richesse commerciale, ou principes d’économie poli-
tique appliquées à la législation du commerce, 2 vols. Geneva, 1803.
———. Nouveaux principes d’économie politique, vol. 1. Paris: Delaunay, 1827.
———. Études sur l’économie politique. Paris, 1836.
Smith, Adam. The Wealth of Nations, Edwin Caanan (ed.). New York: Modern Library, 1937.
Thoreau, David. The Writings of Henry David Thoreau, vol. 7. Boston: Houghton-Mifflin,
1906.

NOTES FOR FURTHER READING

The following three articles from History of Political Economy provide an overview
of the kind of criticism leveled at classical economics: W. D. Grampp, “Classical Econom-
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280 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

ics and Its Moral Critics,” vol. 5 (Fall 1973), pp. 359–374; T. E. Kaiser, “Politics and Politi-
cal Economy in the Thought of the Ideologues,” vol. 12 (Summer 1980), pp. 141–160; and
C. C. Ryan, “The Friends of Commerce: Romantic and Marxist Criticisms of Classical
Political Economy,” History of Political Economy, vol. 13 (Spring 1981), pp. 80–94. Some
helpful general surveys of socialist thought are: Alexander Gray, The Socialist Tradition:
Moses to Lenin (London: Longmans, 1946); G. D. H. Cole, A History of Socialist Thought,
5 vols. (New York: St. Martin’s, 1953–1960); and George Lichtheim, The Origins of
Socialism (New York: Praeger, 1969). Gray is particularly strong on the economic
aspects of socialist thought; Lichtheim concentrates on socialist thought before Marx.
Robert Heilbroner’s ever-popular and readable The Worldly Philosophers, 7th ed. (New
York: Touchstone, 1999), contains a delightful chapter on the utopian socialists. Bio-
graphical details of individual dissenters may be found in Philip Arestis and Malcolm
Sawyer (eds.), A Biographical Dictionary of Dissenting Economists, 2d ed. (Cheltenham,
UK: Edward Elgar, 2000).
Henryk Grossman’s two-part article, “The Evolutionist Revolt against Classical Eco-
nomics,” Journal of Political Economy, vol. 51 (October, December 1943) discusses the
ideas of Condorcet, Saint-Simon, Sismondi, James Steuart, Richard Jones, and Karl
Marx. For more on Condorcet, see Keith M. Baker, Condorcet: From Natural Philosophy
to Social Mathematics (Chicago: University of Chicago press, 1975); and Emma Roth-
schild, Economic Sentiments: Adam Smith, Condorcet, and the Enlightenment (Harvard
University Press, 2001). The intermediate ground between the progressive philosophy of
history of Condorcet and the regressive philosophy of Rousseau was occupied by Condil-
lac. See Arnaud Orain, “Decline and Progress: The Economic Agent in Condillac’s The-
ory of History,” The European Journal of the History of Economic Thought, vol. 10
(Autumn 2003), pp. 379–407.
Saint-Simon’s original works appeared in French, but fragmentary translations are
contained in F. M. H. Markham (ed.), Social Organization, the Science of Man and Other
Writings (New York: Harper & Row, 1964), which also contains a useful introduction.
Additional English translations appear in G. G. Iggers (trans.), The Doctrine of Saint-
Simon: An Exposition. First Year, 1828–1829 (Boston: Beacon Press, 1958). Saint-Simon’s
influence is discussed in Elie Halévy’s Era of Tyrannies, R. K. Webb (trans.) (Garden
City, NY: Anchor Books, Doubleday & Co., 1965), and is the subject of full-length treat-
ment by sociologist Émile Durkheim, Socialism and Saint-Simon, A. W. Gouldner (ed.)
and C. Sattler (trans.) (Yellow Springs, OH: Antioch Press, 1958), and by historian Frank
Manuel, The New World of Henri Saint-Simon (Cambridge, MA: Harvard University
Press, 1962). A leading twentieth-century specialist in industrial organization, E. S.
Mason, “Saint-Simonism and the Rationalisation of Industry,” Quarterly Journal of Eco-
nomics, vol. 45 (August 1931), pp. 640–683, emphasized the relevance of Saint-Simon’s
ideas to modern capitalism. Some of the same themes are repeated by Niles Hansen,
“Saint-Simon’s Industrial Society in Modern Perspective,” Southwestern Social Science
Quarterly, vol. 47 (December 1966), pp. 253–262. F. A. Hayek provides a distinctly
unsympathetic treatment of Saint-Simon and his influence in The Counter-Revolution of
Science: Studies in the Abuse of Reason (New York: Free Press, 1955).
Most of Sismondi’s works (e.g., Nouveaux principes) are available in French only, but
a collection of his essays has been translated into English; see J. C. L. Sismondi, Political
Economy and the Philosophy of Government (New York: A. M. Kelly, 1965 [1847]). See
also, H. W. Spiegel (ed.), The Development of Economic Thought (New York: Wiley, 1952),
pp. 253–268. Secondary literature on Sismondi is rather sparse, but see Mao-Lan Tuan,
Simonde de Sismondi as an Economist, (New York: Columbia University Press, 1927);
and Thomas Sowell, “Sismondi: A Neglected Pioneer,” History of Political Economy, vol. 1
(Spring 1968), pp. 62–88. Lenin sought to refute Sismondi’s ideas in A Characterization of
Economic Romanticism (Moscow: Foreign Languages Publishing House, 1951 [1897]).
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Chapter 11 ■ Nineteenth-Century Heterodox Economic Thought 281

Rousseau’s ideas and political philosophy became embedded in European society.

His notion of envy is contrasted with modern notions by Claire Pignol, “Rousseau’s
Notion of Envy: A Comparison with Modern Economic Theory,” The European Journal of
the History of Economic Thought, vol. 9 (Fall 2012), pp. 529–549. Pignol maintains that
envy functions as a kind of criticism of self-interest, but tension exists between the mod-
ern theory and different concepts of envy expressed by Rousseau.
Henry David Thoreau was the major “Romantic” voice in the United States, but has
not drawn much attention from economists. An exception is Christian Becker, “Tho-
reau’s Economic Philosophy,” The European Journal of the History of Economic Thought,
vol. 15 (Spring 2008), pp. 211–246. Becker represents Thoreau as a critic of classical
political economy, especially Say’s work. Thoreau was concerned that through the mod-
ern economy human beings can become alienated from themselves and nature. David A.
Spencer, “Work in Utopia: Pro-work Sentiments in the Writings of Four Critics of Classi-
cal Economics,” The European Journal of the History of Economic Thought, vol. 16, (Win-
ter 2009), pp. 97–122, examines how Fourier, Carlyle, Ruskin, and William Morris
thought work would be done in their utopian societies. Each believed that the disutility
of labor was a product of capitalist society and could be overcome in utopia, where work
would be a positive activity rather than a drudge.
Robert Owen, A New View of Society and Other Writings (New York: Everyman’s
Library, Dutton, 1927) provides an introduction to the mind of the master of New Lanark
Mills. The standard biography of Owen is Frank Podmore, Robert Owen: A Biography
(New York: Appleton, 1906). E. R. A. Seligman’s Essays in Economics (New York: Macmil-
lan, 1925) includes an essay entitled “Owen and the Christian Socialists.” An Internet
resource, The History Guide: Lectures on Modern European Intellectual History, offers an
introduction to the ideas of Fourier (http://www.historyguide.org/intellect/lecture21a.html),
and Owen and Saint-Simon (http://www.historyguide.org/intellect/lecture22a.html).
Few of Fourier’s works have been translated into English. See Julia Franklin
(trans.), Design for Utopia: Selected Writings of Charles Fourier (New York: Schocken
Books, 1981); and J. Beecher and R. Bienvenu (eds. and trans.), The Utopian Vision of
Charles Fourier: Selected Tracts on Work, Love, and Passionate Attraction (Boston: Bea-
con Press, 1971). N. V. Riasanovsky, The Teachings of Charles Fourier (Berkeley: Univer-
sity of California Press, 1970), provides good coverage of Fourier’s ideas; and E. S.
Mason, “Fourier and Anarchism,” Quarterly Journal of Economics, vol. 42 (1928), pp.
228–262 repays careful reading, even at this late date. John Cunliffe and Guido
Erreygers, “The Enigmatic Legacy of Charles Fourier: Joseph Charlier,” History of Politi-
cal Economy, vol. 33 (Fall 2001), pp. 459–484, tentatively demonstrate that perhaps Fou-
rier’s influence was not negligible after all.
Is anarchy more provocative than passionate attraction? Why else has Proudhon
been translated more than Fourier? See, P. J. Proudhon, What Is Property?, B. R. Tucker
(trans.) (New York: H. Fertig, 1966); P. J. Proudhon, General Idea of the Revolution in the
Nineteenth Century, J. B. Robinson (trans.) (London: Freedom Press, 1923); and P. J.
Proudhon, System of Economic Contradictions: or the Philosophy of Poverty, B. R.
Tucker (trans.) (Princeton, NJ: B. R. Tucker, 1888). P. J. Proudhon, Proudhon’s Solution
of the Social Problem, Henry Cohen (ed.) (New York: Vanguard, 1927), comprises a
group of articles on banking and other topics. For biographical details on Proudhon’s
life, see George Woodcock, Pierre-Joseph Proudhon (New York: Macmillan, 1956); and J.
H. Jackson, Marx, Proudhon and European Socialism (New York: Macmillan, n.d.). This
last book details the relation between the two leading socialists of the mid-nineteenth
century. Proudhon’s ideas have provoked a variety of responses. For two dramatic reac-
tions, see J. S. Shapiro, “Pierre Joseph Proudhon: Harbinger of Fascism,” American His-
torical Review, vol. 50 (July 1945), pp. 714–737; and Dudley Dillard, “Keynes and
Proudhon,” Journal of Economic History, vol. 2 (May 1942), pp. 63–76. For a brief
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282 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

glimpse of “America’s Proudhon” see B. N. Hall, “Josiah Warren, First American Anar-
chist,” History of Political Economy, vol. 6 (February 1974), pp. 95–108.
The broad sweep of nineteenth-century German economics is explored by historian
David F. Lindenfeld, The Practical Imagination: The German Sciences of State in the
Nineteenth Century (Chicago: University of Chicago Press, 1997). See also, Keith Tribe,
Strategies of Economic Order: German Economic Discourse, 1750-1950 (Cambridge Uni-
versity Press, 1995), for an overview of two hundred years of German economic thought
from the Staatswissenschaften of the eighteenth century to National Socialism and the
Social Market of the nineteenth. T. W. Hutchison discusses both the “older” and
“younger” German historical schools in his Review of Economic Doctrines, 1870–1929
(Oxford: The Clarendon Press, 1953), chaps. 8 and 12; and again in “Some Themes from
Investigation into Method,” in J. R. Hicks and W. Weber, Carl Menger and the Austrian
School of Economics (London: Oxford University Press, 1973). Joseph Schumpeter pro-
vides a useful and perceptive overview of the stage and its actors in his History of Eco-
nomic Analysis (see references), pp. 800–824. Those especially interested in
methodology should consult Felix Kaufman, Methodology of the Social Sciences (New
York: Oxford University Press, 1944).
Friedrich List’s ideas were favored by American protectionists in the nineteenth cen-
tury, but the American position had already been staked out much earlier by Alexander
Hamilton in his Report on the Subject of Manufactures (1791), reprinted in A. H. Cole
(ed.), Industrial and Commercial Correspondence of Alexander Hamilton (New York: A.
M. Kelley, 1968). Margaret E. Hirst, Life of Friedrich List and Selections from His Writ-
ings (London: Smith, Elder and Company, 1909) contains excerpts from List’s Outlines of
American Political Economy, which was written on behalf of the American protectionists
during List’s visit to the United States. H. W. Spiegel, The Growth of Economic Thought,
3d ed. (Durham, NC: Duke University Press, 1991) contains additional references to
List’s works.
Noting the cursory treatment usually accorded to the German Historical School in
standard textbooks, H. K. Betz, “How Does the German Historical School Fit?” History of
Political Economy, vol. 20 (Fall 1988), pp. 409–430, seeks to define the group’s contribu-
tions to the theory of economic policy and pattern modeling. Haim Barkai examines
money and monetary issues in German historical thought in “The Old Historical School:
Roscher on Money and Monetary Issues,” History of Political Economy, vol. 21 (Summer
1989), pp. 179–200; and again in “Schmoller on Money and the Monetary Dimension of
Economics,” History of Political Economy, vol. 23 (Spring 1991), pp. 13–39.
Yuichi Shionoya (ed.), The German Historical School: The Historical and Ethical
Approach to Economics (London: Routledge, 2001) contains thirteen essays (some
slightly anomalous) on various members of the older and younger schools and their
impact on Japanese economists. Same author, The Soul of the German Historical School
(Berlin: Springer, 2005) contains methodological essays on Schmoller, Weber, and
Schumpeter. H. H. Nau and Bertram Schefold (eds.), The Historicity of Economics: Con-
tinuities and Discontinuities of Historical Thought in 19th and 20th Century Economics
(Berlin: Springer, 2002) consists of six conference papers that deal with the legacies of
historical economics since Schmoller. This volume seeks to establish a link between the
German Historical School and the New Institutional Economics on grounds of a com-
mon concern for institutions and path dependency. The very existence of the German
Historical School has been called into question by Heath Pearson, “Was There Really a
German Historical School of Economics?” History of Political Economy, vol. 31 (Fall
1999), pp. 547–562. Bruce Caldwell, “There Really Was a German Historical School of
Economics: A Comment on Heath Pearson,” History of Political Economy, vol. 33 (Fall
2001), pp. 649–654, defends the distinction; but see Pearson’s rejoinder following
Caldwell’s article.
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Chapter 11 ■ Nineteenth-Century Heterodox Economic Thought 283

On Schmoller and the later historicists, see Nicholas Balabkins, Not by Theory
Alone . . . The Economics of Gustav von Schmoller and Its Legacy to America (Berlin:
Duncker und Humblot, 1988); Ben B. Seligman, Main Currents in Modern Economics
(New York: Free Press, 1962), chap. 1; and W. C. Mitchell, Types of Economic Theory
(New York: A. M. Kelley, 1969), chap. 19. Mitchell’s assessment of the methodenstreit is
especially informative. For a different and more contemporary view of the famous con-
troversy, see Sam Bostaph, “The Methodological Debate Between Carl Menger and the
German Historicists,” Atlantic Economic Journal, vol. 6 (September 1978), pp. 3–16.
Closer to the heat of the moment, Menger’s position in the methodenstreit was chroni-
cled by his disciple, Eugen Böhm-Bawerk, “The Historical vs. the Deductive Method in
Political Economy,” Annals of the American Academy of Political and Social Science, vol.
1 (October 1890), pp. 244–271.
Erik Grimmer-Solem, The Rise of Historical Economics and Social Reform in Ger-
many, 1864–1894 (Oxford: Clarendon Press, 2003) attempts to revise the prevailing
hackneyed view of the younger historical school, but before delving into Grimmer-
Solem’s book, see Heath Pearson’s review of it in History of Political Economy, vol. 37
(Summer 2005), pp. 395–397. Helke Peukert, “The Schmoller Renaissance,” History of
Political Economy, vol. 33 (Spring 2001), pp. 71–116, analyzes the revival of interest in
Schmoller in the late twentieth century. Heino H. Nau, “Gustav Schmoller’s Historico-
Ethical Political Economy: Ethics, Politics and Economics in the Younger German His-
torical School, 1860–1917,” The European Journal of the History of Economic Thought,
vol. 7 (Winter 2000), pp. 507–531, contributes to this revival. For a sympathetic view of
the historical school and its contributions, in particular the positive accomplishments of
a single member of the younger school, see A. Schweitzer, “Typological Method in Eco-
nomics: Max Weber’s Contribution,” History of Political Economy, vol. 2 (Spring 1970),
pp. 66–99.
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12

Karl Marx
Historical Determinism
vs. Utopian Socialism

Whether understood or misunderstood it would be hard to find a more influential

writer in the history of social thought than Karl Marx. Despite the decline of Marx-
ist-inspired economies throughout the world today, the man and his system of
thought captured the imagination of intellectuals the world over. Marx influenced
many fields: philosophy, sociology, psychology, and political theory. But his major
work, Das Kapital (Capital), is about economics above all. What set him apart from
so many other economists was his ability to weave together the philosophical, his-
torical, sociological, psychological, political, and economic threads of argument into
a coherent whole.
Born in Trier, Prussia, in 1818, Marx was the son of middle-class Jewish parents
who later converted to Christianity. As a youth he was popular with his playmates
and enjoyed an amicable relationship with his parents. At the age of seventeen, he
entered the University of Bonn as a law student, but despite a sharp mind, his stud-
ies suffered from the distractions of youth. He attended class rarely, indulging
instead in the good times and high jinks of college life. His father grew tired of his
son’s poor academic performance, withdrew him from the University of Bonn after
his first year, and enrolled him at the University of Berlin, an institution less tolerant
of nonacademic distractions. During the continuance of his training in jurispru-
dence and political economy at Berlin, Marx came under the influence of Georg
Wilhelm Friedrich Hegel and Ludwig Andreas von Feuerbach, whose ideas helped
shape his own views of history, religion, and society.
Marx switched schools again, and after completing his PhD dissertation at the
University of Jena in 1841, he moved back to Bonn, hoping to secure a teaching
position at the university he had formerly attended. He abandoned this hope in
1842, at which point he assumed the editorship of the Rheinische Zeitung, a German
newspaper in which he could air his unorthodox ideas and indulge his taste for the
literature of the French socialists. After strict censorship was imposed on the Rhein-
ische Zeitung in 1843 Marx resigned as editor. In June of the same year he married
his childhood sweetheart (Jenny von Westphalen) and moved to Paris, where he
founded a new journal—the Deutsch-Französische Jarbucher. All the while Marx
continued to write, though mostly on philosophical topics. In Paris, however, he
began a systematic study of economics, especially of Smith and Ricardo. There, too,

284
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Chapter 12 ■ Karl Marx 285

he studied the materialist philosophers, including Locke; he became acquainted

with Proudhon; and he began to distill most of his major ideas. His most active liter-
ary decade was yet to come, but in 1844 Marx wrote a number of manuscripts,
which were later collected and published as Economic and Philosophic Manuscripts
of 1844.
In the meantime, Marx had become an outcast in his native country. The Prus-
sian government declared him guilty of treason in 1844 for his articles in the Jarbu-
cher, making it impossible for him to return to his homeland. The following year,
prodded by Prussia, he was also expelled by France. He fled to Brussels, where, in
due course, his Theses on Feuerbach (1845), The German Ideology (1846, with
Engels), and The Poverty of Philosophy (1847) were published—the last a scathing
critique of Proudhon’s earlier Philosophy of Poverty. In 1847 Marx gave a series of
lectures, which were later published as Wage Labour and Capital (1849). The Com-
munist Manifesto followed in 1848, and in 1849 Marx and his family settled in Lon-
don, where he spent the remainder of his life, a great part of which was spent
writing and studying economics in the library of the British Museum. In 1851, Marx
entered a ten-year period as occasional contributor to the New York Daily Tribune,
whose fees helped sustain his family’s meager existence.
Marx began a feverish period of writing and publishing in 1857. In that year
alone he prepared a lengthy critique of political economy that was to serve as an
outline for his later magnum opus. Now known as the Grundrisse, these manu-
scripts were undiscovered and unpublished until World War II. Marx began A Con-
tribution to the Critique of Political Economy in 1858 and finished it the following
year. By 1863, he had also completed Theories of Surplus Value. The first volume of
Capital appeared in 1867, but he had not completed the second and third volumes
by his death in 1883. These last two volumes appeared under the editorship of
Marx’s lifetime friend and collaborator, Friedrich Engels, who died in 1895, a year
after the publication of the third and final volume.
Marx’s personal life was marked by all kinds of adversity, including abject pov-
erty and political repression. Certainly, Marx could be bitter about his personal tri-
als. He made no effort to hide his bitterness when, near the end of his life, he wrote
acidly: “I hope the bourgeoisie will remember my carbuncles all the rest of their
lives!” Possibly this bitterness explains why Marx is frequently portrayed as a sul-
len, brooding genius. But this characterization obscures one of the most remarkable
things about the man—his extraordinary success, despite adversity, in the personal
relationships that matter most. His love for his wife, and hers for him, was enduring
and uncompromising. His children adored him, reflecting the same filial love that
Marx had bestowed on his own father. Carbuncles notwithstanding, Karl Marx had,
by several criteria, a very fruitful life.

■ OVERVIEW OF THE MARXIAN SYSTEM

Marx’s mature thought provides a theory of historical processes, based on
material and economic forces, culminating in social and economic change of the
existing order. In contrast to the overt, intellectual specialization of a later day,
Marx’s thought ranged over philosophy, history, and economics. As a philosopher
and historian he was steeped in, but not a part of, the German tradition. As an econ-
omist he was likewise steeped in, but not a part of, the British classical tradition.
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286 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

Hegel, Feuerbach, and German Philosophy

The dominant figure in German philosophy during the nineteenth century was
Georg Hegel (1770–1831), whose ideas influenced not only Marx but also the Ger-
man historicists (see chapter 11). The aspect of Hegel’s philosophy that most influ-
enced Marx was his theory of progress. Hegel claimed that history holds the key to
the science of society. He viewed history not as a sequence of accidental occur-
rences or a collection of disconnected stories but rather as an organic process
guided by the human spirit. It is not smoothly continuous but instead is the outcome
of opposing forces. According to Hegel historical progress occurs when one force is
confronted by its opposite. In the struggle, both are annihilated and are transcended
by a third force. This so-called dialectic has frequently been summarized, conceptu-
ally, by the interplay of “thesis,” “antithesis,” and “synthesis.” The Hegelian dialectic
maintains that at some point in history an idea, or thesis, is confronted by an oppos-
ing idea, or antithesis. In the ensuing battle of ideas, neither one remains intact, but
both are synthesized into a third, and this is how all general knowledge, as well as
history, advances.
Although Marx found fault with some elements of Hegel’s philosophy, he
adopted the Hegelian dialectic, then modified it to accommodate Ludwig Feuer-
bach’s doctrine of materialism. Feuerbach, another leading German philosopher,
was every bit as Hegelian as Marx, but in The Essence of Christianity (1841), written
ten years after Hegel’s death, he added “materialism” to Hegel’s concept of “self-
alienation.” Materialism to Feuerbach meant that humans are not only “species
beings,” as Hegel asserted, but also sensuous beings, so that sense perception must
therefore become the basis of all science. Feuerbach maintained that all history is
the process of preparing humans to become the object of “conscious,” rather than
“unconscious” activity.
According to Feuerbach, one area where unconscious activity predominates is
religion. Religion is the mere projection of idealized human attributes onto an oth-
erworldly object (i.e., God). This supernatural object is then worshipped by humans
as all-powerful, all-knowing, and all-perfect. Claiming to be a “realist,” Feuerbach
argued that religion is unreal. He regarded the attributes of the divinity as nothing
more than the idealized attributes of humans, which, of course, cannot be realized
in this imperfect world. Humans are willing to accept their imperfect, earthly exis-
tence only because they unconsciously promise themselves perfection in another
world. In other words, religion makes life bearable. And it is for this reason, pro-
claimed Feuerbach, that religion is such a universal phenomenon.1
From this perch it is a short step to reason that religion is a form of self-alien-
ation. Feuerbach and Marx both used the term “alienation” to refer to a process—and
a result—of converting the products of individual and social activity into something
apart from themselves, both independent of them and dominant over them. How-
ever, whereas Feuerbach confined his analysis to the way in which humans alienate
themselves in religion and in philosophy, Marx applied the concept to all manner of
political and economic activity, including the very institutions of capitalism. In Marx,
for the first time, the state joins hands with God as an “alien” being. The state derives
its power and its existence from the fact that human beings are either incapable or
unwilling to face head-on the problems that confront them in daily social interac-
tions with one another. Over time, this monolithic structure called the “state”
increases its power over people’s lives, simply because they allow it to do so.
1
Marx’s acceptance of this view underlies his description of religion as “the opiate of the masses.”
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Chapter 12 ■ Karl Marx 287

Marx’s Economic Interpretation of History

The philosophical backdrop of Hegel and Feuerbach is essential to understand-
ing the innovative character of Marx’s thought. Grafting Feuerbach’s materialism to
Hegel’s dialectic, Marx developed a “dialectical materialism,” which was uniquely his
own. He then extended this idea to the economic realm. Marx considered the prime
mover of history to be the way in which individuals make a living, that is, the way in
which they satisfy their material needs. This is important because unless their mate-
rial needs are satisfied, human beings would cease to exist. In Marx’s words, “Men
must be able to live in order to ‘make history.’ . . . [Therefore] the first historical act
is . . . the production of the means to satisfy these needs, the production of material
life itself” (German Ideology, in Marx, Writings, p. 419). Showing his understanding
and appreciation of the interrelations between economics and history, Marx declared
production both a historical and an economic act. He made production the focal point
and driving force among the mutually conditioning forces of production, distribution,
exchange, and consumption. For Marx, economics became the science of production.
Production is a social force insofar as it channels human activity into useful
ends. But Marx asserted that methods of production help to shape human nature
itself. In one of his earlier works he wrote:
The way in which men produce their means of subsistence depends first of all on
the nature of the actual means they find in existence and have to reproduce. This
mode of production must not be considered simply as being the reproduction of
the physical existence of the individuals. Rather it is a definite form of activity of
these individuals, a definite form of expressing their life, a definite mode of life on
their part. As individuals express their life, so they are. What they are, therefore,
coincides with their production, both with what they produce and with how they
produce. The nature of individuals thus depends on the material conditions deter-
mining their production. (German Ideology, in Marx, Precapitalist, p. 121)

Like Adam Smith, Marx recognized that the development of productive forces
in every economy depends on the degree to which the division of labor is carried.
Whereas Smith anticipated natural harmony, Marx saw conflict of interests as the
logical outcome of the progressive division of labor. Conflict arises, he said, in a
series of events. The division of labor leads first to the separation of industrial and
commercial labor from agricultural labor, and hence to the separation of town and
country. Next it leads to the separation of industrial from commercial labor, and
finally to a division among workers within each kind of labor. Conflict continues as
individual interests contradict community interests and each worker becomes
“chained” to a specific job. Eventually (à la Feuerbach) labor becomes an alien
power, opposing the worker and enslaving him.
According to Marx the conflict between individual interests and community
interests encourages the rise of the state as an independent power, a power divorced
from the real interests of the individual and the community, even though it owes its
being to the social classes already determined by the division of labor. Each class in
power seeks to promote its own interest as the general community interest. But the
community perceives the resulting class interest as an alien force that it cannot con-
trol. The situation becomes intolerable when two conditions are fulfilled. First, the
great mass of humanity is rendered propertyless in a world of wealth and culture.
This will only happen after production reaches a high level of productive power and
a high degree of development, as under mature capitalism. Second, the develop-
ment of productive forces must be universal. As a practical premise, the phenome-
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288 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

non of the “propertyless” class must reach worldwide proportions; otherwise,

revolution and communism could exist only as local events, not as global realities.

Static versus Dynamic Forces in Society

What Marx called the “forces of production,” developed through rational applica-
tion of division of labor, are essentially dynamic. They consist of land, labor, capital,
and technology, each of which is constantly changing in quantity and/or quality as a
result of changes in population, discovery, innovation, education, and so on. During
the course of their social lives, however, humans enter into certain definite relations
that are independent of their will but indispensable to their lives as productive beings.
These relations of production correspond to a worker’s developmental stage of skill
and productivity. Taken together, they constitute the “rules of the capitalist game.”
They are essentially static and consist of two types: property relations and human
relations. Property relations exist between people and things; human relations exist
between people. According to Marx, the sum total of these relations constitutes the
economic structure of society, on which is superimposed a legal and political super-
structure corresponding to definite forms of social consciousness. Every aspect of the
socioeconomic structure owes its origin to the relations of production simply because
institutions exist in order to make humans conform to the relations of production.
Figure 12-1 provides a simple schematic summary of Marx’s theory of society.
As the division of labor is pushed to its logical conclusion, labor becomes increas-
ingly fragmented. The ensuing conflicts of interest are further aggravated by the

Social
Superstructure
law
religion
government

Relations of Production
private property
wage system

Figure 12-1
Forces of Production Marx’s “social pyr-
land amid,” in which
labor the structure of
capital society owes its
technology origin to the basic
facts of economic
production.
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Chapter 12 ■ Karl Marx 289

institution of private property, which ensures the splitting up of accumulated capital

among different owners and thus the division between capital and labor. In terms of
figure 12-1, the dynamic forces of production come into conflict with the static rela-
tions of production. Once this conflict reaches a sufficient pitch, class struggle and
revolution occur, and the social pyramid crumbles, from top to bottom. Marx suc-
cinctly summarized the dynamic process of social change determined by the forces
of production in his preface to A Contribution to the Critique of Political Economy:
The mode of production of material life determines the character of the social,
political, and spiritual processes of life. It is not the consciousness of men that
determines their existence, but on the contrary, their social existence that deter-
mines their consciousness. At a certain stage of their development, the material
forces of production in society come in conflict with the existing relations of pro-
duction, or—what is but a legal expression for the same thing—with the property
relations within which they have been at work before. From forms of development
of the forces of production these relations turn into their fetters. Then comes the
period of social revolution. With the change of the economic foundation the entire
immense superstructure is more or less rapidly transformed.
No social order ever disappears before all the productive forces, for which there
is room in it, have been developed; and new higher relations of production never
appear before the material conditions of their existence have matured in the womb
of the old society. . . . The bourgeois relations of production are the last antagonis-
tic form of the social process of production—antagonistic not in the sense of indi-
vidual antagonism, but of one arising from conditions surrounding the life of
individuals in society; at the same time the productive forces developing in the
womb of bourgeois society create the material conditions for the solution of that
antagonism. (pp. 20–21)

All of this is, of course, more than a theory of economics; it is a theory of his-
tory, politics, and sociology as well. In his iconic work, Capital, Marx used his more-
or-less integrated theory of social behavior to analyze capitalism, not socialism or
communism. That being said, a full understanding of the dynamics of his analysis
would be extremely difficult without familiarity of Marx’s view of how social
change comes about.

■ MARX’S EARLY WRITINGS ON CAPITALIST PRODUCTION

Das Kapital was the result of many years of investigation by Marx into the laws
of history, economics, and sociology. These years of study and contemplation pro-
duced gems that were all but lost after Marx launched his major work in 1867.
Revisiting Marx’s early writings adds dimension to his mature thought and provides
insights into the intellectual path of his feverish mind.

The Economic and Philosophical Manuscripts of 1844

Marx began a critical study of political economy shortly after he moved to Paris
in 1843. The following year he completed several manuscripts that were apparently
intended to be a major part of a forthcoming book. The book never materialized,
however, and the manuscripts remained unpublished for more than eighty years.
When a full edition of these extant works was published in 1932 under the title Eco-
nomic and Philosophic Manuscripts of 1844, the occasion generated much excite-
ment among Marxian scholars and some reinterpretation of Marx’s later works.
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290 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

Contrary to some interpretations, we find a basic continuity between Marx’s early

writings and Capital. However, by the time he wrote the latter, Marx had abandoned
the purely metaphysical concepts that he had initially acquired from the German
philosophers in favor of a more empirical analysis.
The central theme of the Manuscripts is that once capitalism became a domi-
nant force in Western civilization history became the saga of alienation in people’s
lives as producers. Marx represented communism, therefore—achieved through a
revolution against private property—as the final escape from alienation. Although
he had not yet worked out the labor theory of value by this time, Marx already
expressed in the Manuscripts the idea that labor is the source of all wealth. He had
already made the empirical observation that the worker gets only a small part of
this wealth, barely enough to continue working. The lion’s share of the product of
labor goes to the capitalist, and this leads to a bitter struggle between capital and
labor. Marx reasoned that in this struggle the capitalist has all the advantages, and
aims to keep wages to a minimum. Capitalism, therefore, turns labor into a mere
commodity and reduces all human relations to money relations. The capitalist inev-
itably is enriched by these relations at the expense of the worker, who settles into a
subsistence-level existence.
In an early analysis of profit, also contained in the Manuscripts, Marx noted a
trend toward monopoly concentration of capital into fewer and fewer hands. This
trend leads to an increase in total profits and an increase in the total misery of the
working class. Marx theorized that eventually the contradictions within the capital-
ist system would lead to its demise, thus opening the way for humans to become
truly free. All these ideas reappear in Marx’s more mature works; although, as
might be expected, they are worked out with more precision and detail the second
time around.
What the Manuscripts of 1844 do not contain is a penetrating analysis of the
basic contradictions of capitalism—one must look to Capital for that. But they do
contain a fairly mature statement of methodological criticism aimed at political
economy. For example:
Political economy starts with the fact of private property, but it does not explain it
to us. It expresses in general, abstract formulas the material process through
which private property actually passes, and these formulas it then takes for laws. It
does not comprehend these laws, i.e., it does not demonstrate how they arise from
the very nature of private property. Political economy does not disclose the source
of the division between labor and capital, and between capital and land. When, for
example, it defines the relationship of wages to profit, it takes the interest of the
capitalists to be the ultimate cause; i.e., it takes for granted what it is supposed to
explain. Similarly, competition comes in everywhere. It is explained from external
circumstances. As to how far these external and apparently accidental circum-
stances are but the expression of a necessary course of development, political
economy teaches us nothing . . . exchange itself appears to it to be an accidental
fact. The only wheels which political economy sets in motion are greed and the
war amongst the greedy—competition. (Manuscripts, pp. 106–107)

Clearly, Marx criticized economists for not explaining (understanding?) the under-
lying causes of capitalism. In his view it was simply not enough to understand the
mere workings of markets; one must also know how the market mechanism came
about and where it is going. Marx felt it essential to grasp the connection between,
as he put it: “private property, greed, and the separation of labor, capital, and landed
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Chapter 12 ■ Karl Marx 291

property; between exchange and competition, value and the devaluation of men,
monopoly and competition, etc.—the connection between this whole estrangement
and the money system” (Manuscripts, p. 107).
Moreover, Marx criticized political economy on the basis of social contradic-
tions that he had empirically observed. The basic contradiction he cited is that “the
worker becomes all the poorer the more wealth he produces . . . [he] becomes an
ever cheaper commodity the more commodities he creates” (Manuscripts, p. 107).
The devaluation of workers, in other words, proceeds in direct proportion to the
increasing value of commodities, and in the process workers confront the objects of
their labor (commodities) as things outside themselves, things that, once com-
pleted, they have no control over or ownership of—as alien things, a power inde-
pendent of its producer. This idea, of course—that labor is by its very nature the
externalizing of a human capacity—Marx got from Hegel. But he now criticized
economics for concealing the alienation inherent in the nature of labor by not con-
sidering the direct relation between the worker and production. This relationship,
so assiduously analyzed by Marx, is the hallmark of Marxian economics and is the
feature that distinguishes it most from classical economics.

The Grundrisse (1857–1858)

Marx’s Manuscripts of 1844 represent an initial foray into economic criticism by
a young radical. They do not have the polish or incisiveness of his magnum opus
published more than two decades later. But in the ensuing years, Marx perfected the
tools of analysis he inherited from the classical economists, and persistently worked
them into his dialectic. By 1858 he had accumulated a number of manuscripts that
collectively might be considered an outline and draft version of the technical argu-
ments later used in his magnum opus, Capital. This collection of papers bears the
title Grundrisse der Kritik der Politischen Ökonomie (Outlines of the Critique of
Political Economy). Only fragments of the Grundrisse have been translated into
English, but they reveal some things that are not included in Capital, such as a dis-
cussion of precapitalist systems and a study of the interrelations of the component
parts of capitalism (e.g., production, distribution, exchange, and consumption).
Marx upbraided the classical economists for their basically ahistorical view of
production. In the Grundrisse, he sought to relate the process of production to the
stage of social development. He particularly took issue with Mill’s position that pro-
duction—as opposed to distribution—is subject to immutable laws independent of
history (see chapter 8). His own view was that production takes place within a
social context and only by individuals who are at a certain stage of social develop-
ment. Moreover, every form of production creates its own legal relations and forms
of government. Marx concluded that the so-called general conditions of production
espoused by the classical economists were nothing more than abstract concepts
that together did not make up any real stage in the history of production.
These abstract concepts make it impossible, said Marx, for economics to deal
with the true nature of capitalist production—which involves the study of labor as
basic to productive enterprise, the analysis of the historical bases of capitalist pro-
duction, and the examination of the fundamental conflict between bourgeoisie and
proletariat. Marx began to weave together these ideas in his Grundrisse. He final-
ized his labor theory of value and his theories of surplus value, and of money. The
following year, in A Contribution to the Critique of Political Economy, Marx unveiled
his thesis that conflict between the development of the productive forces and the
relations of production provides the driving force of social revolutions. Thus, by
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292 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

1860, the foundation was set for Marx’s crowning achievement. The first volume of
Capital appeared in 1867. (On the comparative frameworks of Smith and Marx, see
the box, Method Squabbles 3: Invisible Hand or Heavy Fist?)

Method Squabbles 3: Invisible Hand or Heavy Fist?

When economics was still a fledgling science, Adam Smith carefully elaborated his vision
of a productive economy that achieves economic growth and prosperity by relying on indi-
vidual initiative and limited government. His implicit acceptance of the revolutionary slogan,
“that government governs best which governs least” rests on his belief that coordination and
harmony will come about in a market economy through the free play of competition.
Marx claimed that Smith merely parroted the interests of the ruling capitalist class, which
he referred to as the bourgeoisie. In contrast to Smith, he characterized the market process as a
disorganized, uncoordinated system, in which producers typically overproduce and consum-
ers exercise no choice over their purchases. According to Marx, the main feature of capitalism
was “the anarchy of production.” He denounced capitalists as thieves who robbed the work-
ers by paying them less than the full value of their services, a situation he termed the exploita-
tion of labor.
To Marx, it made no sense to describe the market as organized economic activity because
there was no organizer. He maintained that coordination of economic activity required con-
scious, centralized control. Thus, he proposed an alternative social system whose goal would
be to eliminate exploitation and increase the efficiency of production. In the end, all society
would be turned into one immense factory, directed by workers themselves, who would be
liberated from the shackles of capitalism. Marx denigrated Smith’s “invisible hand” as a euphe-
mism for the existing chaotic order, in which “chance and caprice have full play in distributing
the producers and their means of production among the various branches of industry.”
At base, a fundamental point of method separates Smith from Marx. Whereas Smith
reflected the Enlightenment emphasis on the primacy of the individual, Marx mirrored the
German ideology of group supremacy. It is as though, for Marx, the workers have no individ-
ual faces or interests; instead they are defined by their membership in a common body, which
Marx called (borrowing Sismondi’s term), the proletariat. Identity does not exist apart from
this group. Marx would not admit that any meaningful gains for the proletariat could arise
from economic growth in the existing capitalist regime. Thus, meaningful revolutionary
reform for Marx simply meant displacing one group of rulers (the bourgeoisie) with another
(the proletariat).
By not looking beyond the problems of collective decision making (no matter who the rul-
ers), Marx put a far greater burden than did Smith on the innate goodness of mankind. Smith
may not have approved entirely of the human behavior he observed, but he took mankind as
he found it. For his part, Marx believed in the perfectibility of society because he believed in
the perfectibility of human nature. After more than a century of experience with Marxist
schemes of collective organization, we appear to be no closer to his ultimate “reality.”

■ THE NATURE OF CAPITALISM

At this point in our review of Marx it should be clear that by the time he was
ready to write Capital, he had certain clear-cut objectives in mind—objectives that
were consistent with his dialectical view of history. Specifically, he wanted to show
(1) how the commodity form of market exchange leads to class conflict and exploi-
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Chapter 12 ■ Karl Marx 293

tation of the labor force, (2) how the commodity system will be thwarted eventually,
and fail to operate because of its own inherent contradictions, and (3) why class
conflict under capitalism, unlike class conflicts under earlier economic systems, will
ultimately lead to rule by the exploited rather than by a new ruling class.
Marx conceived capitalism as an economic system in which people make a liv-
ing by buying and selling things (i.e., commodities). Commodities, he said, are dis-
tinguished by four characteristics. They are: (1) useful, (2) produced by human
labor, (3) offered for sale in the market, and (4) separable from the individual who
produced them. In Capital, Marx set out to analyze the production and distribution
of commodities. Any such explanation would be empty without a theory of value.
For inspiration and authority, he turned to Smith and Ricardo on this point.

The Labor Theory of Value

After a careful review of classical economic literature, Marx determined that
labor is the essence of all value. To him, value was an objective property of each and
every commodity. It therefore had to be rooted in something more substantial than
the purely “superficial” market forces of supply and demand. In fact, Marx could
not abide purely subjective valuations (by utility comparisons, for example) because
he was a materialist who held that material relations alone determine value. He also
believed that these relations determine value prior to the determination of price, so
that price reflects merely a value caused by the purely objective element common to
all commodities, which is to say, labor.
Contradiction in Classical Value Theory? We have seen that classical eco-
nomics contained not one but two theories of exchange value: the short-run deter-
mination of price by supply and demand and the long-run theory of “natural price,”
or cost of production. Marx sensed a contradiction in this conventional presenta-
tion. The theory of natural price holds that price is invariant in the long run,
whereas even casual observation tells us that market prices fluctuate constantly. If
such fluctuations are the result of mere chance, then so, too, are economic crises.
Marx could not admit this prospect without denying his theory of dialectical materi-
alism, so it is no surprise that he rejected classical value theory. In Wage Labour and
Capital he wrote: “It is solely in the course of these fluctuations that prices are
determined by the cost of production. The total movement of this disorder is its
order” (Marx–Engels Reader, p. 175).
Seemingly contradictory statements like this animate Marx’s dialectic, while
stirring consternation among the uninitiated. “What does he mean?” The answer is
that Marx recognized, as did the classical economists, that under competition mar-
ket prices do not fluctuate randomly but revolve around a definite point. If the sell-
ing price of a commodity falls below its cost of production for too long, its producer
is forced out of business. If the selling price exceeds the cost of production, excess
profits arise, which attract competitors and lead temporarily to overproduction,
driving prices down. Consequently, the point around which competitive market
price fluctuates is cost of production. To Marx, however, this meant labor costs and
labor costs alone. Thus, he saw value as being determined not by the “laws of the
market” but by production itself.
Murray Wolfson, a prominent Marxian scholar, has explained the matter in
another way. Market prices are ideal (i.e., subjective) estimates of the ratios of
exchange by potential buyers and sellers. But competition forces these ideal esti-
mates to conform to the material reality of the labor consumed in their production.
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294 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

One might, of course, explain prices directly by the interaction of these ideal esti-
mates until the subjective valuations are in equilibrium. Marx’s materialism, how-
ever, closed that avenue. The direction of causation cannot be from the ideal
valuation to the objective exchange ratio. To conform to Marx’s belief system a sci-
entific explanation must go from the material to the ideal. Hence, Marx’s labor the-
ory of value is unique because it is rooted in materialist philosophy.
Wages and Capital. Having settled on an objective labor theory of value,
Marx faced Ricardo’s problems anew: (l) If labor is the essence of exchange value,
what is the exchange value of labor? (2) How is the value of goods produced by
machinery determined? Marx approached the first problem this way. The value of
labor power may be divided into an amount necessary for the subsistence of labor
and an amount over and above that. The former, which Marx called “socially neces-
sary labor,” determines the exchange value of labor itself—its wage. The latter,
termed “surplus value,” is appropriated by the capitalist. Marx made it clear that
capitalism could not exist unless the worker produced a value greater than his or
her own subsistence requirements:
If a day’s labor was required in order to keep a worker alive for a day, capital could
not exist, for the day’s labor would be exchanged for its own product, and capital
would not be able to function as capital and consequently could not survive. . . . If,
however, a mere half-day’s labor is enough to keep a worker alive during a whole
day’s labor, then surplus value results automatically. (Grundrisse, p. 230)

Marx asserted that surplus value arises in production, not exchange. Thus, the
capitalist turns to labor to get surplus value from each worker engaged in production,
a process described by Marx as “exploitation of labor.” Exploitation exists because
the extra value contributed by labor is expropriated by the capitalist. Surplus value
arises not because workers are paid less than they are worth but because they pro-
duce more than they are worth. Since this extra amount is expropriated by the own-
ers of land and capital, surplus value may be regarded as the sum of the nonlabor
shares of income (i.e., rent, interest, and profit) that comprise the price of final goods.
Marx touted the concept of surplus value as his main achievement, and it is an
integral part of his central theme of class conflict and revolution. Two classes
emerge under capitalism, with one class being forced to sell its labor power to the
other in order to earn a living. This contractual arrangement transforms labor into a
commodity alien to the worker. Without the difference between the exchange-value
of labor (i.e., its subsistence wage) and its use-value (value of labor’s output), the
capitalist would have no interest in buying labor power; hence, it would not be sal-
able and its commodity-like character would disappear. So for Marx the ingredients
for social conflict—alienation and polarization of classes—are inherent in the
nature of capitalism.
Ricardo had proffered labor as the best measure of value, though not necessar-
ily as the sole cause of value. Marx trumped Ricardo. He saw labor as both the mea-
sure and the cause of value. Moreover, he held that only labor—not machines—can
produce surplus value. How, then, does one value machinery? Ricardo fumbled
awkwardly with this question. Marx answered that machines are “congealed labor”
and therefore equal in value to the cost of the labor that produced them. This is a
forced answer, because it denies that machines are productive in themselves and
should therefore be valued in excess of the labor that has gone into their produc-
tion. Nevertheless, Marx was so committed to the labor theory of value that he
either ignored this objection or relegated it to minor importance.
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Chapter 12 ■ Karl Marx 295

The “Great Contradiction.” Some of Marx’s critics raised a serious objection

to the labor theory in the form of what has come to be known as the “great contra-
diction,” which was posed in terms of the following question: If the exchange value
of commodities is determined by the labor time they contain, how can this be recon-
ciled with the empirically observed fact that the market prices of these commodities
frequently differ from their labor values? Or to put it another way: Inasmuch as
competition guarantees a uniform rate of profit throughout the economy, how do we
account for the different capital/labor ratios that exist across industries? A Marxian
theory of value (i.e., labor alone creates surplus value) holds that profits are higher
in labor-intensive industries, but empirically this is not the case. Thus, since capital/
labor ratios differ while the rate of profit remains uniform, it cannot be true, Marx’s
critics argued, that value is determined by payments to labor alone.
Marx may have anticipated this problem in his early writings, but his celebrated
rebuttal to his critics is contained in the third volume of Capital, published posthu-
mously by Engels. Marx invoked the theory of the competition of capitals, which
operates to establish a uniform rate of profit for all firms engaged in production. He
then added the aggregate, average profit so-derived to the (different) costs of pro-
duction in different industries, and found that the individual deviations of market
prices from true (labor) values tend to cancel out (in the aggregate). Lo and behold!
Problem solved! Marx’s “solution” is demonstrated below in the discussion of the
transformation problem. However, the solution requires the use of peculiar Marxian
terms, which we now attempt to explicate.
Some Marxian Definitions. Marx’s “solution” to the great contradiction uti-
lized certain terminology that he borrowed from classical economics and other
terms of his own invention. What follows is a thumbnail sketch of his terms, includ-
ing their “mathematical” notation.
Constant capital (c) = charges on fixed capital (i.e., depreciation
plus the cost of raw-material inputs)
Variable capital (v) = total wages paid to labor
Outlay (k) = cost of production (excluding profit), or c + v
Surplus value (s) = contribution of workers for which they are
not paid, or excess of gross receipts over the
sum of constant and variable capital
Rate of surplus value (s) = ratio of surplus value to variable capital
employed, or s/v
Rate of profit (p) = ratio of surplus value to outlay, or s/(c + v)
Organic composition of capital (O) = ratio of capital to labor employed in production
Although the terminology is peculiar to Marx, the concepts employed are famil-
iar to contemporary students. For example, in terms of national income accounting
it could be said that GNP = c + v + s and NNP = v +s.
The Transformation Problem. On Marx’s behalf, and citing his authority in
Volume 3 of Capital, Engels presented Marx’s “solution” to the great contradiction
with the aid of an illustration replicated on the following page as table 12-1. Marx’s
analysis and discussion rest on three major assumptions: (1) different commodities
are produced with different organic compositions of capital (i.e., different capital/
labor ratios) and use up constant capital at different rates in production; (2) for con-
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296 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

Table 12-1 Transformation of Values into Prices

(1) (2) (3) (4) (5) (6) (7) (8) (9)
Deviation
Capital of Price
Used Surplus Labor Average Sales from
Commodity Capitals Up Cost Value Value Profit Price Value†
A 80c + 20v 50 70 20 90 22 92 +2
B 70c + 30v 51 81 30 111 22 103 –8
C 60c + 40v 51 91 40 131 22 113 –18
D 85c + 15v 40 55 15 70 22 77 +7
E 95c + 5v 10 15 5 20 22 37 +17
Totals 500* 202 312 110 422 110 422 0
*This total includes a combination of “stocks” and “flows” (c + v) and is used to determine the average profit in col-
umn 7.
†
Although the sales price (column 8) and labor value (column 6) differ for each commodity, column 9 shows the alge-
braic sum of individual differences is zero.

venience, the rate of surplus value is taken to be 100 percent; and (3) competition
will tend to equalize the rate of profit among industries at the “average rate,” that is,
the ratio of aggregate surplus value to aggregate outlay.
Marx noted that the organic composition of capital in any single industry will
depend on the technical relation of labor power to other means of production. But
for purposes of illustration, the ratios of constant capital to variable capital in table
12-1 are arbitrarily chosen. Five different commodities are represented in column 1,
each produced with different capital/labor ratios, as revealed in column 2. Commod-
ity A, for example, is produced with 80 units of constant capital and 20 units of vari-
able capital. For simplicity assume that 80 and 20 are dollar expenditures so that the
heterogeneous units of “capital” and “labor” can be summed to determine outlay in
each of the five industries. It can be noted, therefore, that outlay equals $100 in each
industry and that the aggregate outlay of the simple economy is $500. Column 3
shows the units of constant capital used up in the production process for each of the
five industries. The dollar cost of each commodity is determined in column 4 by
adding wage costs (variable capital) to column 3. Land is left out of the illustration
as a means of production but can easily be accommodated along with constant cap-
ital. Column 5 shows surplus value in each industry, entered at 100 percent of
expenditures on variable capital. Column 6 reveals the “true” value (labor value) of
each commodity according to Marx’s labor theory. The values in this column are
determined by adding cost (column 4) to surplus value (column 5).
According to Marx, the cost of a commodity differs from its sales price by the
average amount of profit, which is added to cost (column 4) in order to determine
the sales price (column 8). Column 7 is the average profit for each industry and is
uniform across industries because of the law of competition. The profit rate in
Marxian terms is s/(c + v), or 110/500 = 0.22, which, when multiplied by the outlay
in each industry ($100), yields the dollar amounts shown in column 7. A comparison
of columns 8 and 6 shows that market price differs from labor value for each com-
modity, as the critics contended, but column 9 reveals that the algebraic sum of the
individual differences is zero. Marx concluded: “The deviations of prices from val-
ues mutually balance one another by the uniform distribution of the surplus value,
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Chapter 12 ■ Karl Marx 297

or by the addition of the average profit of 22 percent of advanced capital to the

respective cost-price of the commodities” (Capital, vol. 3, p. 185).
This so-called transformation of values into prices supports Marx’s contention
that in the aggregate, labor is the true source of value, and in his preface to the third
volume of Capital, Engels touted it as a triumph over Marx’s critics. The truth is,
however, that few economists today are willing to accept the transformation prob-
lem as a valid substantiation of the labor theory of value. Ingenious as it is, Marx’s
solution denies that machinery is productive over and above the amount of labor
congealed in it, a view that modern economists find counterintuitive and empiri-
cally invalid.
It should be noted that in the final analysis, the mechanics of value theory was
of relatively minor importance to Marx, who was more interested in the construc-
tion of a quasi-Ricardian model of the development of an entire socioeconomic sys-
tem. The narrower subject of value theory gained importance after Marx’s death
because of an emphasis on price determination in neoclassical economics. More-
over, debates over the transformation problem have been more intense among neo-
classical economists than among neo-Marxians.

The Laws of Capitalist Motion

The dynamics of Marx’s theory—what he called “the laws of capitalist
motion”—represents a major departure from classical economics and reflect Marx’s
emphasis on technological change as the driving force of his economic theory.
Adam Smith was a preindustrial writer who understood progress in terms of ratio-
nal human behavior rather than in terms of technical advance. David Ricardo had
very limited industrial experience; it was never his intention to recast political econ-
omy as a theory of technological change. If anything, he saw the economic chal-
lenge to society as an agricultural problem. John Stuart Mill was more open to the
prospects of technological change, yet he did not make it a core element of his the-
ory as Marx did. Marx described five laws, or general tendencies, inherent in capi-
talism. Each stemmed from the dynamic nature of the economy, and each was
rooted in the conflict between the dynamic “forces of production” and the static
“relations of production.”
The Law of Accumulation and the Falling Rate of Profit. Under capitalism,
business people try to acquire more surplus value in order to increase their profit.
By Marx’s definition surplus value is derived from labor. Thus, we might expect
capitalists to seek out labor-intensive production methods in order to maximize
their profits. In fact, however, entrepreneurs continually strive to substitute capital
for labor. Marx spelled out the incentive:
Like every other increase in the productiveness of labour, machinery is to cheapen
commodities, and, by shortening the portion of the working day, in which the
labourer works for himself, to lengthen the other portion that he gives, without
equivalent, to the capitalist. In short, it is a means for producing surplus value.
(Capital, vol. 1, p. 405)

The individual capitalist can profitably substitute capital for labor because it takes
time to adjust to new methods of production. This gives the first capitalist to intro-
duce labor-saving machinery a differential advantage. Mechanized firms will be
able to produce at lower costs than the average market price that is determined by
productive conditions of more-mechanized and less-mechanized firms.
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298 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

However, what is true for the individual is not true for all. If every capitalist
introduces more machinery, the organic composition of capital rises, surplus value
falls, and so does the average rate of profit. (Verify this from table 12-1.) Hence, the
collective result of each capitalist’s drive to accumulate more capital and more
profit tends to drive down the average rate of profit. Another reason why the rate of
profit might fall over time is that workers may push for higher wage rates. If real-
ized, this prospect will drive up production costs, while prices will still be deter-
mined by “socially necessary labor.” Ricardo recognized this prospect, but he felt
that such a development would be checked by the Malthusian population trap. But
Marx was no Malthusian; he maintained that population is culturally and socially
determined. Therefore, higher wages will not necessarily be forced down again by
rapid population growth.
The Law of Increasing Concentration and the Centralization of Industry. The
drive for profit described above eventually and inevitably leads to a greater substi-
tution of capital for labor and transforms small-scale industry into large-scale enter-
prises with greater division of labor and far more output capacity. This increase in
production and productive capacity, Marx felt, would lead to general overproduc-
tion, thus driving prices down to the point where only the most efficient producers
would survive. The less efficient firms would be driven out of business by this pro-
cess, and their assets then gobbled up by the survivors. As a result, industry would
become more and more centralized, and economic power would be increasingly
concentrated in the hands of a few.
The Law of a Growing Industrial Reserve Army. The dynamic change caused
by technological innovation and capital-labor substitution has a drastic effect on the
working class, namely unemployment. In the passage below, note how Marx turns
into a curse the division of labor that Smith hailed as an economic blessing:
The self-expansion of capital by means of machinery is directly proportional to the
number of workers whose means of livelihood have been destroyed by this
machinery. The whole system of capitalist production is based upon the fact that
the worker sells his labour power as a commodity. Thanks to the division of labour,
this labour power becomes specialised, is reduced to skill in handling a particular
tool. As soon as the handling of this tool becomes the work of a machine, the use-
value and the exchange-value of the worker’s labour power disappear. The worker
becomes unsalable, like paper money which is no longer legal tender. That portion
of the working class which machinery has thus rendered superfluous . . . either
goes to the wall in the unequal struggle of the old handicraft and manufacturing
industry against machine industry, or else floods all the more easily accessible
branches of industry, swamps the labor market, and sinks the price of labour-
power below its value. (Capital, vol. 1, p. 470)

Marx maintained that this displacement of workers by machines creates a

“growing industrial reserve army of unemployed,” one of the inherent contradic-
tions he attributed to capitalism. As the foregoing discussion illustrates, this unem-
ployment is of two types: (1) technological unemployment (caused by the
substitution of machinery for labor) and (2) cyclical unemployment (caused by over-
production, which in turn is caused by increasing concentration and centralization).
The Law of Increasing Misery of the Proletariat. Marx claimed that the col-
lective misery of the proletariat increases as the industrial reserve army grows. To
make matters worse, capitalists will try to offset a falling rate of profit by lowering
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Chapter 12 ■ Karl Marx 299

wages, imposing longer workdays, introducing child and female labor, and so forth,
all of which contributes to the absolute misery of the working class.
The first effect of this reactive widespread use of machinery is to bring women
and children into the labor force, because slight muscular strength can be amplified
by the use of machines. Instead of selling only his own labor power, therefore, the
worker is forced to sell that of his wife and children. Hence, Marx says, the worker
“becomes a slave trader.” Increased exposure to the rigors of factory life leads to
high child mortality rates and to moral degradation among women and children.
Marx cited public health reports in Britain in an attempt to confirm these allegations.
Because it is the most powerful means for shortening the working time required
to produce a commodity the machine also becomes the most powerful means for
prolonging the workday, allowing the capitalist to appropriate more surplus value.
Because specialized and costly machinery left idle even for short periods is expen-
sive to capitalists, they strive to minimize the length of idle machine time. The
results of adding capital inputs, therefore, are longer workdays, less leisure time,
and more misery for the laborer. Longer workdays and intensification of work effort
sap the strength and endurance of the working class.
From a historical standpoint, this seems the least valid of Marx’s arguments. In
strictly economic terms, Marx’s doomsday prophecy has not come to pass. Of
course it is unclear whether the working class has made great economic strides
because of Marx’s influence or despite his prediction of increasing misery. At any
rate, his formulation of the increasing-misery doctrine does not lend itself readily to
empirical testing. Some Marxists have attempted to reconcile actual working condi-
tions with this part of Marx’s theory by asserting that the relative misery of the
working class has increased—they point to the dehumanizing effects of today’s
automated production, or to the increasing alienation and polarization of workers
and ethnic minorities. But it is fair to say that such arguments have not proved per-
suasive to non-Marxists.
The Law of Crises and Depressions. Marx linked the explanation of business
cycles to investment spending. In this he anticipated Keynes (see chapter 21) and
other economists of a later generation. He noted that capitalists will invest more at
some times than at others. When the army of unemployed grows and wages fall,
capitalists will tend to hire more labor and invest less in machinery and equipment.
But when wages rise capitalists will substitute machines for workers, bringing
about unemployment and depressed wages, precipitating periodic crises. He tied
these periodic crises to his increasing-misery doctrine. The mere occurrence of cri-
ses was not enough; Marx had to show capitalism’s susceptibility to crises of
increasing severity. He did this by stressing the never-ending drive of the capitalist
to accumulate. But this drive to accumulate is, for Marx, self-contradictory because
it leads to the overproduction of capital, and thus to repeated crises:
As soon as capital would have grown to such a proportion compared with the
labouring population, that . . . the increased capital produces no larger, or even
smaller, quantities of surplus-value than it did before its increase there would be
an overproduction of capital. That is to say, increased capital C + C would not
produce any more profit . . . there would be a strong and sudden fall in the average
rate of profit . . . due to a change in the composition of capital. (Capital, vol. 3, pp.
294–295)

The falling average rate of profit occasioned by the introduction of more

machinery signals the impending crisis. Over time, Marx argued, these crises would
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300 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

become more severe; that is, they would affect more people (because of increases in
population over time), and last longer. Marx maintained there would be a tendency
toward permanent depression because the industrial reserve army gets larger as the
crises become more severe. The logical outcome of such a tendency is social revolu-
tion. Eventually the proletariat must unite, throw off their chains, and take over the
means of production.

The End of Capitalism and Beyond

According to Marx the classical economists misrepresented the economic sys-
tem insofar as they considered money a mere medium of exchange. Commodities
rarely trade for other commodities directly; instead, they are sold for money, which
is then used to purchase other commodities. Symbolically, the classical representa-
tion of production and exchange is C–M–C, where C stands for commodities and M
stands for money. But Marx held that in a capitalist economy, the process is M–C–M,
where M > M. In other words, money (capital) is accumulated to purchase (or pro-
duce) commodities, which are then sold for an even greater sum of money. M is M
plus profit (surplus value). We have seen that in the Marxian system the drive to
accumulate surplus value involves the kind of internal contradictions that lead to the
demise of the capitalist economy.
Marx’s writings leave no doubt that he believed in a global revolution, although
he rarely discussed the nature of the post-capitalist world. We know that the new
society he envisioned was to be a communist one in which bourgeois private prop-
erty would no longer exist, because he speaks of:
communism as the positive transcendence of private property, or human self-
estrangement, and therefore as the real appropriation of the human essence by and
for man; communism therefore as the complete return of man to himself as a
social (i.e., human) being—a return become conscious, and accomplished within
the entire wealth of previous development. This communism, as fully developed
naturalism, equals humanism, and as fully developed humanism equals natural-
ism; it is the genuine resolution of the conflict between man and nature and
between man and man—the true resolution of the strife between existence and
essence, between objectification and self-confirmation, between freedom and
necessity, between the individual and the species. Communism is the riddle of his-
tory solved, and it knows itself to be this solution. (Manuscripts, p. 135)

In The Communist Manifesto, Marx spoke of communism as a revolutionary

new mode of production and described a ten-point communist agenda that he envi-
sioned for advanced economies (pp. 31–32):
These measures will of course be different in different countries. Nevertheless in
the most advanced countries the following measures will be generally applicable.

1. Abolition of property in land and application of all rents of land to public purposes
2. A heavy progressive or graduated income tax
3. Abolition of all right of inheritance
4. Confiscation of the property of all emigrants and rebels
5. Centralization of credit in the hands of the state, by means of a national bank
with state capital and an exclusive monopoly
6. Centralization of the means of communication and transport in the hands of
the state
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Chapter 12 ■ Karl Marx 301

7. Extension of factories and instruments of production owned by the state, the

bringing into cultivation of wastelands, and the improvement of the soil gener-
ally in accordance with a common plan
8. Equal obligation of all to work; establishment of industrial armies, especially
for agriculture
9. Combination of agriculture with manufacturing industries; gradual abolition
of the distinction between town and country by a more equitable distribution
of the population over the country
10. Free education for all children in public schools; abolition of children’s fac-
tory labor in its present form; combination of education with industrial pro-
duction, etc.

This ten-point program raises a number of questions regarding implementation

and operation, but Marx stopped short of giving his followers a blueprint for imple-
mentation. Obviously he saw his task as the analysis of capitalism and its internal
contradictions, and apparently he preferred to leave the building of new societies to
others. Consequently, after Marx’s death the door was left ajar for considerable con-
troversy and disagreement over the applied aspects of his political economy. A bit-
ter battle near the turn of the century between moderate revisionists, such as
Eduard Bernstein, and the militant Marxists/Leninists ensued. Bernstein admirably
summed up the genius and the pitfalls of Marx’s ideas this way:
A dualism runs through the whole monumental work of Marx . . . the work aims at
being a scientific inquiry and also at proving a theory laid down long before its
drafting. Marx had accepted the solution of the Utopians in essentials, but had rec-
ognized their means and proofs as inadequate. He therefore undertook a revision
of them, and this with the zeal, the critical acuteness, and love of truth of a scien-
tific genius. . . . But as Marx approaches a point when that final aim enters seri-
ously into question, he becomes uncertain and unreliable. . . . It thus appears that
this great scientific spirit was, in the end, a slave to a doctrine. (Evolutionary
Socialism, pp. 209–210)

■ CONCLUSION
Marx had a profound influence on the twentieth century, and it is a testimonial
to his far-ranging intellect that his influence surpassed the boundaries of econom-
ics. Even within the narrow discipline of economics, however, Marx’s reach
extended far beyond the small group of economists who were Marxist in the strict
sense—people such as Paul Sweezy, Maurice Dobb, Paul Baran, and Ernest Mandel,
to name a few. Any economist who reasons from the primacy of production in
explaining economic relations may be said to have felt the influence of Marx. (Piero
Sraffa is perhaps the leading example of a later generation). The same can be said
for those who embrace the dialectical method, whether or not they accept the ulti-
mate conclusions of Marx’s analysis.
In Marx’s time, the dialectical method, especially its Hegelian variant, perme-
ated the Continent, whereas the English-speaking world remained aloof, more
influenced by the empiricism of Locke and Hume. As a result, scientific thought in
general has been empirical in nature while social, political, and theological thought,
especially with its roots on the Continent, has tended to be dialectical. This has led
to very different perspectives, which explains the observed lack of understanding
and tolerance between the different intellectual traditions.
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302 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

Modern Marxists have ostensibly rallied around the essential core of humanism
in Marx’s thought. The complexities of mass production and the “third world”
deprivation of various groups and nations have made the kind of alienation Marx
described seem very real to a large segment of society. Even those who decry the
necessity of violent revolution for meaningful social change are often spurred by a
Marx-like humanism to seek alternative forms of social reform. In the end, this may
prove to be the most durable part of Marx’s legacy.

REFERENCES
Bernstein, Eduard. Evolutionary Socialism: A Criticism and Affirmation, E. C. Harvey
(trans.). New York: Schocken Books, 1965.
Feuerbach, Ludwig Andreas. The Essence of Christianity, Marian Evans (trans.). London:
John Chapman, 1854.
Marx, Karl. A Contribution to the Critique of Political Economy, S. W. Ryazanskaya
(trans.). Moscow: Progress Publishers, 1970.
———. Capital, Ernest Untermann (trans.) and F. Engels (ed.). 3 vols. Chicago: Charles
Kerr, 1906–1909.
———. Grundrisse der Kritik der Politischen Ökonomie, 2 vols. Berlin: Dietz-Verlag, 1953.
———. Economic and Philosophic Manuscripts of 1844, Martin Milligan (trans.) and D. J.
Struik (ed.). New York: International Publishers, 1964.
———. Precapitalist Economic Formations, J. Cohen (trans.) and E. J. Hobsbawm (ed.).
New York: International Publishers, 1965.
———. Writings of the Young Marx on Philosophy and Society, L. D. Easton and K. H.
Guddat (eds. and trans.). Garden City, NY: Anchor Books, Doubleday, 1967.
———, and F. Engels. The Communist Manifesto, Samuel H. Beer (ed.). New York:
Appleton-Century-Crofts, 1955.
———. The Marx–Engels Reader, R. C. Tucker (ed.). New York: W. W. Norton, 1972.
Wolfson, Murray. A Reappraisal of Marxian Economics. New York: Columbia University
Press, 1966.

NOTES FOR FURTHER READING

The standard source of biographical information on Marx is Franz Mehring’s Karl
Marx: The Story of His Life, Edward Fitzgerald (trans.) (London: G. Allen, 1936). Two other
sources worth mention are E. H. Carr’s Karl Marx: A Study in Fanaticism (London: Dent,
1934); and Robert Payne’s more recent Marx (New York: Simon & Schuster, 1968). The
personal side of Marx is explored by Edmund Wilson in To the Finland Station (Garden
City, NY: Doubleday, 1940). See also David McLellan, Karl Marx (New York: Viking, 1975).
Ernest Mandel has written several interpretative works on Marx’s economics. An
Introduction to Marxist Economic Theory (New York: Pathfinder Press, 1970) is a brief
and highly readable introduction to Marxian economics for student and professor alike.
Thomas Sowell, Marxism (New York: William Morrow, 1985) presents another lucid and
carefully reasoned account. The Formation of the Economic Thought of Karl Marx, Brian
Pearce (trans.) (New York: Monthly Review Press, 1971), is more difficult but neverthe-
less very instructive. Finally, Mandel’s two-volume work, Marxist Economic Theory,
Brian Pearce (trans.) (New York: Monthly Review Press, 1968), challenges the most
ardent Marx enthusiast. For another view on the development of Marx’s economics, see
Roman Rosdolsky, The Making of Marx’s “Capital” (London: Pluto Press, 1977). The
impact of Marx’s ideas, both as originally propounded and as interpreted and reformu-
lated over the years, is the subject of David McLellan (ed.), Marx: The First 100 Years
(New York: St. Martin’s Press, 1983).
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Chapter 12 ■ Karl Marx 303

Two works that compare and contrast Marx to other major thinkers are Spencer
Pack, Aristotle, Adam Smith and Karl Marx: On Some Fundamental Issues in 21st Cen-
tury Political Economy (Cheltenham, U.K.: Edward Elgar, 2010); and Heinz D. Kurz,
“Technical Progress, Capital Accumulation and Income Distribution in Classical Eco-
nomics: Adam Smith, David Ricardo and Karl Marx,” The European Journal of the His-
tory of Economic Thought, vol. 17, (December 2010), pp. 1183–1222, which discusses
how the classical authors developed a sophisticated typology of forms of technological
change that can be analyzed in terms of an inverse movement of wages and profits. Fer-
dinando Meacci, “Different Divisions of Capital in Smith, Ricardo and Marx,” Atlantic
Economic Journal, vol. 17 (December 1989), pp. 13–21, provides a different kind of com-
parison between Marx and Ricardo involving divisions of capital.
The development and continuity of Marx’s thought has been discussed by later writ-
ers, both in regard to Marx’s overall thought and in regard to specific aspects of his ana-
lytical system. See, for example, Murray Wolfson, “Three Stages in Marx’s Thought,”
History of Political Economy, vol. 11 (Spring 1979), pp. 117–146, in which he argues that
Marx was successively an empiricist, a humanist, and a materialist, and that his concep-
tion of the ideal society changed with each successive stage. Regina Roth, “Marx on
Technical Change in the Critical Edition,” The European Journal of the History of Eco-
nomic Thought, vol. 17, (December 2010), pp. 1223–1251, examines Marx’s fascination
with technological progress, both in terms of its negative effects on the working class
and its revolutionary power to transform society.
The following articles stress Marx’s early thought on various aspects of his mature
theory: J. E. Elliot, “Continuity and Change in the Evolution of Marx’s Theory of Alien-
ation: From the Manuscripts through the Grundrisse to Capital,” History of Political Econ-
omy, vol. 11 (Fall 1979), pp. 317–362; Allen Oakley, “Aspects of Marx’s Grundrisse as
Intellectual Foundations for a Major Theme in Capital,” History of Political Economy, vol.
11 (Summer 1979), pp. 286–302; and Arie Arnon, “Marx’s Theory of Money: The Forma-
tive Years,” History of Political Economy, vol. 16 (Winter 1984), pp. 555–576. Arnon
shows, for example, how Marx’s monetary theory evolved from a Ricardian starting point
but wound up against Ricardo on the side of Thomas Tooke. Suzanne Brunhoff, Marx on
Money, M. J. Goldbloom (trans.) (New York: Urizen Books, 1976), presents a mature view
of Marx’s monetary theory, which Arnon supplements by his historical work. For more on
the subject of Marx’s monetary theory, see Don Lavoie, “Marx, the Quantity Theory, and
the Theory of Value,” History of Political Economy, vol. 18 (Spring 1986), pp. 155–170,
who accuses Marx of being a “closet” quantity theorist; and Murray Wolfson, “Comment:
Marx, the Quantity Theory, and the Theory of Value,” History of Political Economy, vol. 20
(Spring 1988), pp. 137–140, who explains the dualism in Marx’s thought that underlies
Lavoie’s interpretation. Eckhard Hein, “Money, Interest and Capital Accumulation in Karl
Marx’s Economics: A Monetary Interpretation and Some Similarities to Post-Keynesian
Approaches,” The European Journal of the History of Economic Thought, vol. 13 (Winter
2006), pp. 113–140, argues that many elements of Marx’s economics are comprised of
monetary analysis rather than real analysis. He claims that Marx’s theory of value, his
rejection of Ricardo on Say’s law, and his theories of credit and interest fit this pattern.
The influence of classical economics on Marx’s thought and the extent to which his
analysis emulated earlier economists has been a subject of repeated discussion. See G.
S. L. Tucker, “Ricardo and Marx,” Economica, vol. 28 (August 1961), pp. 252–269; and
Bela Belassa, “Karl Marx and John Stuart Mill,” Weltwirtschaftliches Archiv, vol. 83
(1959), pp. 147–163. Although the answer seems obvious on the surface, the question of
how close Marx’s value theory was to Ricardo’s continues to crop up. One important
source of ideas on Marx’s theory of value is I. I. Rubin, Essays on Marx’s Theory of Value
(Toronto: Black Rose Books, 1972). The proposition that labor alone is the source of sur-
plus value is explored by Stephen Merrett, “Some Conceptual Relationships in Capital,”
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304 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

History of Political Economy, vol. 9 (Winter 1977), pp. 490–503. Shalom Groll, “The
Active Role of ‘Use Value’ in Marx’s Economic Analysis,” History of Political Economy,
vol. 12 (Fall 1980), pp. 336–371, advances the unconventional view that demand played
an important role in Marx’s theory of value and that Marx’s concept of demand is closer
to modern theory than to Ricardo’s. On this subject, see also Steve Keen, “Use-Value,
Exchange Value, and the Demise of Marx’s Labor Theory of Value,” Journal of the His-
tory of Economic Thought, vol. 15 (Spring 1993), pp. 107–121, who asserts that if Marx
had been consistent in applying his own logic, he could not have advocated a labor the-
ory of value. J. S. Dreyer, “The Evolution of Marxist Attitudes toward Marginalist Tech-
nique,” History of Political Economy, vol. 6 (1974), pp. 48–75, explains how marginalist
techniques of pricing have crept into Marxian economics. The subject of value in Marx-
ian economics continues to draw attention and to spur revision. See, for example, Sam-
uel Bowles and Herbert Gintis, “The Marxian Theory of Value and Heterogeneous
Labour: A Critique and Reformulation,” Cambridge Journal of Economics, vol. 1 (June
1977), pp. 173–192; Ian Steedman, “Heterogeneous Labour, Money Wages, and Marx’s
Theory,” History of Political Economy, vol. 17 (Winter 1985), pp. 551–574, who concludes
that Marx’s concept of abstract labor is of little or no use and that his concept of value is
essentially no different from the classical concept of a quantity of labor; and David Lead-
beater, “The Consistency of Marx’s Categories of Productive and Unproductive Labour,”
History of Political Economy, vol. 17 (Winter 1985), pp. 591–618, who defends Marx’s use
of the categories and finds them consistent and effective for analyzing the determinants
and limitations of capitalist accumulation. See also Robert Chernomas, “Productive and
Unproductive Labor and the Rate of Profit in Malthus, Ricardo, and Marx,” Journal of the
History of Economic Thought, vol. 12 (Spring 1990), pp. 81–95.
Although the phrase “laws of capitalist motion” is uniquely Marxian, Marx drew
freely on classical economics, especially in formulating those “laws” relating to the
behavior of profits and wages. On Marx’s profit theory, see Angus Walker, “Karl Marx,
the Falling Rate of Profit and British Political Economy,” Economica, vol. 38 (November
1971), pp. 362–377; M. A. Lebowitz, “Marx’s Falling Rate of Profit: A Dialectical View,”
Canadian Journal of Economics, vol. 9 (May 1976), pp. 232–254; and Shalom Groll and
Z. B. Orzech, “Technical Progress and Values in Marx’s Theory of the Decline in the Rate
of Profit: An Exegetical Approach,” History of Political Economy, vol. 19 (Winter 1987),
pp. 591–614, which challenges the dominant view that Marx attributed the falling rate of
profit to changes in the organic composition of capital. For a logical (not empirical)
attempt to show that the tendency of the rate of profit to fall is not unique to capitalism,
see E. L. Khalil, “The Implication for Socialism of Marx’s Theory of the Tendency of the
Rate of Profit to Fall,” Journal of the History of Economic Thought, vol. 16 (Fall 1994), pp.
292–309.
Marx’s wage and employment theories are matters of continuing debate. On Marx’s
conviction that overproduction would be a frequent occurrence under capitalism, see
Bernice Shoul, “Karl Marx and Say’s Law.” Quarterly Journal of Economics, vol. 71
(November 1957), pp. 611–629. Immiserization (Marx’s term for the worsening condi-
tions of the proletariat) may spring from a number of causes: low wages, long hours,
unemployment, alienation, exploitation, and so forth. Murray Wolfson, Z. B. Orzech, and
Susan Hanna, “Karl Marx and the Depletion of Human Capital as Open-Access
Resource,” History of Political Economy, vol. 18 (Fall 1986), pp. 497–514, have explored
the possibility of exploitation in terms of external costs rather than in terms of Marx’s
main theoretical formulation based on the labor theory of value. They conclude that
there may be more exploitation in the former sense than in the latter. The causes of
immiserization, and the historical accuracy of Marx’s prophecy that it will increase over
time, are discussed by Thomas Sowell, “Marx’s ‘Increasing Misery’ Doctrine,” American
Economic Review, vol. 50 (March 1960), pp. 111–120; F. M. Gottheil, “Increasing Misery
Ekelund-Hebert 6E.book Page 305 Thursday, August 1, 2013 11:03 AM

Chapter 12 ■ Karl Marx 305

of the Proletariat: An Analysis of Marx’s Wage and Employment Theory,” Canadian

Journal of Economics and Political Science, vol. 28 (February 1962), pp. 103–113; R. L.
Meek, “Marx’s Doctrine of Increasing Misery,” Science and Society, vol. 26 (1962), pp.
422–441; and D. Furth, A. Heertje, and R. Van Der Veen, “On Marx’s Theory of Unem-
ployment,” Oxford Economic Papers, vol. 30 (July 1978), pp. 253–276.
The possible link between immiserization and the Malthusian population problem is
the subject of a series of papers in the American Economic Review. W. J. Baumol, “Marx
and the Iron Law of Wages,” American Economic Review, vol. 73 (May 1983), pp. 303–
308, touched off the debate by claiming that Marx did not subscribe to the view that
wage levels must fall toward subsistence under mature capitalism, a position emphati-
cally rejected by Sam Hollander, “Marx and Malthusianism: Marx’s Secular Path of
Wages,” American Economic Review, vol. 74 (March 1984), pp. 139–151; but defended by
M. D. Ramirez, “Marx and Malthusianism: Comment,” American Economic Review, vol.
76 (June 1986), pp. 543–547. Reacting to the Baumol/Ramirez versus Hollander debate,
Allin Cottrell and W. A. Darity, Jr., “Marx, Malthus, and Wages,” History of Political Econ-
omy, vol. 20 (Summer 1988), pp. 173–190, have taken the middle ground—they argue
that Baumol/Ramirez fail to establish that Marx rejected the falling-wage doctrine but
that Hollander went too far in ascribing to Marx the consistent position that wages must
be driven downward. Cottrell and Darity find that immiserization of the proletariat need
not be linked to a secular decline in real wages. Outside this debate, but on the same
general subject, Michael Perelman, “Marx, Malthus, and the Organic Composition of
Capital,” History of Political Economy, vol. 17 (Fall 1985), pp. 461–490, advances the
notion that Marx viewed the “Malthusian problem” as merely one of the many internal
contradictions of capitalism. For more on the nature of wages in the Marxian system, see
Francis Green, “The Relationship of Wages to the Value of Labour-Power in Marx’s
Labour Market,” Cambridge Journal of Economics, vol. 15 (June 1991), pp. 199–214.
The sparks of controversy have been ignited once again by Sam Hollander on yet
another issue, namely whether or not Marx’s economics may be characterized as gen-
eral equilibrium theory. Hollander argues the affirmative in “Marxian Economics as
‘General Equilibrium’ Theory,” History of Political Economy, vol. 13 (Spring 1981), pp.
121–155; but his claim has been challenged by Dusan Pokorny in “Karl Marx and Gen-
eral Equilibrium,” History of Political Economy, vol. 17 (Spring 1985), pp. 109–132, who
finds no textual evidence in Marx to support Hollander’s claim.
The most famous critique of Marx’s economics in the nineteenth century, designed
to be the definitive repudiation of Marxian analysis, was launched by the Austrian econ-
omist Eugen Böhm-Bawerk, Karl Marx and the Close of His System, Paul Sweezy (ed.)
(New York: A. M. Kelley, 1949). Joining Böhm-Bawerk in his attack on Marx was the
Russian economist Ladislaus von Bortkiewicz, “The Transformation of Values into Prices
in the Marxian System,” reprinted in the volume by Böhm-Bawerk referred to above; and
same author, “Value and Price in the Marxian System,” International Economic Papers,
no. 2 (1952). Together, these works touched off a long debate, which is still raging, on the
validity of Marx’s solution to the “transformation problem.” The following works repre-
sent a cross-section of the issues in this protracted debate: J. Winternitz, “Values and
Prices: A Solution of the So-Called Transformation Problem,” Economic Journal, vol. 58
(June 1948), pp. 276–280; K. May, “Value and Prices of Production: A Note on Winter-
nitz’s Solution,” Economic Journal, vol. 58 (December 1948), pp. 596–599; Francis Seton,
“The Transformation Problem,” Review of Economic Studies, vol. 24 (June 1957), pp.
149–160; and Ronald Meek, “Some Notes on the Transformation Problem,” Economic
Journal, vol. 66 (March 1956), pp. 94–107.
After a brief hiatus, the debate was revived in 1971 by Paul Samuelson, “Under-
standing the Marxian Notion of Exploitation: A Summary of the So-Called Transforma-
tion Problem between Marxian Values and Competitive Prices,” Journal of Economic
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306 Part III ■ Responses to the Industrial Revolution—Orthodox and Heterodox

Literature, vol. 9 (June 1971), pp. 399–431. Samuelson’s article drew additional comment
from Joan Robinson and Martin Bronfenbrenner in the December 1973 issue of the same
journal. Furthermore, the debate continued with interpretations and commentary by W.
J. Baumol and Michio Morishima and a “final word” by Samuelson in the March 1974
issue of the Journal of Economic Literature. Nevertheless, see the article by Allen Oakley,
“Two Notes on Marx and the ‘Transformation Problem,’” Economica, vol. 43 (November
1976), pp. 411–418. For an important, albeit analytically complex attempt to illuminate
the basic Marxian premises concerning value, see Murray Wolfson, “The Transformation
Problem: Exposition and Appraisal,” Journal of the History of Economic Thought, vol. 12
(Fall 1990), pp. 179–195.
Surprisingly little has been written about Marx’s vision of communism or about the
relative economic merits of socialism versus competition from a strictly Marxian per-
spective. Perhaps this is because Marx spent far more time analyzing the weaknesses of
capitalism than sketching out the postcapitalist society. Several articles skirt these
issues. See J. E. Elliot, “Marx and Contemporary Models of Socialist Economy,” History
of Political Economy, vol. 8 (Summer 1976), pp. 151–184; same author, “Marx and Engels
on Communism, Scarcity, and Division of Labor,” Economic Inquiry, vol. 18 (April 1980),
pp. 275–292; and same author again, “Marx and Schumpeter on Capitalism’s Creative
Destruction: A Comparative Restatement.” Quarterly Journal of Economics, vol. 95
(August 1980), pp. 45–68.
M. C. Howard and J. E. King, “Marxian Economists and the Great Depression,” His-
tory of Political Economy, vol. 22 (Spring 1990), pp. 81–100, detail how the Great Depres-
sion was viewed by Marxists. Same authors, “Karl Marx and the Decline of the Market,”
Journal of the History of Economic Thought, vol. 30 (June 2008), pp. 217–234, explore
Marx’s thought regarding the long-run tendencies of capitalism and show how his views
were misunderstood by his followers who believed that capitalism in the nineteenth and
twentieth centuries was in the midst of its final stages.
T. W. Hutchison, “Friedrich Engels and Marxian Economic Theory,” Journal of Politi-
cal Economy, vol. 86 (April 1978), pp. 303–320, suggests that Engels’s contributions to
Marx’s economics are much more important than has been generally recognized, specifi-
cally Engels’s account of the essential functions of the competitive-price mechanism. See
also Øyvind Horverak, “Marx’s View of Competition and Price Determination,” History of
Political Economy, vol. 20 (Summer 1988), pp. 275–298, who tries to bring Marx’s theory
of competition into sharper relief by contrasting it with the neoclassical concept of compe-
tition. Finally, Joan Robinson, Essay on Marxian Economics (London: Macmillan, 1966),
attempts to reconcile Marxian and orthodox economics. Among other things, she con-
tends that Marx’s argument regarding the fate of capitalism does not depend crucially on
the labor theory of value. But old habits die hard, and the debate over Marx’s labor theory
of value rages on. For additional sparks in this old tinderbox, see Jean Cartelier, “Marx’s
Theory of Value, Exchange and Surplus Value: A Suggested Reformulation,” Cambridge
Journal of Economics, vol. 15 (September 1991), pp. 257–270; Chai-on Lee, “Marx’s
Labour Theory of Value Revisited,” Cambridge Journal of Economics, vol. 17 (December
1993), pp. 463–478; and Stephen Pratten, “Structure, Agency, and Marx’s Analysis of the
Labour Process,” Review of Political Economy, vol. 5 (October 1993), pp. 403–426.
The fall of the Berlin Wall in 1989 sent many Marxists into retreat. Several years
later a mini-symposium was organized around the question: “With Marxian economics
in disarray as a touchstone for actual economies (in Eastern Europe, the former Soviet
Union, etc.), is it now time for historians of economics to reclaim their interest in Karl
Marx?” See the keynote paper by Anthony Brewer and ensuing comments from John
Elliot, Duncan Foley, Samuel Hollander, M. C. Howard, J. E. King, Takashi Negishi, Ales-
sandro Roncaglia, Margaret Schabas, and Ian Steedman in History of Political Economy,
vol. 27 (Spring 1995), pp. 109–206.
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Part IV
THE NEOCLASSICAL ERA

Mill’s recantation of the wages-fund doctrine and Marx’s mounting challenge to the
market system undoubtedly stirred much soul-searching about the adequacy of
classical economics. But the new departure we now call neoclassical economics was
spurred by more than doubt and criticism. After all, classical economics was macro-
economic in its orientation. It was, therefore, ill-equipped to handle the microeco-
nomic problems of efficiency and resource allocation, which came increasingly to
the fore as the nineteenth century wore on. Even before Mill’s Principles appeared
in 1848, certain French economists and engineers began to raise questions about
individual demand, consumer welfare, profit maximization, and efficient allocation
of resources, primarily in the context of providing those public goods that Smith
had consigned to government, such as roads, bridges, canals, and later, railways.
The introduction of the railroad, in particular, focused attention on fixed and vari-
able operating costs, return on investment, and the location of market activity, all
firm-specific issues that classical macroeconomics largely ignored.
This next part of the book traces the development of early neoclassical econom-
ics. It begins with certain writers who lived in the midst of the classical period but
pioneered the new approach ahead of their time. It then considers the multiple
founders of neoclassical theory, stressing the more or less simultaneous discovery
of the new analytics by English, German, and French writers. You will learn that
neoclassical economics is united by its focus (the firm and/or the individual rather
than the entire economy) and its embrace of subjective over strictly objective con-
siderations in its formulation of value. It is diverse, moreover, in its tolerance of sev-
eral different methods. For example, mathematics began to encroach on economic
analysis with more and more vigor during the neoclassical period, but different
writers had far different views on the nature, role, and adequacy of mathematics as
a tool of economic inquiry. There were also major differences among the pioneers
of neoclassical economics on the extent to which subjectivism should replace objec-
tivism in the formulation of the new theories.

307
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Ekelund-Hebert 13.fm Page 309 Thursday, August 1, 2013 2:21 PM

13

Proto-Neoclassical
Economics in France
Cournot and Dupuit

We concluded chapter 7 with a classical macroeconomic model built on principles

established by Ricardo and other classical writers. This model utilized the basic
tenets of classical economic theory (population doctrine, wages-fund theory, etc.) to
make deductions and generalizations about aggregate output, income distribution,
and population. While British political economy was consolidating and extending its
sphere of influence in the first half of the nineteenth century, great strides of a differ-
ent sort in the establishment of formal economic analysis were being made outside
Britain. The subject of these efforts was not the macroeconomic variables of income,
output, population, profits, and wages (as distributive shares) but rather the behav-
ior of microeconomic quantities such as prices, quantities offered and demanded,
and profits connected with specific commodities or services. Writers in this parallel
tradition developed theories about the effects of various forms of economic organi-
zation (monopoly, for example) on prices and outputs, and investigated the effects of
transport costs, rents, and transport pricing schemes on the location of industries.
Because many of the issues considered by these writers involved public or quasi-
public goods that were supplied by government entities, important tenets of public
finance and welfare economics were advanced in this period, and the theories of
price discrimination and product differentiation took root. When viewed in retro-
spect, the era was one of the most fertile in the history of economic analysis.
Whereas the pioneers of the macroeconomic foundations of economics were British,
the leading analysts of its microeconomic foundations were French. French eco-
nomic orthodoxy, however, was ambivalent, if not hostile, to its contributions.

■ A. A. COURNOT (1801–1877)
One of the most original minds ever to attack economic theory, Antoine-Augus-
tin Cournot faced tragedy and disappointment at several turns. Born in 1801 in
Haute-Saône, France, Cournot received his early education at local schools before
entering the École Normale in Paris at the age of twenty, where he studied mathe-
matics. Despite an ominous (and ultimately fulfilled) presentiment of impending
blindness, Cournot indulged his insatiable appetite for books (scientific and other-

309
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310 Part IV ■ The Neoclassical Era

wise) throughout his youth. When he graduated from the École Normale Cournot
remained in Paris, where, after a period of relative poverty, he obtained work as the
secretary to one of Napoleon’s generals, Marshall Gouvion Saint-Cyr. He completed
his doctorate at the University of Paris during this period (1823 to 1833) and came
into contact with leading intellectuals of the day, many of them physical scientists
and engineers. During his tenure as a university student, Cournot published several
mathematical articles as well as Marshall Saint-Cyr’s military memoirs.
Cournot’s papers on mathematics attracted the attention of the great physicist
and statistician Poisson, who helped him secure a position in 1834 as professor of
mathematics at Lyons, where he taught differential calculus and completed the ini-
tial work on his book on probability (Exposition de la théorie des chances et des pro-
babilités). The next year Cournot was appointed school superintendent at Grenoble,
and within a few months he assumed additional responsibilities as inspector gen-
eral of education (succeeding Ampère, the renowned student of electrical science).
In 1838, Cournot married and also published his seminal work on microeconomics,
Recherches sur les principes mathématiques de la théorie des richesses (Researches
into the Mathematical Principles of the Theory of Wealth). He was also made a trav-
eling inspector general of education, based in Paris.
Trouble with his vision forced Cournot to take a leave of absence in 1844, which
he spent in Italy. He became superintendent of the Dijon Academy in 1854, where he
remained until his retirement in 1862, at which time he returned to Paris. Throughout
this period and during his retirement in Paris, Cournot continued to publish books on
social philosophy and on economics. Probably as a result of his piecemeal loss of
sight, the character of his work altered. His two later books on economics, Principes
de la théorie des richesses and Revue sommaire des doctrines économiques, published
in 1863 and 1877, respectively, do not employ mathematics to treat economic ques-
tions, and they do not add significantly to Cournot’s original work on economic the-
ory, which he published decades earlier. Cournot died suddenly in 1877, never having
achieved due recognition in his native country or elsewhere for his contributions. The
importance of his work was later extolled by Léon Walras, which eventually brought
him belated recognition. Cournot would probably be more than a little surprised and
pleased at the course of microeconomic analysis in the post-1877 period because his
impact and influence now permeate the very core of modern economic theory.

Cournot on Method
Cournot’s ideas on the proper method in political economy are of great impor-
tance in assessing his role in theory development. Defending the use of mathemat-
ics as a kind of shorthand for expressing complex ideas, Cournot evaluated the
earlier efforts of Smith, Say, and Ricardo:
There are authors, like Smith and Say, who, in writing on Political Economy, have
preserved all the beauties of a purely literary style; but there are others, like
Ricardo, who, when treating the most abstract questions, or when seeking great
accuracy, have not been able to avoid algebra, and have only disguised it under
arithmetical calculations of tiresome length. Any one who understands algebraic
notation, reads at a glance in an equation results reached arithmetically only with
great labor and pains. (Researches, p. 4)

Cournot’s chief criticism of past writers was, “They imagined that the use of symbols
and formulas would have no other end than that of leading to numerical calculations”
and they did not see that the object of mathematical analysis was to “find relations
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Chapter 13 ■ Proto-Neoclassical Economics in France 311

between magnitudes which cannot be estimated numerically and between functions

whose law is not capable of being expressed by algebraic symbols.” This view of
method persists in his later works also. “Science,” he wrote in 1863, “is not obliged to
await empirical laws . . . in order to draw certain and useful consequences from gen-
eral characteristics which they can supply, or certain relationships which can exist
between them and upon which reason, alone, sheds light.”1 Accordingly, he champi-
oned the use of mathematics, specifically differential and integral calculus, in express-
ing arbitrary functions, provided that certain conditions are met. An example—the
law of demand—familiar to all students of economics, illustrates Cournot’s method.
As most students know, the law of demand states that quantity demanded is a
function of price, or D = F(P). The quantity demanded at each price is, moreover,
related to a number of other variables (e.g., income, wealth, tastes, etc.), but these
are assumed constant when drawing up an individual demand schedule. According
to conventional analysis, a change in one of the nonprice determinants causes the
entire demand curve to shift, which connotes a change in demand. A change in
quantity demanded, by contrast, occurs along a given demand curve when price
changes, all other determinants remaining constant. Cournot understood perfectly
the value of the ceteris paribus assumption, or “other things equal” condition. This
is evident in his Principes de la théorie des richesses, where he noted that the loi de
débit, or law of sales (“sales” being synonymous with “demand”),
rests essentially on population, on the distribution of wealth, on general well-
being, on tastes, on the habits of the consuming population, on the multiplication
of markets, on the extension of the market resulting from transport improvements.
All these conditions relative to demand remain the same; if we suppose that pro-
duction conditions change (i.e., that costs rise or fall, that monopolies are
restricted or suppressed, that taxes are increased or lightened, that foreign compe-
tition is prohibited or allowed) prices will vary and the corresponding variations in
demand, provided that prices are actually raised, will serve for the construction of
our empirical tables. If, to the contrary, prices change because the law of demand
has itself changed, due to a change in causes which no longer influence production
but consumption, the construction of our tables will be made impossible, since
they must show how demand changes by virtue of a change in price and not by vir-
tue of other causes.

It is clear from his explicit treatment of demand that Cournot expressed the idea as
a mathematical function, so that demand meant a price–quantity relationship (i.e.,
change in price leads to change in quantity demanded) whereas a change in any
other demand variable (e.g., income) leads to a change in the price–quantity rela-
tionship itself (i.e., a shift of the function or schedule). This method of analysis is so
common today that the modern theorist would not think of expressing complex
ideas in verbal form alone, but at the time Cournot wrote, verbal expression was the
common tack of the economic theorist. He was, therefore, a pioneer in the true
sense of the term.
What, we may ask, did Cournot hope to accomplish by this line of inquiry?
What kind of theory did he seek to develop with mathematical tools? Did it have
practical consequences or was it out of touch with reality, a common complaint
against economic theory today? The answer to these questions reveals the bril-

1
Quotations without page references in this chapter are from unpublished translations made by the
authors of this text. Original French texts are cited in the references at the end of the chapter, but
where translations exist, English titles are substituted for the French.
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312 Part IV ■ The Neoclassical Era

liantly dual nature of Cournot’s approach to method. Economic analysis, he argued,

needs to be grounded in empirical observation and in facts. He rejected purely
“speculative” foundations for his demand function, such as utility, and affirmed an
empirical approach. The title of the chapter on demand in the original Recherches,
“De la loi du débit,” or “The Law of Sales,” hints at this empirical approach, and
Cournot quickly set the record straight. He noted: “Sales or demand increase when
price decreases.” He acknowledged that prices and the law of demand could fluctu-
ate during a year, so he expressed his curve as a relation between average annual
price, P, and “the quantity sold annually in the country or in the market under con-
sideration,” F(P). Hence, D = F(P) is a curve connecting time-series data on sales
and the prices at which these sales are realized over the course of a year.
Cournot’s theoretical specification of demand (a continuous, negatively sloped
function) resulted from his own observation and from simplifications and observa-
tions of the relations between price and quantity. Theory may then be lifted from
these facts and manipulated in order to arrive at deductions based on certain
assumptions. But theory needs to be derived and specified in the first instance from
actual observed facts—not from caprice. The tools derived this way possess a use-
fulness and a generality that far transcend the empirical facts that spawned them. It
was part of Cournot’s genius to have been able to recognize and explain how facts,
theory, and model construction are intertwined.

Cournot’s Micro Models

Cournot turned this empirical method into the creation of numerous models of
firm behavior based on the demand curve. We shall consider his two most enduring
models: (1) the monopoly model and (2) the duopoly (two producers) model.
A Monopoly Model. In chapter 5 of the Researches, Cournot erected a monop-
oly model of business behavior on the principle of profit maximization. The basic
facts of the (illustrative) model are that a proprietor has sole ownership of a mineral
spring that has healthful qualities unlike any other. Hence this is a strong monopoly
both because of exclusive ownership and unique product. Rather than charge the
highest obtainable price—which by virtue of the law of demand would probably
result in few sales—Cournot argued that the proprietor will adjust his price so as to
get the greatest net revenue. In the case of zero costs, he demonstrated mathemati-
cally that the monopolist’s best outcome is to maximize gross receipts. Assuming a
demand function D = F(p) that is always negatively sloped (i.e., dD/dp < 0), the pro-
prietor will adjust p such that total revenue, pF(p), is at a maximum. The quantity of
sales that will produce this maximum is found by applying differential calculus.
Sales will reach a maximum when the extra revenue from an additional unit sold is
zero, i.e., when marginal revenue is zero. When costs are present, Cournot showed
that profit maximization occurs when marginal cost equals marginal revenue (or
when the slope of a profit function,  = TR – TC, equals zero).
Cournot’s monopoly model may be presented graphically, as in figures 13-1a and
13-1b. Assume the linear demand curve in figure 13-la to represent Cournot’s law of
demand. (Ignore curve MC for the present.) The (zero-cost) proprietor will adjust his
sales of mineral water such that he sells quantity Qn at price Pn since at quantity Qn
the addition to total revenue (i.e., marginal revenue) is equal to the addition to total
cost (i.e., marginal cost). That is, MR = MC at quantity Qn. Alternatively, but equiva-
lently, the zero-cost proprietor simply maximizes total revenue, as seen at quantity
Qn in figure 13-1b. In the zero-cost case, the TR curve becomes the profit function, 0.
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Chapter 13 ■ Proto-Neoclassical Economics in France 313

This “marginal principle,” derived by applying differential calculus, eventually

became the central organizing principle of microeconomic theory. It allowed
Cournot (and anyone else after) to solve the basic questions faced by each firm—
what quantity to produce and what price to charge? Cournot gave a straightforward
solution. Assuming that (D) was equal to the cost of making a number of liters
equal to D, Cournot’s profit equation becomes  = pF(p) – (D). Profit maximization
requires that the slope of the profit function equal zero—or, in Cournot’s notation,
that D + dD/dp {p – d[(D)]/dD} = 0. In plainer language, profit maximization takes
place where MR – MC = 0. As Cournot put it, “Whatever may be the abundance of
the source of production, the producer will always stop when the increase in
expense exceeds the increase in receipts” (Researches, p. 59).

Price,
costs
MC

Pc

Pn

AR = demand
(a) MR
Qc Qn Quantity of mineral water

Costs,
revenues, TC
profits

TR = π0

(b)
Qc Qn Quantity of mineral water
π1

Figure 13-1 In a zero-cost situation, the firm will sell Qn at Pn . With positive costs,
quantity Qc will be sold at Pc , following the marginal principle. Note that at Qc , the profit
function 1 is at a maximum.
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314 Part IV ■ The Neoclassical Era

In reference to figure 13-1a, Cournot established that profits are at a maximum

where MR = MC. Output produced will be Q, and price will be Pc; further, Qc will be
lower and Pc will be higher than in the case of zero costs. Figure 13-1b is an alterna-
tive way to treat the problem and its solution using the mineral-springs proprietor’s
total cost, revenue, and profit functions. Verify that the proprietor will cease pro-
duction at Qc in figure 13-1b, where the profit function 1 is at a maximum (Cournot
included a second condition—that the slope of the profit function be zero at Qc and,
further, that profits decline with either increases or decreases in quantity). Note that
the mineral spring is not operated to maximize gross returns at Qn but to maximize
net returns at Qc. The geometrically inclined reader will see that at Qc, the slope of
the TC function is equal to the slope of the TR function, or MC = MR, as in figure
13-1a. Cournot’s development of the theory of monopoly would, in short, compare
most favorably with that of any modern textbook writer, for it is precisely Cournot’s
theory that modern writers on monopoly are explicating.
Duopoly Analysis. Perhaps the most famous theory developed by Cournot
relates to his second model, in which he introduced an additional seller of mineral
water. In a profoundly original theoretical conception, Cournot’s duopoly (two sell-
ers) analysis laid the groundwork for many other ideas of importance to economics,
such as imperfect competition (see chapter 20) and game theory (see chapter 25).
Although Cournot’s theory of duopoly was later altered and refined (notably by the
English economist Francis Y. Edgeworth and the French mathematician Joseph Ber-
trand), its originality endures.
Cournot considered two sellers, A and B, who both sell the same product and
know the total (aggregate) demand curve for their perfectly homogeneous product,
mineral water. Otherwise, they are completely ignorant of each other’s actions, to
the extent that A thinks that B will keep his quantity constant no matter what A
does, and B thinks the same thing about A’s quantity. Unrealistically, both sellers
continue to make this assumption no matter how much experience they have to the
contrary. In the language of duopoly, this assumption is called a zero-output conjec-
tural variation, i.e., a conjecture that B will have no output reaction to A’s actions.
Cournot further assumed that either A or B could supply all the mineral water
demanded and, moreover, that mineral-water production is costless. He analyzed
the problem of output and price determination both mathematically and graphically
in the Researches, but our explanation emphasizes the graphical approach.
Cournot developed a new tool, reaction curves, to illustrate the optimal solution to
the duopoly problem. Figure 13-2 depicts a concave reaction function AA, which
reveals A’s choice of outputs with respect to B’s choice of outputs. Specifically, it shows
the outputs that firm A will select in order to maximize profits, given B’s selection of
outputs. For example, if B selects output b0, then in order to maximize profits A will
want to charge a certain price for its output a0. If, on the other hand, B produces quan-
tity b1, A will be led by the profit motive to produce a lower quantity a1, and so on for all
other quantities B might produce. Whatever quantity B chooses, moreover, A “thinks”
that it will be permanent, and so A acts to maximize his or her profits with this in mind.
What quantity will A and B end up producing? Clearly, the problem cannot be
solved without adding B’s reaction function, so that we may see the kind of
responses B will make to A’s output. The two functions are combined in figure 13-3,
where B’s reaction function is defined in the same manner as A’s was above.
Suppose B decides to produce some output—say, b0—on the assumption that A
will keep output at level a0. B would then be maximizing his or her profits at output
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Chapter 13 ■ Proto-Neoclassical Economics in France 315

b0. On the assumption that B would hold output at level b0, A would maximize prof-
its by producing output a1. Such a move would cause B to reassess the situation and
to increase his or her output to b1, which maximizes his or her profits when A sells
a1. However, the assumption is constantly violated (though sellers A and B never
catch on), and the process of output variation to maximize profits goes on as traced
by the arrows in figure 13-3.

Output of
firm A

A
A's reaction
a0
function
Figure 13-2
a1
A’s reaction curve
describes the profit-
maximizing output
level for A given each
level of output that B
chooses. Thus when B
chooses to produce b0 , A
A will maximize profits O b0 b1 Output of
by producing a0 . firm B

Output of
firm A B

J B's reaction
a0 function

A
a1 L

N
a E
Figure 13-3
Beginning at point J A's reaction
(when B’s output is function
b0), the arrows trace
the path to stable
equilibrium (point
E) through succes- B A
O b0 b1 b
sive output adjust- Output of
ments by A and B. firm B
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316 Part IV ■ The Neoclassical Era

Point E (figure 13-3) represents an equilibrium solution for firms A and B. What
this means is that if each firm moves away from point E, it will always return. At
point E the duopolists both share profits (Cournot expressed this amount mathe-
matically) and charge a common price that is lower than the price that would result
under simple monopoly (a fact that Cournot himself noted) but higher than the one
that would be charged under full and open competition. To be precise, duopoly out-
put would be two-thirds the output produced if the market were competitive. The
generalized result is that output would be n/(n + 1) times competitive output. Thus,
if there were five sellers, quantity sold would be five-sixths of competitive output. If
there were 2,000 sellers, output would clearly approach the competitive amount. In
this manner Cournot related his duopoly theory to the competitive model in which
the number of sellers is large.

Cournot: An Evaluation
Besides duopoly theory, Cournot provided many other important theoretical
insights. Among them were (1) a clear statement of the simple competitive model;
(2) a very advanced model of composite and derived demand (for copper and zinc to
produce brass); and (3) last but not least, a full-blown discussion of the stability of
various economic equilibriums, which considers the possibility of wild variations in
quantity and price. (The reader may gain some notion of the third issue by reversing
the reaction curves or by switching the labels of the axes in figure 13-3.) Cournot’s
book was, in short, filled with new ideas.
Still, Cournot’s contributions to method and to monopoly-duopoly theory have
dominated the attention of theorists. And these ideas, especially those related to
duopoly, attracted several critics. As previously mentioned, Edgeworth and Ber-
trand tinkered with Cournot’s duopoly model, altering many of his assumptions.
Why, for example, should a duopolist consider the quantity and not the price of his
rival constant? More pointedly, how can A (for example) continue to assume that
B’s output will remain constant in spite of repeated evidence to the contrary? What
if there was an output limit on one or both of the duopolists? And so on.
Many of these issues have been resolved but it is part of the continuing fascina-
tion of Cournot’s model that the solution of one issue brings up two more. Cournot-
like models have inspired theoretical offshoots such as oligopoly models, bilateral
bargaining, and alternative assumptions concerning conjectural variation in mod-
ern game theory. His simple model was, and continues to be, the font of many ideas
in economic theory (see, for example, the box on the following page, The Force of
Ideas: Game Theory, The Brainchild of Cournot). His powerful ideas should place
Cournot among the first rank of economic theorists. Moreover his vision of what
economic theory could be was sweeping and ultimately, influential. He conceived
economic theory as a box of tools, rooted in empiricism, which would comprise the
organizing principles in analyzing myriad economic problems. This cognizance, so
tragically ignored by his contemporaries, carried him to a pinnacle of achievement
seldom reached in the history of economic theory.

■ JULES DUPUIT (1804–1866)

While Cournot was working out the foundations of microeconomics, a venera-
ble French institution—the École des Ponts et Chaussées (School of Civil Engineer-
ing)—nurtured a man who would combine micro tools with a theory of utility to
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Chapter 13 ■ Proto-Neoclassical Economics in France 317

The Force of Ideas: Game Theory, the Brainchild of Cournot

Game theory, one of the most interesting and robust tools of modern economic analysis,
was spawned in the nineteenth century and matured in the twentieth. The formal founda-
tions of the idea are ascribed to the great twentieth-century mathematician John von Neu-
mann and to the economist Oskar Morgenstern who collaborated on The Theory of Games and
Economic Behavior, published in 1944. But the idea was clearly anticipated by Cournot.
Initially applied to such topics as politics and military strategy, many of the applications of
game theory are currently in use in economics. Von Neumann and Morgenstern pointed out
that Cournot’s duopolists played a kind of “game” in that each made some independent conjec-
ture about the other’s output decision. As discussed in this chapter, one duopolist conjectured
or believed that the other would hold output constant in the face of profit-maximizing adjust-
ments in his or her own output. Given Cournot’s assumptions, neither of the duopolists learned
that this conjecture was unrealistic, so the outcome of the rivalry is that each seller shares the
market equally and together they produce a level of output in equilibrium, equal to two-thirds
the level of output that would be produced under competitive conditions (see text).*
Modern game theory incorporates less naive behavioral conjectures than Cournot’s origi-
nal model, inasmuch as it considers the payoffs associated with alternative conjectures. Con-
sider the following problem, which is attributed to the mathematician A. W. Tucker. Suppose
that two kidnappers are caught in the act but that the police only have hard evidence to con-
vict them for a lesser offense. In an attempt to improve their evidence, the police sequester
the prisoners separately and try to get confessions from them in the following manner. Each
kidnapper is separately informed that (1) if one confesses, that one goes free and the other
gets the death penalty; (2) if neither confesses, both will receive the lighter penalty that
accompanies the lesser crime; (3) if both confess, both will receive a severe penalty but one
less than death. Given the payoffs and the uncertainty, the expected solution is that both kid-
nappers confess.
This famous example is called the prisoner’s dilemma. Its relevance to war games and to
many kinds of economic behavior is fairly obvious. Advertising strategies between competing
firms, for example, fit this model, as does any situation where strategic actions between indi-
viduals are interdependent. The prisoner’s dilemma is a radical simplification because the pris-
oners are isolated and unable to communicate with each other so that they cannot collude in
formulating a response to the police. Other “games” might be structured to allow cooperation
or collusion, and all sorts of strategies might be evaluated. Its many applications have made
game theory a valuable tool of economic analysis in evaluating competitive strategies and the
various forms of industrial organization.
*Cournot’s formal model was outfitted with other assumptions later in the nineteenth century by French
mathematician Joseph Bertrand (who added the conjecture that the duopolist holds price constant) and
by the neoclassical economist F. Y. Edgeworth (who conjectured that the duopolist holds quantity con-
stant but with an output limit on each). See the notes for further reading at the end of this chapter.

establish the foundations of demand theory, public finance, public-goods theory,

and welfare economics. Like Cournot, this brilliant French engineer practiced eco-
nomics as an avocation, not a profession; and like Cournot, he brought keen practi-
cal insight to his analysis of economic problems.
Arsène-Jules-Étienne Juvenal Dupuit was born on May 18, 1804, in Fossano,
Italy, when the region was ruled by France. He returned to France with his parents
at the age of ten. There he continued his education in the secondary schools at Ver-
sailles, at Louis-le-Grand, and at Saint-Louis, where he finished brilliantly by win-
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318 Part IV ■ The Neoclassical Era

ning a physics prize in a large competition. In 1824 he entered the famed French
School of Civil Engineering (the École des Ponts et Chaussées). As a newly certified
civil engineer he was put in charge of roadway and navigation projects in the depart-
ment of Sarthe in 1827. He married in 1829 and in 1836, two years before Cournot
published his Researches, Dupuit was promoted to the rank of first-class engineer.
Dupuit concerned himself with problems of economic interest throughout his
illustrious career as an engineer. His experiments on the deterioration of roadways
led to his Essay and Experiments on Carriage Hauling and on the Friction of Rota-
tion (1837). A subsequent contribution on the same subject earned him a gold
medal, awarded by vote of fellow engineers. Eventually he received France’s crown-
ing glory, induction to the Legion of Honor, on May 1, 1843.
The floods of the Loire in 1844 and 1846 stimulated Dupuit’s Theoretical and
Practical Studies on the Movement of Running Water (1848), and his classic Floods:
An Examination of the Means Proposed to Prevent Their Return (1858). In 1850,
Dupuit was called to municipal duty in Paris as director and chief engineer. There
he studied municipal water distribution and supervised the construction of sewers.
In December of 1855, Dupuit was named Inspector-General of Civil Engineering,
the highest rank in the corps. He was, in short, one of the most distinguished engi-
neers in France at the time. But political economy was Dupuit’s hobby and the
object of his passionate attention, and his career as an engineer afforded him
opportunities to indulge his taste for economic questions. Unfortunately, a projected
book entitled Political Economy Applied to Public Works, to which Dupuit referred
as early as 1844, was never brought to completion (death intervened in 1866). With
the exception of his short plea for free trade, Commercial Freedom, published in
1861, Dupuit’s reputation as an economist must stand with a considerable number
of journal contributions to economic policy and theory.

Dupuit’s Unique View of Economics

Dupuit’s special insights into economic analysis were the combined result, on
the one hand, of his technical and scientific training in calculus and functions and,
on the other, of his keen observation and utilization of the mountain of statistics on
public-works revenues and costs gathered by himself and his fellow engineers. In
economics, Dupuit was self-taught; he read Smith, Ricardo, and Say, the French
expositor of classical economics. He was also influenced by Say’s successor at the
Collège de France, Pellegrino Rossi (see chapter 18). However, Dupuit’s economics
marks a clear departure from the old school. Classical economists such as Smith,
Say, Malthus, and Ricardo undoubtedly influenced Dupuit’s opinions on macroeco-
nomic issues. But the one writer who could have helped him most in the area of
microeconomics—Cournot—was apparently unknown to him. And, at one point,
both lived and worked in Paris simultaneously!
Dupuit’s contributions relate primarily to his engineering interests. According
to one of his biographers, “Political economy, which attracts at every turn the engi-
neer’s interest, had also been the object of his constant study, and he was no less
learned in that science than in that of public works.” But it was the combination of
these interests that produced Dupuit’s special genius for theory and concept forma-
tion. His analytical tools were forged by three considerations. He focused on: (1)
subjects of economic interest and importance; (2) relevant, observed facts and sta-
tistics abstracted from these subjects; and (3) mathematical analysis—deductive
logic and graphical depiction—to organize and reorganize relations suggested by
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Chapter 13 ■ Proto-Neoclassical Economics in France 319

these facts and statistics. Theories conceived and derived in this manner, could be
confronted with new facts and data for confirmation or alteration.
In other words, Dupuit’s method treated political economy as a combined sci-
ence of reason and observation. Cournot also combined the two, but with far less
emphasis on empirical support and its correspondence to theory. Dupuit realized
that unorganized statistics are meaningless. “To better see the facts, to better
observe them, one must clarify them by light of reason,” he wrote. His major effort
in economic analysis was directed toward a real-world problem—measuring public
utility, the social welfare produced by public goods and services. In keeping with
this goal he made seminal discoveries in the theoretical areas of marginal utility,
demand, consumer surplus, simple and discriminating monopoly, and marginal-cost
pricing. In each case, the issue of chief concern was to understand the optimum
price and output policies of public goods.

Marginal Utility and Demand

Dupuit was the first economist to present a cogent discussion of the concept of
marginal utility and to relate it to a demand curve. Fully utilizing his powers of
observation and abstraction, Dupuit was able to show, as early as 1844, that the util-
ity that an individual (and a collection of individuals) obtains from a homogeneous
stock of goods is determined by the use to which the last units of the stock are put.
In doing so, he clearly pointed out that the marginal utility of a stock of some partic-
ular good diminishes with increases in quantity taken. Based on observation Dupuit
established that each consumer “attaches a different utility to the same object
according to the quantity he can consume.” He illustrated his point with a practical
example of a technological improvement in how water is supplied to a hillside town:
Water is distributed in a city which, situated on a height, could procure it only with
great pains. There was then such a value that the hectoliter per day was 50 francs
by annual subscription. It is quite clear that every hectoliter of water consumed in
these circumstances has a utility of at least 50 francs.

He posited that each unit of a given quantity of water will have a different utility and
continued his argument by focusing on the effect of reductions in water’s price. He
supposes that as a result of the installation of pumps, costs of procuring water in the
town drop by 20 francs:
What happens? First, the inhabitant who consumed a hectoliter will continue to do
so and will realize a benefit of 20 francs on his first hectoliter; but it is highly prob-
able that this lower price will encourage him to increase his consumption; instead
of using it parsimoniously for his personal use, he will use it for needs less press-
ing, less essential, the satisfaction of which is worth more than 30 francs, since this
sacrifice is necessary to obtain water, but is worth less than 50, since at this price
he relinquished this consumption. (“Utility and Its Measure”)

Each increment of the same commodity carries a different utility because additional
units will allow “less pressing, less essential” needs to be met. Therefore the addi-
tional utility derived from additional units of the same commodity must decline.
Elaborating this point, Dupuit supposed that when the price fell to 20 francs,
the individual would demand 4 hectoliters “to be able to wash his house every day;
give them to him at 10 francs, he will ask for 10 to be able to water his garden; at 5
frs. he will ask for 20 to supply a water font; at 1 franc he would want 100 to have a
continuous flow [i.e., a fountain],” and so on. Dupuit clearly and unambiguously as-
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320 Part IV ■ The Neoclassical Era

serted that it is the least

MU =
pressing need for a com-
price
modity, not its most press-
ing need that defines the
exchange value of the en-
tire stock of goods. He af-
firmed this argument by a
n graphical representation, as
p1
shown in figure 13-4.
p2 c Assume that the con-
sumer is originally in equi-
librium when the price of
water is at p1 and the quan-
tity taken is q1. Now as-
sume with Dupuit that the
O q1 q2 price of water falls to p2. At
Quantity of water
the lower price for water
the individual is in disequi-
Figure 13-4 As the price of water declines from p1 to p2, librium at point c. The mar-
the consumer will begin to satisfy less pressing wants. ginal utility of the last unit
of the consumer’s existing
Therefore the consumption of water will increase from q1
stock is greater than the
to q2.
now-lower marginal utility
of water represented by the
lower price. In terms of price, what the consumer would pay for q1 of water is
greater than the price he or she must pay for quantity q1. The same quantity of wa-
ter (q1) could be bought at a lower total expenditure, but Dupuit assumed that the
consumer would not do this. Attached to each incremental unit of water between
quantity q1 and quantity q2 is a marginal satisfaction greater (albeit diminishing)
than that which would obtain for the incremental unit corresponding to price p2.
Thus, in an effort to maximize total satisfaction, the individual will increase pur-
chases of water up to, but not beyond, quantity q2.
As suggested by the labeling of the vertical axis (marginal utility = price) of fig-
ure 13-4, the marginal-utility curve is Dupuit’s demand curve (courbe de consomma-
tion), and although most of his examples are concerned with transportation and
communication, he maintained that the same laws apply to all goods and services.
He provided explicit directions for the construction of such a curve in his article enti-
tled “Tolls,” which appeared in the 1852–53 French Dictionary of Political Economy:
If, in a table of two columns, one inserts in the first all the prices, from 0, the one
which corresponds to the greatest consumption, up to the price that stops all con-
sumption, and in the second, regarding the price, the corresponding quantity con-
sumed, we will have the exact representation of what we call the law of consumption.

In a paper entitled “On the Measurement of the Utility of Public Works,” Dupuit
constructed such a demand curve in 1844, six years after Cournot’s Researches was
published.
Like Cournot, Dupuit gave the equation for the curve of consumption as y =
f(x) or, alternatively, Qd = f(p). Additionally, Dupuit (as Léon Walras and other econ-
omists were to do later) placed the independent variable, price, on the x axis and
the dependent variable, quantity, on the y axis. For reasons that will be explained
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Chapter 13 ■ Proto-Neoclassical Economics in France 321

later, Alfred Marshall (see chapter 16) reversed the axes, and thereafter, most econ-
omists adopted Marshall’s practice (if not always his procedure, which treated mar-
ginal-demand price as a function of quantity). Dupuit’s construction is reproduced
as figure 13-5. He described it as follows:
If . . . [we supposed that] along a line OP the lengths Op, Op, Op . . . represent
various prices for an article, and that the verticals pn, pn, pn . . . represent the
number of articles consumed corresponding to these prices, then it is possible to
construct a curve NnnnP which we shall call the curve of consumption. ON repre-
sents the quantity consumed when the price is zero, and OP the price at which con-
sumption falls to zero. (“Measurement of the Utility of Public Works,” p. 106)

It is obvious that this curve is identical in conception to that of figure 13-4; that
is, Dupuit’s demand curve is a marginal-utility curve. Dupuit made his meaning
clear, with reference to figure 13-5, by stating, “The utility of . . . np articles is at
least Op and . . . for almost all of them the utility is greater than Op.”
The relation that Dupuit posited between price, marginal utility, and quantity
was, a “fact of experience,” he said, that “has been verified statistically.” It was a the-
ory of powerful originality, for in linking the demand curve with utility Dupuit estab-
lished a new subset of economic analysis—welfare economics. Specifically, Dupuit
maintained that the total area under the demand curve of figure 13-5 (area OPN)
represents the total utility produced by the commodity. At some price—say, Op—
there is some amount that consumers would be willing to pay for the commodity
over and above what they must pay. The amount that they must pay is represented
by area Opnr in figure 13-5, and it represents the firm’s receipts (ignore for the
present the other price-output combinations). In the case of zero costs (assumed in

Quantity

r n
r‫׳‬ n‫׳‬

r‫״‬ n‫״‬

O p p‫׳‬ p‫״‬ P Price

Figure 13-5 The area inside OPN represents the total utility derived from a
commodity having the demand curve PN. At price Op, consumers pay an
amount equal to Ornp and receive a surplus utility equal to nPp.
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322 Part IV ■ The Neoclassical Era

figure 13-5) areas Opnr may be called “producer surplus” or “producers’ rents.”
The amount that consumers would be willing to pay over and above what they must
pay is area pnP. In Dupuit’s terms this is “utility remaining to consumers,” but
Alfred Marshall later renamed the concept “consumer surplus.” Dupuit’s numerical
examples of these concepts (presented in the following section) illustrate their theo-
retical importance; but even more noteworthy they demonstrate Dupuit’s analytical
craftsmanship in developing theories of monopoly and price discrimination.

Consumer Surplus, Monopoly, and Price Discrimination

In the course of his economic writings, Dupuit was led to investigate some of
the factors that give rise to monopoly pricing. Conditions existing among French
railroad companies were of particular interest to him because the circumstances of
that market did not fit easily into received economic models. He noted that “the
interest of ordinary capitals is regulated by the law of supply and demand . . . while
the means of transportation are monopolies.” Thus, generally speaking, “ways of
communication,” or forms of transportation, are sheltered from competition.
To illustrate his point Dupuit compared the economic principles that determine
house rents with those affecting transport rates. The degree of existing competition
matters. Exorbitant rents for lodging, according to Dupuit, could not exist for very
long because, “if it was known that house rental yields a revenue superior to the
rental of other capitals, speculation would focus very quickly on the construction of
houses and equilibrium would be established.” Thus, the entry of new firms in the
face of supranormal profits keeps monopoly rents from persisting over the long run
in the housing market. But as Dupuit indicated, freedom to enter the railroad indus-
try is inhibited by certain factors indigenous to that industry. Enormous amounts of
capital, in the first instance, restrict the possibility of entry to a limited number of
firms. Also, Dupuit recognized that because of the uniqueness of the first enterprise,
a “new one can survive only at the expense of the first and . . . the profit which is
sufficient for one is not sufficient for two.”
With the exception of Cournot, whose work was unknown to him, Dupuit broke
new ground by addressing the principles on which the simple monopolist (as consti-
tuted above) behaves. He formulated the rule of monopoly profit maximization in
the course of his discussion of the effects on utility of tolls and transport charges.
Table 13-1, reproduced from an 1849 article, illustrates Dupuit’s early conception of
this well-known principle.
The data in table 13-1 refer to a tariff or rate that a monopoly railroad may
charge for passage. In this instance Dupuit was considering the case of an unregu-
lated monopolist free to charge a rate that would maximize profits. He declared: “If
the road or bridge or canal is private property, the owner company has only one
aim, and that is to get the largest possible income from the toll.” Thus, the monopo-
list facing the demand schedule derived from the data in table 13-1, with no costs of
production, would charge a rate of 5 francs in order to maximize gross receipts.
Dupuit then extended the example to include costs of production. He said that the
“cost of traction” could be represented by 2 francs per unit of passage. These trac-
tion costs are variable, rising as distance increases. Dupuit continued:
The rate which maximizes net yield is not the same as that which maximizes gross
yield. The latter rate was 5, the former is 6, and it would grow indefinitely with the
cost. It follows that when traction cost diminishes, the toll must diminish to yield
maximum receipts. (“Tolls and Transport Charges,” p. 20)
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Chapter 13 ■ Proto-Neoclassical Economics in France 323

By focusing on net revenue, Dupuit correctly stated the principle of profit maximiza-
tion and pointed out that if the level of traction costs increased, the profit-maximiz-
ing tariff would increase and output would decrease. The net receipts, additionally,
are net only of variable expenses. Fixed costs, such as “certain administrative
expenses, interest on construction expenditures, etc.,” must also be covered in the
long run. Consequently, Dupuit’s net receipts are not long-run profits, as are his
gross receipts (without costs of production). Dupuit, referring to the data in table
13-1, said, “If fixed costs were more than 104 [francs] and it were possible to charge
only one uniform rate, the railroad would be a losing proposition with any tariff.”

Table 13-1 A Monopoly Demand and Utility Calculation

Yield of the Tariff
Tariff Number of Passengers Utility Gross Net
0 100 445 0 –200
1 80 425 80 –80
2 63 391 126 0
3 50 352 150 50
4 41 316 164 82
5 33 276 165 99
6 26 234 156 104
7 20 192 140 100
8 14 144 112 84
9 9 99 81 63
10 6 69 60 48
11 3 36 33 27
12 0 0 0 0

In addition to an analysis of profit maximization, Dupuit’s early treatment of

monopoly contained another important analytical tool, which was later used by
Alfred Marshall. Specifically, both investigations posited a relation between monop-
oly revenue and consumer surplus, given, of course, the constancy of the marginal
utility of money. Making an implicit identification of the demand curve with a utility
function, Dupuit supplied a utility calculation for his railroad example (see column
3, table 13-1). In this case the price that maximized net revenue would be a tariff of
6 francs, and the total utility (consumer surplus, producer surplus, and costs) pro-
duced by this tariff would be 234 francs.
According to Dupuit, total utility always breaks down into three parts: lost util-
ity, producer surplus, and consumer surplus. At the 6 franc tariff the total utility of
234 francs divides as follows: Assuming fixed costs are nonexistent, the lost utility
equals 52 francs, the total variable costs of carriage (i.e., 2 francs × 26 passengers).
The producer surplus is identical to the net receipts of 104 francs. The consumer
surplus is the residual of 78 francs (i.e., 234 – 52 – 104).
If we momentarily depart from Dupuit’s presentation and assume that the fixed
cost is exactly 104, then monopoly revenue disappears. In the short run the 104
francs accruing to the owner of the railway is of the nature of an economic rent (i.e.,
producer surplus) on fixed investment, but as Dupuit succinctly pointed out, these
fixed costs must ultimately be met by the monopolist. Thus, under the assumption
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324 Part IV ■ The Neoclassical Era

that the fixed costs are 104 francs there would be no monopoly revenue. A con-
sumer surplus is produced, however, in the amount of 78 francs.

Price Discrimination and Welfare: Numerical Analysis

Dupuit was the first to present a cogent analysis of how consumer surplus could
be decreased or increased by a policy of price discrimination. He explained this
result with the aid of tables 13-2 and 13-3. Table 13-2 utilizes the same demand data
as table 13-1 but adds a fixed cost of 110 francs. The result of adding fixed costs is
that there now exists no single tariff that will maximize profit. A tariff of 6 francs
will, however, minimize losses. Dupuit demonstrated that profits are nevertheless
possible if price discrimination is allowed. Suppose 14 passengers could be induced
by some means of differentiation to pay a tariff of 8 francs while 12 continued to pay
6 francs. The same 26 passengers would then yield gross revenue of 184 francs and
profit of 22 francs. Consumer surplus, however, would decline from 78 to 50 francs.
Table 13-3 shows these results and the effects of various other combinations of
dual pricing. Using a two-class tariff of 4 and 7 as an example, Dupuit showed how
consumer surplus could be increased over the single tariff case. From table 13-2 we
know that 41 passengers are willing to buy tickets at a price of 4 francs. Dupuit
assumed it possible to distinguish 20 passengers from this group who would be will-

Table 13-2 Monopoly Demand, Utility, and Costs

Costs Revenue
Number of Total
Tariff Passengers Utility Variable Fixed Total Gross Net
0 100 445 200 110 310 0 –310
1 80 425 160 110 270 80 –190
2 63 391 126 110 236 126 –110
3 50 352 100 110 210 150 –60
4 41 316 82 110 192 164 –28
5 33 276 66 110 176 165 –9
6 26 234 52 110 162 156 –6
7 20 192 40 110 150 140 –10
8 14 144 28 110 138 112 –26
9 9 99 18 110 128 81 –47
10 6 69 12 110 122 60 –62

Table 13-3 The Two-Class Tariff

Single Tariff Two-Class Tariff
(6) (6,8) (5,10) (4,7) (3,7) (2,6)
Number of passengers 26 (12,14) (27,6) (21,20) (30,20) (37,26)
Total utility 234 234 276 316 352 391
Gross revenue 156 184 195 224 230 230
Total costs 162 162 176 192 210 236
Net revenue –6 22 19 32 20 –6
Consumer surplus 78 50 81 92 122 161
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Chapter 13 ■ Proto-Neoclassical Economics in France 325

ing to pay a price of 7 francs for the journey. In this case discrimination would yield
gross receipts of 224 francs [(20 × 7) + (21 × 4)]. Subtracting total costs of 192
francs leaves net receipts to the monopolist of 32 francs. The consumer surplus is cal-
culated as the difference between total utility and gross receipts, a value of 92 francs.

Discrimination: Dupuit’s Graphics

Dupuit also expressed these ideas graphically. In figure 13-6, suppose OM is the
profit-maximizing price. The utility produced by the commodity or service depicted
by the demand curve of figure 13-6 would be distributed in the following manner:
the monopoly revenue would equal the area OMTR; the consumer surplus (or the
utility remaining to consumers, in Dupuit’s terminology) would equal area TMP;
finally, the lost utility, utilité perdue, would equal the triangle RTN.
Under conditions of competition this lost utility would result from scarcity of
resources. However, since Dupuit assumed zero costs of production in this instance,
lost utility in his example can only be attributable to restrictions of output under
monopoly. The significance of Dupuit’s theory of price discrimination is that he
showed how economic welfare could be increased (i.e., lost utility could be
reduced) by differential pricing. He explained with reference to figure 13-6:
When the consumers can be placed in several categories [by separating markets or
differentiating products or services] each of which attributes a different utility to
the same service, it is possible, by a certain combination of taxes, to increase the
product of the toll [the sum of consumer surplus and monopoly revenue] and to
diminish the loss of utility. (“Measurement of the Utility of Public Works,” p. 108)

Thus, if the monopolist faced with the demand curve of figure 13-6 was able to
increase the total quantity sold to Or via discrimination, the total utility (the sum of
consumer surplus and monopoly revenue in the no-cost case) would equal the area
OPnr, which is greater than OPTR by RTnr. The increase in monopoly receipts
would clearly depend on the number of submarkets that the monopolist would be
able to establish and invade. As Dupuit correctly pointed out:
If from among the pn consumers at price Op you can distinguish the number pq
who would consume at the price OM, and from among the latter the number Mq
who would consume at price Op, and can oblige them by various combinations to
pay those prices, then the yield . . . will be the sum of the three rectangles Ornp +
pqTM + Mqnp; the utility to consumers [consumer surplus] will be the three tri-
angles nqT + Tqn + npP; while the loss of utility is merely that due to the lowest
price, the triangle Nrn. (“Measurement of the Utility of Public Works,” pp. 108–109)

It can readily be seen that monopoly profits under discrimination (assuming no

costs) increase considerably over those that result from the simple monopoly price
OM. Specifically, profits increase by Mpnq+ Rqnr, and it is important to note that
they can be increased without increasing output beyond that established under the
simple monopoly output OR. In other words, price discrimination could affect the
distribution of welfare without affecting the total utility produced. But Dupuit
believed that discrimination was desirable only if it increased quantity beyond that
obtained under a single-price, simple monopoly system, for only in that event would
lost utility (utilité perdue) be reduced.
With respect to figure 13-6, Dupuit knew that output would increase if only one
of the markets could be served at the simple monopoly price but more than one
could be served with price discrimination. The market in which price Op is charged
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326 Part IV ■ The Neoclassical Era

Price

p‫׳‬ n‫׳‬

Figure 13-6 In addi-

q‫׳‬ tion to price OM, a lower
M T price, Op, will enlarge
the seller’s revenue and
q
p n the consumers’ surplus
by reducing lost utility.
A higher price, Op, will
enlarge the seller’s reve-
nue but lower the con-
O r‫׳‬ R r N Quantity sumers’ surplus.

would have been served in any event, given the simple monopoly profit-maximizing
price OM. But the relatively weaker market delineated by price Rq would not have
been entered at the simple monopoly price OM. Dupuit’s implicit suggestion that
output would increase (by Rr) if discrimination allowed the monopolist to enter
markets not entered at the simple monopoly price was only much later given scien-
tific treatment by A. C. Pigou and Joan Robinson (see chapter 20). Yet it is certainly
clear that as early as 1844 Dupuit was at the threshold of output analysis under
price discrimination, which finally yielded to Robinson’s expert treatment almost a
century later.

Dupuit and Entrepreneurship

As one of the first writers in economics to closely analyze product quality and
its impact on markets, Dupuit was naturally led into a discussion of the role of the
entrepreneur. He associated the entrepreneur’s role with demand discovery, which
he conceived as a two-stage process: The first stage emphasizes innovation; the sec-
ond stresses calculation and judgment. Both functions are complex and subtle.
In the first instance, the entrepreneur must devise winning combinations of char-
acteristics that make up a desirable product or service. Dupuit therefore linked entre-
preneurship to product differentiation. He recognized that some product variations
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Chapter 13 ■ Proto-Neoclassical Economics in France 327

are natural and some are contrived, but he did not consider the distinction crucial. The
important thing in his judgment was whether product differentiation creates value in
the subjective judgment of the consumer. He was aware that different elasticities of
demand enter the calculation and that shrewd entrepreneurs will seize the opportuni-
ties that present themselves in this regard. He cited product labeling as a case in point:
The same merchandise, disguised in different stores under various forms, is often
sold at very different prices to the rich, the well-to-do, and the poor. There is the
fine, the very fine, the extra fine, and the super fine, which, although drawn from
the same barrel, present no real difference other than a better label and a higher
price. Why? Because the same thing has a very different utility value for the con-
sumer. If the goods were sold merely at the average price, all those who attached
less utility than the price would not buy, and thus would incur a loss; and the seller
would lose because many of his customers would be paying for only a very small
part of the utility they receive (“Utility and Its Measure,” p. 177).

In the second instance, the entrepreneur must estimate the utility that consumers
attach to a particular good or service in order to devise an optimal pricing scheme.
The most important issue for Dupuit was the combined and simultaneous effect of
product differentiation on the entrepreneur’s profits and the consumers’ utility. He
took it for granted that consumers’ total utility would rise if the sales of goods and
services increased, and he saw price/product differentiation as a means to increase
total sales by inducing marginal consumers who would otherwise be “priced out” of a
single product, single price market to enter a price/product differentiated market. It is
up to the entrepreneur to motivate this process. Because all exchange involves trans-
action costs, Dupuit said that the entrepreneur must account for such aspects as con-
venience, location, and waiting (time). In transport markets, for example, he advised
that nominal rates (e.g., train tickets) might be lowered to offset the transaction costs
imposed by slow-moving trains, inconvenient departure/arrival schedules, traffic con-
gestion, and the opportunity costs associated with alternative modes of transport. In
other words, entrepreneurial responsibilities extend to attempts to accommodate cus-
tomers’ opportunity costs by adjusting nominal price to real demands.
Ultimately the quest for entrepreneurial profits, which is the essence of
dynamic competition, requires intuition, inventiveness, and judgment. It is much
more complex than merely selling the same good at the same price as one’s rivals,
or even at different prices imposed by natural market divisions. Dupuit looked
beyond these simple constraints and raised the notion of competition to a situation
in which entrepreneurs constantly tinker with ideas that eventually take form in var-
ious attributes that alter the utility-producing nature of a product or a service. The
idea that the entrepreneur produces and/or sells a single product at a single price
never fit comfortably into economic analysis because there are too many examples
to the contrary. Yet, neoclassical analysis embraced the idea, warts and all, in an
attempt to manage change and improve theoretic precision. At a time when micro-
economics was still embryonic, Dupuit emphasized economic activity rather than
market structure. This brought him into close contact with the Austrian variant of
neoclassical economics (see chapter 23) rather than its British counterpart.

Benefit-Cost Analysis: The Early Application of Price Theory

to Public Goods
Although Dupuit deserves credit as the first writer to analyze the optimum pro-
vision of public goods and public works from a welfare standpoint, belated research
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328 Part IV ■ The Neoclassical Era

has shown that he was but one of a long line of French engineer-economists inter-
ested in these problems. The French engineers Joseph Minard and Henri Navier, for
example, were working on similar questions before Dupuit. Nevertheless, Dupuit’s
invention of the marginal-utility function enabled him to give much improved esti-
mates of the benefits derived from governmentally supplied goods, and it is his for-
mulation that has inspired contemporary research on these issues.
Dupuit’s general rule for the provision of public goods, such as highways, water
distribution, and public transport, was that the government should provide these
goods if a pricing scheme could be devised to cover the total annual cost associated
with the good while simultaneously producing “net utility.” In other words, the good
should be provided if the marginal annual receipts of an enterprise could cover the
marginal costs (including capital costs) to be amortized annually over a specified
number of years.
Dupuit’s theory of the optimum provision of public goods may be illustrated uti-
lizing the model of price discrimination developed above. His analysis of discrimi-
nation was completely general in its description of the pricing technique.
Specifically, he recognized that a public monopoly, in contrast to a private monop-
oly, may follow a policy of constrained discrimination. In Dupuit’s view, government
ownership finds its raison d’être in society’s decisions concerning the distribution of
real income. If the public interest is an overriding consideration in the provision of a
good or service, the government should operate the enterprise in such a manner as
to maximize the consumer surplus. Whereas the size of the consumer surplus is of
no significance to a private monopolist, it is of prime importance to a government
concerned with the distribution of income. As Dupuit noted:
The conduct of a monopoly raises a series of important questions. . . . Is the largest
possible profit to be earned? Is the yield to be a fixed sum and the loss of utility
reduced to a minimum? (“Tolls and Transport Charges,” p. 31)

The government would likely seek to maximize the consumer surplus under the
full-cost constraint, which Dupuit presumably invoked as an allocative criterion.
This could be accomplished by using a single price, and in several examples the sin-
gle price was suggested. However, Dupuit did not overlook the value of a policy of
price discrimination by a government-operated monopoly.
Table 13-3 illustrates one situation in which price discrimination by a govern-
ment monopoly can increase public utility (i.e., aggregate welfare). To make his
case, Dupuit first described the solution that a private company would take. Assum-
ing unconstrained profit maximization, he wrote that “the tariff (4,7) yields decid-
edly more than the other combinations, and that is the one which a private company
would adopt.” (Note that this profit-maximizing two-class tariff nevertheless results
in an improvement in consumer surplus over the simple monopoly rate of 6; output
would increase, and average [simple] price would decline as well.) The two-class
tariff does not maximize consumer surplus, however, and should the government
assume ownership of the enterprise, some sort of alternative pricing scheme could
be established to augment the consumer surplus. Dupuit pointed out with reference
to table 13-3:
The tariff (2,6) maximizes utility [net utility, or producer surplus and consumer
surplus], though it does involve the railway in a loss of 6; but this loss can be
avoided by raising the second-class price just a little above 2, which would reduce
utility to about 260 and passengers to 60. This is the tariff which the government
would adopt, because it would cover all costs. The railway operated by a private
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Chapter 13 ■ Proto-Neoclassical Economics in France 329

company would serve only forty-one passengers and give them a utility of 92; if
operated by the government, it would serve 60 passengers and give them a utility
of about 160. (“Tolls and Transport Charges,” pp. 22–23)

Thus, Dupuit’s welfare measure (consumer surplus) provided a mechanism for ana-
lyzing the effects of discriminating monopoly under alternative property and insti-
tutional arrangements. His early and original insights into welfare theory, nurtured
as they were by an economic and empirical tradition among French engineers
engaged in public service, provided the necessary backdrop against which an
important and fruitful area of modern economics is being enacted. The clear enun-
ciation and application of the utility principle and the demonstration that society’s
welfare could be improved by public action in a private economy when conditions
of competition are not ubiquitously effective leave Dupuit unchallenged as the most
important early precursor of modern doctrine and practice in the field.

■ ENGINEERS AND CROSS-FERTILIZATION OF ECONOMIC IDEAS

A thorough examination of Cournot’s and Dupuit’s contributions to economic
analysis demonstrates that a sophisticated economic theory of the firm was under-
way with surprising momentum before 1850, especially in France. A later giant in
microeconomic theory, Alfred Marshall (see chapter 16) paid tribute to the special
genius of French engineers in his Industry and Trade (p. 117):
Frenchmen are especially fitted for certain large enterprises by their talent for
engineering. From early times French cathedrals and fortifications, French roads
and canals have borne evidence to high creative faculty. Since the Revolution the
engineering profession has been held in special honour in France: there is perhaps
no other country in which the ablest lads are so generally inclined towards it.

To be sure, French institutions exalted engineering studies and facilitated the train-
ing of able personnel. Napoleon reformed French higher education into a two-tiered
system: the universities and the grandes écoles. The latter, which persist to this day,
are institutions of higher learning of limited size and scope, concentrating on rigor-
ous, functional, and specialized training, and restricting admissions to only the
brightest students.
Cournot and Dupuit were products of the grandes écoles, Cournot of the École
Normale and Dupuit of the École des Ponts et Chaussées. Schooled in mathematics,
committed to scientific rigor, and alert to intellectual opportunities, these “residual
economists” pioneered important aspects of the modern theory of the firm in pre-
cisely those areas left underdeveloped by the British tradition: the evaluation of
investment plans, the consequences of fixed and variable costs for pricing deci-
sions, the rudiments of product differentiation, the conditions for successful price
discrimination, and other implications of profit maximizing behavior in imperfectly
competitive markets.
At the École des Ponts et Chaussées in particular, an impressive and lengthy
oral and written tradition in economic inquiry accumulated from the inception of
the school in 1747. By the 1830s Henri Navier (1785–1836), Joseph Minard (1781–
1870), and Charlemagne Courtois (1790–1863) were plumbing the depths of benefit-
cost analysis in the evaluation of public works. Civil engineers like them paved the
way for Dupuit’s pioneer analysis. Moreover, the influence of the grandes écoles
extended beyond national borders. The École des Ponts et Chaussées had a policy
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330 Part IV ■ The Neoclassical Era

of accepting foreign students, and one of the most capable who entered in 1830 was
an American, Charles Ellet (1810–1862), whom Jacob Viner ranked “with Cournot
and Dupuit as a pioneer formulator of the pure theory of monopoly price in precise
terms” (Long View, p. 388). And there were others: Alphonse Belpaire from Bel-
gium, and Wilhelm von Nördling from Austria, who improved the statistical specifi-
cation and discovery of railway cost functions.
This French engineering tradition that spawned Dupuit developed momentum
that carried it into the twentieth century, encouraging further innovations by Émile
Cheysson (1836–1910), René Tavernier (1853–1932), and Clément Colson (1853–
1939). But France was not the only country with a strong engineering tradition that
spilled over into economics. The earliest foundations of a parallel German tradition
are not as clear, but one practitioner in particular contributed to economic theory at
a high level. Wilhelm Launhardt (1832–1918), the successor in Germany of J. H. von
Thünen and H. K. von Mangoldt, taught engineering at the Hanover Technical
School where, like at the École des Ponts et Chaussées, the focus of economic
inquiry was on the provision of public goods. Launhardt’s Mathematische Begrund-
ung der Volkwirtschaftslehre (1885), translated in 1993 as Mathematical Principles
of Economics, is an excursion into the central problem of exchange, which in some
respects builds on Walras’s earlier analysis (see chapter 17), and in some respects
anticipates Marshall (see chapter 16). Launhardt’s emphasis throughout the Mathe-
matical Principles on the comparison of both competitive and monopoly outcomes
with the arrangement that maximizes total utility is also evocative of Dupuit’s path-
breaking contribution.
In England, where the engineering tradition was more practical and less theo-
retical, two engineers in particular did work that compares favorably to the French
and Germans: Dionysius Lardner (1793–1859) and Fleeming Jenkin (1833–1885).
Lardner especially influenced W. S. Jevons (see chapter 15) to forge ahead with the
development of microeconomic theory. In sum, nineteenth-century engineers from
different cultures and countries were alert to certain economic problems outside the
net of classical economics and were actively seeking solutions to those problems.
The global intellectual landscape of economics in the nineteenth century was nei-
ther provincial nor myopic, even though the contemporary “keepers of truth” were
not always receptive to contributions from allied disciplines. Insularity is, in large
measure, the enemy of progress in economic theory. A review of the material in this
chapter should serve to demonstrate that economists stood to gain from the efforts
of the engineers, and it is entirely possible that the reverse is also true. Specializa-
tion and division of labor, in intellectual pursuits as well as in the economic theory
of production, have definite advantages, but these advantages can be diluted by
overspecialization and close-mindedness. Economists, no less than other specialists,
must therefore guard against slavish efforts to protect their own turf at all costs.

■ CONCLUSION
Engineers are mainly practitioners who daily face the necessity of getting
things done. Finding no analytical precedent in classical economics for the prob-
lems that confronted them, French engineers and their counterparts in other coun-
tries were stimulated to forge new analytical tools. Sadly, because their expertise
was considered “too technical” (i.e., mathematical) by the reigning, orthodox econ-
omists, their contributions were not always embraced. Such was the fate of Cournot
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Chapter 13 ■ Proto-Neoclassical Economics in France 331

(though not an engineer he rationalized a method that engineers could readily iden-
tify and implement) and Dupuit, in France, and of Launhardt in Germany. The fact
that these writers received belated recognition after so many years is testimony to
the vigilance required to repel intellectual arrogance and myopia—a vigilance
which, if not maintained, condemns us to the continuous rediscovery of earlier
truths at potentially high costs.

REFERENCES
Cournot, A. A. Researches into the Mathematical Principles of the Theory of Wealth, N. T.
Bacon (trans.). New York: A. M. Kelley, 1960 [1838].
———. Principes de la théorie des richesses. Paris: Librarie Hachette, 1863.
Dupuit, Jules. “On the Measurement of the Utility of Public Works,” in R. H. Barback
(trans.), International Economic Papers, no. 2. London: Macmillan, 1952, pp. 83–
110 [1844].
———. “On Tolls and Transport Charges,” in E. Henderson (trans.), International Eco-
nomic Papers, no. 11. London: Macmillan, 1962, pp. 7–31 [1849].
———. “Tolls,” in Charles Coquelin (ed.), Dictionnaire de l’économie politique, vol. 11.
Paris: Guillaumin, 1852–1853.
———. “On Utility and Its Measure,” Journal des Economistes, 1st ser., vol. 35 (July–Sep-
tember 1853), pp. 1–27. Reprinted in Mario de Bernardi, De l’utilité et de sa mesure:
Écrits choisis et republiés. Torino: La Riforma Sociale, 1933.
Marshall, Alfred. Industry and Trade, 3d ed. London: Macmillan, 1920.
Viner, Jacob. The Long View and the Short: Studies in Economic Theory and Policy. New
York: Free Press, 1958.

NOTES FOR FURTHER READING

An article that does not bear directly on Cournot or Dupuit, but nevertheless raises
interesting questions about the influence of mechanics on economics, is Ivor Grattan-
Guinness, “How Influential Was Mechanics in the Development of Neoclassical Econom-
ics? A Small Example of a Large Question,” Journal of the History of Economic Thought,
vol. 32 (December 2010), pp. 531–581. Grattan-Guinness presents an overview of several
specific ideas from mechanics that influenced economics in the second half of the nine-
teenth century. By examining the analogies between mechanics and economics in the
work of a series of neoclassical economists, the author concludes that the influence of
mechanics is milder than is commonly thought. Another article that “sets the table” for
the approaching “feast” of public economics is Gilbert Faccarello, “An ‘exception cul-
turelle’? French Sensationist Political Economy and the Shaping of Public Economics,”
The European Journal of the History of Economic Thought, vol. 13 (Spring 2006), pp. 1–
38, which after surveying some ideas in public economics from Turgot and Condorcet to
Say, concludes that French economists devised the first theory of the optimal level of
government expenditure.
Although Cournot’s microeconomics received a great deal of attention from twenti-
eth-century theorists, a very small number of assessments of his work exists in English.
For those who read French, see Claude Ménard, La formation d’une rationalité
économique: A. A. Cournot (Paris: Flammarion, 1978); and François Vatin, Économie
politique et économie naturelle chez Antoine-Augustin Cournot (Paris: Presses Universi-
taires de France, 1998). A review of Ménard’s book, in English, by R. F. Hébert appears
in the History of Economic Thought Newsletter, vol. 23 (Autumn 1979), pp. 21–23. Other
French sources are Émile Callot, La philosophie biologique de Cournot (Paris: 1960);
Georges Loiseau, Les doctrines économiques de Cournot (New York: 1970); François
Ekelund-Hebert 6E.book Page 332 Thursday, August 1, 2013 11:03 AM

332 Part IV ■ The Neoclassical Era

Bompaire, Le principe de liberté économique dans l’oeuvre de Cournot et dans celle de

l’École de Lausanne (Paris: 1931); and two articles by René Roy, “L’Oeuvre économique
d’Augustin Cournot,” Econometrica, vol. 7 (April 1939), pp. 134–144; and “Cournot et
l’école mathematique,” Econometrica, vol. 1 (1933), pp. 13–22. An interesting account of
Cournot’s life is given by A. J. Nichol, “Tragedies in the Life of Cournot,” Econometrica,
vol. 6 (July 1938), pp. 193–197; and by Irving Fisher, “Cournot and Mathematical Eco-
nomics,” Quarterly Journal of Economics, vol. 12 (January 1898), pp. 119–138, 238–244.
The empirical nature of Cournot’s demand theory is documented in C. L. Fry and R.
B. Ekelund, Jr., “Cournot’s Demand Theory: A Reassessment,” History of Political Econ-
omy, vol. 3 (Spring 1971), pp. 190–197. The relationship of Cournot to his contempo-
raries, and the hostile reception accorded his theory, as well as Cournot’s multiple efforts
to gain recognition, are explored by R. B. Ekelund, Jr., and R. F. Hébert, “Cournot and
His Contemporaries: Is an Obituary the Only Bad Review?” Southern Economic Journal,
vol. 57 (July 1990), pp. 139–149. On the same subject, see also R. D. Theocharis, “A Note
on the Lag in the Recognition of Cournot’s Contribution to Economic Analysis,” Cana-
dian Journal of Economics, vol. 23 (November 1990), pp. 923–933. R. W. Dimand,
“Cournot, Bertrand, and Cherriman,” History of Political Economy, vol. 24 (Fall 1995),
pp. 563–578, discovered an enthusiastic early adherent of Cournot in the person of Cana-
dian economist W. B. Cherriman.
A clear and relatively timeless discussion of the Cournot, Bertrand, and Edgeworth
solutions to the duopoly problem is presented by Fritz Machlup in his Economics of Sell-
ers’ Competition (Baltimore: Johns Hopkins University Press, 1952); but see Jean Mag-
nan de Bornier, “The ‘Cournot–Bertrand Debate’: A Historical Perspective,” History of
Political Economy, vol. 24 (Fall 1992), pp. 623–656, for an attempt to correct widespread
misunderstandings about Cournot vis-à-vis Bertrand. Clarence Morrison, “Magnan de
Bornier on Cournot–Bertrand,” History of Political Economy, vol. 33 (Spring 2001), pp.
161–165, took issue with de Bornier, who responded in the same issue, pp. 167–174.
Bruce Larson and Claire Childers, “Operationally Meaningful Theorems in Light of
Cournot,” History of Political Economy, vol. 24 (Winter 1992), pp. 895–908, trace a part of
Cournot’s legacy through the subsequent contributions of Edgeworth and Samuelson.
Nicola Giocoli, “‘Conjecturizing’ Cournot: The Conjectural Variations Approach to Duo-
poly Theory,” History of Political Economy, vol. 34 (Summer 2003), pp. 175–204, opens
the “Pandora’s Box” of conjectural-variations reasoning inaugurated by Cournot.
Among other things, Cournot had a major impact on the development of game the-
ory, the branch of economics pioneered by John von Neumann and Oskar Morgenstern
in The Theory of Games and Economic Behavior (Princeton, NJ: Princeton University
Press, 1944). The pre-1944 literature on the development of two-person zero-sum games
is examined by R. W. and M. A. Dimand, “The Early History of the Theory of Strategic
Games from Waldegrave to Borel,” Toward a History of Game Theory, Annual Supple-
ment to Volume 24, History of Political Economy, ed. E. R. Weintraub (Durham, NC:
Duke University Press, 1992), pp. 15–27.
The economic writings of Dupuit are composed largely of journal contributions in
the Annales des Ponts et Chaussées and in the Journal des Économistes. A collection of
Dupuit’s major articles (in French), published in Italy under the editorship of Mario de
Bernardi, is entitled De l’Utilité et sa mesure: Écrits choisis et republies (Torino: La
Riforma Sociale, 1933). Two of these articles are in published translation (see refer-
ences). At long last, a compendium of Dupuit’s collected works has been assembled and
carefully edited, but in French only; see, Jules Dupuit, Oeuvres économiques complètes,
2 vols., Yves Breton and Gérard Klotz (eds.) (Paris: Economica, 2009). For reviews of this
collection and its significance to the history of economic thought, see Manuela Mosca,
“Œuvres économiques complètes,” The European Journal of the History of Economic
Thought, vol. 18 (Spring 2011), pp. 296–306; and R. B. Ekelund, Jr., and R. F. Hébert,
Ekelund-Hebert 6E.book Page 333 Thursday, August 1, 2013 11:03 AM

Chapter 13 ■ Proto-Neoclassical Economics in France 333

“The Intellectual Legacy of Jules Dupuit: A Review Essay,” History of Political Economy,
vol. 44 (Fall 2012), pp. 493–504.
Long obscured in the Anglo-Saxon tradition of history of economic thought, the
French econo-engineering approach was exposed by R. B. Ekelund, Jr., and R. F. Hébert,
Secret Origins of Modern Microeconomics: Dupuit and the Engineers (Chicago: Univer-
sity of Chicago Press, 1999). Jean-Pascal Simonin and François Vatin (eds.), L’oeuvre
multiple de Jules Dupuit (1804–1866): Calcul d’ingénieur, analyse économique et pensée
sociale (Angers: Presses Universitaire de Angers, 2002), have assembled papers by sev-
eral authors in an attempt to establish the full range of Dupuit’s influence. Dupuit’s con-
tributions to utility theory and to other facets of economic analysis are assessed in the
following works: G. J. Stigler, “The Development of Utility Theory,” Journal of Political
Economy, vol. 58 (August, October 1950), pp. 307–327, 373–396, reprinted in Stigler,
Essays in the History of Economics (Chicago: The University of Chicago Press, 1965); R.
W. Houghton, “A Note on the Early History of Consumer’s Surplus,” Economica, n.s., vol.
25 (February 1958), pp. 49–57; R. B. Ekelund, Jr., “Jules Dupuit and the Early Theory of
Marginal Cost Pricing,” Journal of Political Economy, vol. 76 (May–June 1968), pp. 462–
471; R. B. Ekelund, Jr., “A Note on Jules Dupuit and Neoclassical Monopoly Theory,”
Southern Economic Journal, vol. 25 (January 1969), pp. 257–262; R. B. Ekelund, Jr.,
“Price Discrimination and Product Differentiation in Economic Theory: An Early Analy-
sis,” Quarterly Journal of Economics, vol. 84 (May 1970), pp. 268–278; Arnaud Diemer,
“Jules Dupuit et la discrimination par les prix,” in Pierre Dockès, et al. (eds.), Les tradi-
tions économiques françaises 1848–1939 (Paris: CNRS Éditions, 2000); and R. B. Eke-
lund, Jr., and W. P. Gramm, “Early French Contributions to Marshallian Demand Theory,”
Southern Economic Journal, vol. 36 (January 1970), pp. 277–286. See also R. B. Ekelund,
Jr., and Mark Thornton, “Geometric Analogies and Market Demand Estimation: Dupuit
and the French Contribution,” History of Political Economy, vol. 23 (Fall 1991), pp. 397–
418. The early French tradition in public finance, of which Dupuit was a part, is dis-
cussed in two articles by R. B. Ekelund, Jr., and R. F. Hébert: “Dupuit and Marginal Util-
ity: Context of the Discovery,” History of Political Economy, vol. 8 (Summer 1976), pp.
266–273; and “French Engineers, Welfare Economics and Public Finance in the Nine-
teenth Century,” History of Political Economy, vol. 10 (Winter 1978), pp. 636–668. Also on
Dupuit, see Alan Abouchar, “A Note on Dupuit’s Bridge and the Theory of Marginal Cost
Pricing,” History of Political Economy, vol. 8 (Summer 1976), pp. 274–277; Bernard Grall,
“De l’entretien des routes à la mesure de l’utilité: le calcul de substitution chez Dupuit
(1842–1844),” in Pierre Dockès, et al. (eds.), Les traditions économiques françaises 1848–
1939 (Paris: CNRS Éditions, 2000); and R. B. Ekelund, Jr., and Y. N. Shieh, “Dupuit, Spa-
tial Economics and Optimal Resource Allocation: A French Tradition,” Economica, vol.
53 (November 1986), pp. 483–496. The history of the concept of consumer surplus,
beginning with Dupuit’s seminal contribution, is traced up to the first half of the twenti-
eth century by R. B. Ekelund, Jr., and R. F. Hébert, “Consumer Surplus: The First Hun-
dred Years,” History of Political Economy, vol. 17 (Fall 1985), pp. 419–454. Dupuit was
also surprisingly advanced in his views of consumer behavior and the role of the entre-
preneur in satisfying consumer demands, especially in light of Kelvin Lancaster’s work
on “characteristics-based” demand. See R. B. Ekelund, Jr., and R. F. Hébert, “Dupuit’s
Characteristics-Based Theory of Consumer Behavior and Entrepreneurship,” Kyklos,
vol. 44, Fasc. 1 (1990), pp. 19–34. R. B. Ekelund, Jr., “The Economist Dupuit on Theory,
Institutions, and Policy: First of the Moderns?” History of Political Economy, vol. 32
(Spring 2000), pp. 1–38, makes the case for Dupuit as a complete economist in the mod-
ern sense.
Yves Breton and Gérard Klotz, “Jules Dupuit, Société d’économie politique de Paris
and the Issue of Population in France (1850–66),” The European Journal of the History of
Economic Thought, vol. 13 (Summer 2006), pp. 337–363, presents Dupuit’s thoughts on
Ekelund-Hebert 6E.book Page 334 Thursday, August 1, 2013 11:03 AM

334 Part IV ■ The Neoclassical Era

population and Malthusian problems in an attempt to establish him as more than merely
a brilliant engineer-economist. Philippe Poinsot, “The Foundations of Justice in Jules
Dupuit’s Thought,” The European Journal of the History of Economic Thought, vol. 17
(December 2010), pp. 793–812, argues that the dispute between Dupuit and the French
liberals was not strictly about public utility versus natural rights. For Dupuit, justice is
based on welfare and hence, public utility, although natural rights are not necessarily
excluded from consideration.
The recurrent theme in Ellet’s work is that business decision making could and
should be based on mathematically derived principles, which Ellet called “the Laws of
Trade.” See Charles Ellet, Jr., An Essay on the Laws of Trade in Reference to the Works of
Internal Improvement of the United States (New York: A. M. Kelley, 1966); and same
author, “The Laws of Trade Applied to the Determination of the Most Advantageous Fare
for Passengers on Railroads,” Journal of the Franklin Institute, vol. 30 (1840), pp. 369–
379. With few exceptions, Ellet has been passed over by historians of economic thought.
The notable exceptions are C. D. Calsoyas, “The Mathematical Theory of Monopoly in
1839: Charles Ellet, Jr.,” Journal of Political Economy, vol. 58 (April 1950), pp. 162–170;
an unpublished dissertation by C. H. Shami, Charles Ellet, Jr., Early American Economist
and Econometrician 1810–1862: An Analytical Exposition of His Theories (New York:
Columbia University, 1968); R. B. Ekelund, Jr., and D. L. Hooks, “Joint Demand, Discrim-
inating Two-Part Tariffs and Location Theory: An Early American Contribution,” West-
ern Economic Journal, vol. 10 (March 1972), pp. 84–94; and C. R. Bell, “Charles Ellet, Jr.,
and the Theory of Optimal Input Choice,” History of Political Economy, vol. 18 (Fall
1986), pp. 485–495.
The lively interest in applied economic questions at the École des Ponts et
Chaussées is amplified by examining the contributions of a number of its famous stu-
dents. See R. B. Ekelund, Jr., and R. F. Hébert, “Public Economics at the École des Ponts
et Chaussées: 1830–1850,” Journal of Public Economics, vol. 2 (July 1973), pp. 241–256.
Besides Ellet, who was enrolled at the École as an externe, R. D. Theocharis, “C. Cour-
tois: An Early Contributor to Cost-Benefit Analysis,” History of Political Economy, vol. 20
(Summer 1988), pp. 265–274, has added the name of Charlemagne Courtois to the list of
pioneering engineer-economists.
Émile Cheysson’s contributions to economics have been analyzed by R. F. Hébert in
several articles: “Émile Cheysson and the Birth of Econometrics,” Économies et Sociétés,
vol. 20 (October 1986), pp. 203–222; “A Note on the Historical Development of the Eco-
nomic Law of Market Areas,” Quarterly Journal of Economics, vol. 86 (November 1972),
pp. 563–571; “Wage Cobwebs and Cobweb-Type Phenomena: An Early French Formula-
tion,” Western Economic Journal, vol. 11 (December 1973), pp. 394–403; and “The Theory
of Input Selection and Supply Areas in 1887: Émile Cheysson,” History of Political Econ-
omy, vol. 6 (1974), pp. 109–113. Wilhelm Nordling’s statistical research on railway cost
curves is preserved in Elizabeth Henderson’s translation, “Note on the Cost of Railway
Transport,” International Economic Papers, no. 10 (1960), pp. 64–70. Cheysson incorpo-
rated Nordling’s statistics into his “econometric” model of railway profit maximization.
For an English translation of Launhardt’s pioneer Mathematische Begrundung der
Volkwirtschaftslehre, see Launhardt, Mathematical Principles of Economics, John
Creedy (trans.) (Aldershot, UK: Edward Elgar, 1994), which exposes the full range of
Launhardt’s “general-equilibrium” approach to exchange and value, as well as his sub-
stantial contributions to spatial economics. A brief extract from this same work was
translated earlier and included in W. J. Baumol and S. M. Goldfeld (eds.), Precursors in
Mathematical Economics: An Anthology (London: London School of Economics and
Political Science, 1968). For those who read German, the standard early reference on
Launhardt’s spatial economics is E. Schneider, “Bemerkungen zu einer Théorie der
Raumwirtschaft,” Econometrica, vol. 3 (1935), pp. 70–105.
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Chapter 13 ■ Proto-Neoclassical Economics in France 335

British engineers who helped pioneer advances in nineteenth-century microeco-

nomics include Dionysius Lardner and Fleeming Jenkin, who both fit into the story of
William Stanley Jevons (see chapter 15). Lardner’s book, Railway Economy, resides in
the library at the École des Ponts et Chaussées, but it is not known whether there was
any direct filiation between French and English engineers on microeconomic ideas. D. L.
Hooks, “Monopoly Price Discrimination in 1850: Dionysius Lardner,” History of Political
Economy, vol. 3 (Spring 1971), pp. 208–223, explores Lardner’s contribution to the the-
ory of monopoly price and the concept of demand for a product over economic distance.
Jenkin’s economic writings have been collected and reprinted under the title The
Graphic Representation of the Laws of Supply and Demand, and Other Essays on Politi-
cal Economy, 1868–1884 (London: London School of Economics and Political Science,
1931). For an assessment of Jenkin and his work, see A. D. Brownlie and M. F. L. Prich-
ard, “Professor Fleeming Jenkin, 1833–1885: Pioneer in Engineering and Political Econ-
omy,” Oxford Economic Papers, vol. 15 (November 1963), pp. 204–216. An excellent
commentary on Lardner and Jenkin is provided by R. M. Robertson, “Jevons and His
Precursors,” Econometrica, vol. 19 (July 1951), pp. 229–249.
Ekelund-Hebert 14.fm Page 336 Thursday, August 1, 2013 2:22 PM

14

Microeconomics in
Germany and Austria
Menger, Wieser, and Böhm-Bawerk

German economics in the nineteenth century may be viewed in the literal sense, as
spawned by Germany’s native sons, or it may be treated as the collective wisdom of
economists who expressed themselves in the German language. In the literal sense,
the peak analytical achievements of the nineteenth century were relatively few,
although powerfully original. Several key German writers anticipated the marginal-
ist revolution in economic analysis, and their work is on a par with Cournot and
Dupuit. J. H. von Thünen, H. H. Gossen, and H. K. von Mangoldt contributed to an
analytical tradition that was rich in theoretical insight but was underappreciated by
the German historical school (see chapter 11). As the historicists gained the upper
hand in the universities of late nineteenth-century Germany, the seat of theoretical
economics shifted to Austria, a country politically apart from Germany but joined to
its sister state by a common language and culture.
This chapter deals primarily with the economics of the three writers who
together made up the Viennese school. The founder of this group was Carl Menger
(1840–1921). He was joined by two younger but able disciples: Friedrich Wieser
(1851–1926) and Eugen Böhm-Bawerk (1851–1914). Together they established a
systematic approach to economic analysis that persists today as an alternative to
mainstream (i.e., Anglo-American) neoclassical economics. Many of their students
and their students’ students became prominent twentieth-century economists, espe-
cially Joseph Schumpeter, Ludwig von Mises, Friedrich Hayek, Fritz Machlup, Gott-
fried Haberler, and Oskar Morgenstern (see chapter 23).

■ GERMAN PROTO-NEOCLASSICISTS
In order to stress the continuity of Germanic ideas, we turn first to the pio-
neers—those writers who blazed the way for theoretical economics in Germany and
Austria. The contributions of J. H. von Thünen, H. H. Gossen, and H. K. von Man-
goldt form an analytical backdrop for the Viennese school.

336
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Chapter 14 ■ Microeconomics in Germany and Austria 337

J. H. von Thünen
Johann Heinrich von Thünen (1783–1850) was a successful farmer and brilliant
theorist who worked in isolation on his agricultural estate in Mecklenburg, Ger-
many. He understood, as few economists have before or since, the proper relation
between theory and facts—which is the hallmark of any scientific investigation. It
was this characteristic of his thought that endeared him to Alfred Marshall (see
chapter 16), who claimed to have “loved [him] above all my masters” (Memorials, p.
360). One of the things Marshall learned from von Thünen was how to apply the
principle that all forms of expenditure should be carried to the point at which the
product of the last unit equals its cost: the total product is maximized only when
resources are allocated equimarginally.
Von Thünen is credited with a number of important and original anticipations
of modern economic theory, such as the concepts of economic rent, diminishing
returns, opportunity costs, and the marginal-productivity theory of wages. Above all
else, however, he was a pioneer in the economic theory of location; so we will exam-
ine his contribution to marginal analysis primarily in that context. Like Ricardo, von
Thünen recognized that differences in the cost of producing agricultural products
result from utilization of land of different quality. Whereas Ricardo focused on dif-
ferences in soil fertility, von Thünen concentrated his analysis on differences in land
location (i.e., distance from a central selling point). At the same time, he recognized
that those products that are bulky in relation to value are more costly to transport
than those that are less so, and that perishability of some farm products prevents
long periods in transit.
The problem, therefore, was to devise the best (most profitable) system of land
utilization. Von Thünen’s solution was so carefully worked out that he rightfully
deserves the distinction of being called the father of location theory in economics.
His argument was couched in a theoretical construction, or model, which has the
following characteristics: A large town (market) is situated in the center of a fertile
plain that has neither canals nor navigable rivers. The only means of conveyance is
by horse-drawn wagon or a similar means of transport. All land within the plain is of
equal fertility, and there are no other comparative advantages of production between
plots. At a considerable distance from the city, the plain ends in an uncultivated wil-
derness. The town draws its produce from the plain, the inhabitants of which it sup-
plies with manufactured products. There is no trade with the outside world.
A model developed by Melvin Greenhut (Plant Location, see references) shows
how the boundaries of production are determined for two competing crops once the
costs of production and transportation are known. In figure 14-1 assume that O is
the central market point in the middle of a homogeneous plain. OA is the cost of
producing a dollar’s worth of potatoes and AS is the cost of transporting the pota-
toes over a distance of OJ miles. Similarly, AT and OK represent an identical cost
and distance in the opposite direction. AS and AT show the gradual increase in
transport costs (and total costs) as the distance from O increases. On the other
hand, OB represents the cost of producing a dollar’s worth of wheat, and BM repre-
sents its transport cost for distance OX. (The same relationship exists for cost BN
and distance OX). The freight rate is assumed to be higher on potatoes than on
wheat because the former yields a greater bulk per acre than the latter.
Von Thünen’s assumption of a uniform, homogeneous plain means that labor
and capital are equally productive at all locations and that the cost of production per
acre of output is everywhere the same. From figure 14-1 it will be seen that at a dis-
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338 Part IV ■ The Neoclassical Era

T S
N M

H‫׳‬ L‫׳‬
B
B‫׳׳‬ B‫׳‬

A‫׳׳‬ A A‫׳‬

X K H O L J X‫׳‬

Figure 14-1 The delivered cost of a dollar’s worth of potatoes (AS or AT) exceeds the
delivered cost of a dollar’s worth of wheat (BM or BN) to the east of L and to the west of
H. Therefore potato producers will locate in the OL and OH regions, and wheat will be
grown in the LX and HX regions.

tance beyond OL, the delivered cost of a dollar’s worth of potatoes (cost line AS)
exceeds the delivered cost of a dollar’s worth of wheat (cost line BM). Therefore,
producers of potatoes will tend to locate to the west of L and to the east of H,
whereas wheat producers will locate to the east of L and to the west of H. Further-
more, if transport costs are the same in every direction, OL becomes the radius of a
circle within which potato production will take place. In other words, von Thünen’s
model gives us the least-cost location for each crop within the isolated state. It also
illustrates the principle of equimarginal allocation. Resources should be allocated to
potato production only up to the point where the cost of producing a dollar’s worth
of potatoes equals the cost of producing a dollar’s worth of wheat. Finally, the
model can be generalized to include more than two crops.
Von Thünen’s theory deals with the classical problem in location analysis,
namely, the location of producers over an area that serves consumers at a central
point. Although its assumptions are restrictive, it nevertheless marked a significant
beginning in locational analysis and in mathematical economics. Moreover, Green-
hut has shown that the analysis is not limited to agricultural locations but can be
adapted to the locational decision of manufacturing concerns as well.

H. H. Gossen
The first writer who developed a full-fledged theory of consumption grounded
in the marginal principle was Hermann Heinrich Gossen (1810–1858), also a native
of Germany. He served as a tax assessor for the Prussian government but had retired
from this position by the time he wrote his one great work in 1854, a book entitled
Development of the Laws of Human Relationships and of Rules to Be Derived There-
from for Human Action. Despite Gossen’s high expectations, the book passed almost
unnoticed. In bitter disappointment, he recalled all of the unsold copies from the
publisher (who had published it on commission only) and destroyed them. Afflicted
with tuberculosis soon afterward, Gossen died in 1858, convinced that his ideas,
original and valuable as they were, would never bring honor to his name. So ended
in personal tragedy a life that had much to give theoretical economics but that
received even less recognition in his native country than Cournot had in his.
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Chapter 14 ■ Microeconomics in Germany and Austria 339

Technically speaking, Gossen’s work shares certain traits with the work of
Dupuit, Jevons, Walras, and, to a somewhat lesser extent, Menger. Yet, more than
anyone else—with the possible exception of Jevons—Gossen’s economics seems to
be rooted in an attempt to mathematize Bentham’s hedonic calculus. Gossen viewed
economics as the theory of how people as individuals and as groups realize the
maximum of pleasure with the minimum of pain. He insisted that mathematical
treatment was the only sound way to handle economic relations and applied this
method throughout his work to determine maxima and minima.
Gossen’s book was organized in two parts of about equal length. The first,
devoted to pure theory, has attracted the most (belated) attention for its early for-
mulation of the two laws that have come to bear Gossen’s name. Gossen’s first law
formulated the principle of diminishing marginal utility and gave it graphical
expression. His second law described the condition for utility maximization: To
maximize utility a given quantity of a good must be divided among different uses in
such a manner that the marginal utilities are equal in all uses. Also included in this
first part of his work are Gossen’s laws of exchange (accompanied by complicated
geometrical representation) and his theory of rent. The second part of his book is
devoted to applied theory, including the “rules of conduct pertaining to desires and
pleasures,” and the refutation of certain “social errors” concerning education, prop-
erty, money, and credit. Philosophically, Gossen was a utilitarian and a classical lib-
eral; he was opposed to government intervention, especially in those instances
when individual initiative and free competition suffice as guiding principles of the
economic order.
The neglect of Gossen’s work was a setback for the progress of economic the-
ory. He was rediscovered by Jevons in 1879, but only after independent discoveries
of the same magnitude had been made in economics by Jevons, Menger, and Wal-
ras. Important contributions to the subjective theory of value and the marginal prin-
ciple preceded Gossen’s, of course (Dupuit’s contribution appeared a decade earlier,
for example), but no work carried either idea as far as Gossen did until after 1870.
His bitter disappointment at the neglect of his work was understandable, but he was
also naive. He boasted that his work did for economics what Copernicus had done
for astronomy—a pretentious claim, but one that Léon Walras (see chapter 17) nev-
ertheless took for understatement. But then we must remember Walras’s own disap-
pointment when he did not receive the Nobel Peace Prize after nominating himself.
As for Gossen, perhaps the most encouraging thing that can be said of his personal
tragedy is that the future was on his side.

H. K. von Mangoldt
Unlike von Thünen and Gossen, Hans Karl Emil von Mangoldt (1824–1868)
operated from an academic base. He received his doctorate in 1847 from the Uni-
versity of Tübingen, then studied for two years under Roscher at the University of
Leipzig, and for a short time with Georg Hanssen1 at the University of Göttingen. In
between he pursued a journalistic career that he was forced to abandon in 1854
because of his liberal beliefs. Mangoldt got permission to teach on the basis of his
first book, Die Lehre vom Unternehmergewinn, a study of entrepreneurial profits,
published in 1855. Seven years later he was elected to the chair vacated by Karl
Knies at the University of Freiburg. In 1863, Mangoldt published his second book,

1
Georg Hanssen (1809–1894) held a faculty position at Göttingen where he was known primarily
for his empirical work, but he also did much to draw attention to the work of von Thünen.
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340 Part IV ■ The Neoclassical Era

Grundriss der Volkswirthschaftlehre, a small treatise that had its origin in his lecture
notes but also contained some highly original theoretical innovations. T. W. Hutchi-
son called it “a distant infant cousin of Marshall’s Principles” (Review of Economic
Doctrines, p. 134). Mangoldt died of a heart attack in 1868, after a short life.
Mangoldt’s theoretical work is divided into two parts. His first book, which
developed the theory of profit and the role of the entrepreneur, shows the combined
influence of Roscher and von Thünen (through Hanssen). It was probably inspired
in part by the challenge of socialism, which induced Mangoldt to take a fresh look
at how factor rewards are distributed. Mangoldt was one of a few early writers who
separated the entrepreneur from the capitalist and linked entrepreneurial profit to
risk taking. Specifically, he characterized entrepreneurial profits as the reward for a
range of activities, including finding particular markets, acquisition of productive
agents, skillful combination of factors of production on the right scale, successful
sales policy, and in the final analysis, innovation. Frank Knight found Mangoldt’s
profit theory “a most careful and exhaustive analysis” (Risk, Uncertainty and Profit,
p. 27).
The second part of Mangoldt’s work (Grundriss) consists of a reworking of the
main parts of economic theory from a curiously ambiguous perspective, one that
combined aspects of classical and neoclassical analysis. Despite this ambiguity, the
list of original contributions by Mangoldt is fairly impressive, considering the fact
that Mill’s Principles represented the state of the discipline in Mangoldt’s day. This
list includes a “Marshallian” treatment of supply and demand, embryonic notions of
elasticity and economies of scale, a discussion of multiple equilibriums, the general-
ization of von Thünen’s (marginal productivity) principle of distribution (especially a
generalized concept of rent), and a graphical analysis of price formation under con-
ditions of joint supply and demand. Mangoldt’s subjective theory of value must be
added to the small but growing list of such treatments before 1871, but the subjec-
tive viewpoint did not permeate his analysis as it did the later work of the Austrians.
The purpose of this section has not been to link von Thünen, Gossen, and Man-
goldt with the Austrian school in any overt sense but merely to indicate the depth
and breadth of Teutonic economic thought in the nineteenth century. This sets the
stage for an appreciation of the Austrian contribution. We wish to note, however,
that a retrospective view of the writings of early German theorists gives new force
and meaning to Alfred Marshall’s statement that “the most important economic
work that has been done on the Continent in this century [19th] is that of Germany”
(Principles, p. 66).

■ CARL MENGER (1840–1921)

The fundamental details of Menger’s life can be set forth simply. He was born in
1840 in Galicia, then part of Austria, descended from a family of Austrian civil ser-
vants and army officers. Menger studied law at the universities of Prague and Vienna,
and in 1867 he turned to economics, perhaps because of an interest in stock market
prices (he covered the stock market for a time as a writer for the Vienna Zeitung).
Menger published his carefully written Grundsätze (translated as Principles of Eco-
nomics) in 1871, and his fame began to spread soon thereafter. He received an
appointment to the University of Vienna, where he remained on faculty until his
retirement in 1903. Between 1876 and 1878 he served as tutor to Crown Prince Rudolf.
At first blush, Menger appears to have been the epitome of the plodding, pedan-
tic academic. But in fact he was the leader of a veritable theoretical revolution, the
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Chapter 14 ■ Microeconomics in Germany and Austria 341

founder of a school of thought, and a verbal scrapper par excellence against what
he regarded as the excesses of German historicism. By his own volition, he became
a major protagonist in the methodenstreit (method struggle) with historicist Gustav
Schmoller (see chapter 11). Menger entered the fray by attacking Schmoller in his
Untersuchungen über die Methode des Sozialwissenschaften (1883) in which he
defended the deductive method against Schmoller’s extreme historicism. Empha-
sizing all-important subjective factors, Menger defended self-interest, utility maxi-
mization, and complete knowledge as the elemental foundations of economics. He
considered aggregative, collective ideas useless, unless they were firmly grounded
in individual behavior.
Schmoller defended the historical method as the only method relevant for ana-
lyzing the social organism. In Schmoller’s view, the Austrians, by focusing on the
individual’s behavior under constraints, were leaving out the most important
things—dynamic institutions. In the end, the debate became personal and, in conse-
quence, pointless. Schmoller and his followers (effectively, it would seem) boycot-
ted Austrian professors at German universities, and it was a long while before
Germany produced theorists of the first rank. In the end, however, the steady influ-
ence of Menger’s Principles2 and the work of his disciples began to overcome his-
toricist criticism, and the controversy ended with the Austrians getting the upper
hand. Austrian economics picked up adherents in England (William Smart and
James Bonar), and the principle of subjective utility analysis eventually carried the
day. For that reason, Menger’s Principles took on a leading role in the development
of Austrian economics.

Menger and Economizing Man

Menger’s economic theory is characterized by careful logic beginning at the
most fundamental levels. He began his investigation into value theory, for example,
with a lengthy and systematic discussion of goods, which he distinguished from
what he called “useful things.” In order for a thing to possess goods-character, four
conditions must be met simultaneously: (1) the thing must fulfill a human need, (2)
it must have properties that would establish a causal connection between it and the
satisfaction of the need, (3) there must be a recognition of this causal connection,
and (4) there must be command of the thing sufficient to direct it to the satisfaction
of the need. If one of these conditions was missing, a person would have a useful
thing, but not a commodity in the market sense.
Armed with a basic definition of an economic good, Menger proceeded to dis-
tinguish goods by order. Goods of the first order are capable of satisfying human
needs directly, while higher-order goods (capital, production goods) derive goods-
character from their ability to produce lower-order goods. Higher-order goods can
satisfy human needs only indirectly, for as Menger pointed out with reference to the
production of bread, “What human need could be satisfied by a specific labor ser-
vice of a journeyman baker, by a baking utensil, or even by a quantity of ordinary
flour?” (Principles, pp. 56–57).
Menger emphasized the complementarity of higher-order goods in establishing
their “goods character.” The ability of higher-order goods to satisfy human needs
requires command over complementary goods of higher order. He illustrated the

2
Ironically, Menger dedicated his Principles to Wilhelm Roscher, founder of the older historical
school. As noted in chapter 11, Roscher was far less extreme in his (historicist) critique of eco-
nomic theory than Schmoller.
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342 Part IV ■ The Neoclassical Era

causal connection between first-order goods and higher-order goods with an exam-
ple in which he hypothesized what would happen if the demand for tobacco disap-
pears. According to Menger:
If, as the result of a change in tastes, the need for tobacco should disappear com-
pletely, the first consequence would be that all stocks of finished tobacco products
on hand would be deprived of their goods-character. A further consequence would
be that the raw tobacco leaves, the machines, tools, and implements applicable
exclusively to the processing of tobacco, the specialized labor services employed in
the production of tobacco products, the available stocks of tobacco seeds, etc.,
would lose their goods-character. The services, presently so well paid, of the
agents who have so much skill in the grading and merchandising of tobaccos in
such places as Cuba, Manila, Puerto Rico, and Havana, as well as the specialized
labor services of the many people both in Europe and in those distant countries,
who are employed in the manufacture of cigars, would cease to be goods. (Princi-
ples, p. 65)

It is the causal sequence, i.e., the notion that the value (and goods-character) of
first-order goods is transmitted or imputed to higher-order goods, which so typifies
Austrian economics. Menger also emphasized a basic complementarity and interde-
pendence of all goods we consume. This complementarity, which Menger so bela-
bored with respect to consumption, was also, as we shall see, carried over to the
theory of production by the Austrians.

Economic Goods and the Valuation Process

Having established the fundaments of the things that are traded in a market,
Menger set out to show how humans, on the basis of a knowledge of available sup-
ply and demand, direct the available quantities of goods to the greatest possible sat-
isfaction. He maintained that the origins of human economy were coincident with
the origins of economic goods. Economic goods are defined as those whose require-
ments are greater than the available supply. Noneconomic goods, conversely, are
those, such as air or water, whose supply exceeds requirements. And here Menger
makes an interesting point—that the basis for property is the protection of owner-
ship of economic goods. (By contrast, communism is founded on noneconomic rela-
tions.) Of course, there is nothing inherent in goods that make them economic or
noneconomic; their character can change with changes in supply or demand.
According to Menger, a good is said to have value if economizing humans per-
ceive that the satisfaction of one of their needs (or the greater or lesser completeness
of its satisfaction) depends on their command over the good. Utility is the capacity of
a thing to satisfy human needs, and as such it is a prerequisite of goods-character. Of
course, noneconomic goods may also possess utility since the subjective valuation
between use and need (one’s need for air or water, for instance) relates to a specific
quantity; but economic goods, Menger pointed out, presuppose scarcity.
Menger’s distinctions call to mind Smith’s water–diamond paradox. Smith, it
will be recalled, was puzzled by the fact that water, which has so much value in use,
has no value in exchange, while diamonds, which have practically no value in use,
are expensive. Menger argued that both water and diamonds undisputedly possess
utility, the difference being that diamonds are scarce relative to the demand for
them. Further, the subjective valuation between use and need for water could not be
related to a specific quantity, and water therefore cannot possess use value. Use
value presupposes scarcity, and economic goods alone possess use value.
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Chapter 14 ■ Microeconomics in Germany and Austria 343

The Equimarginal Principle

Although Gossen has priority in this regard, Menger nevertheless presented one
of the first clear discussions of the equimarginal principle of welfare maximization.
He first emphasized that satisfactions have different degrees of importance to people:
The maintenance of life depends neither on having a comfortable bed nor on hav-
ing a chessboard, but the use of these goods contributes, and certainly in very dif-
ferent degrees, to the increase of our well-being. Hence there can also be no doubt
that, when men have a choice between doing without a comfortable bed or doing
without a chessboard, they will forgo the latter much more readily than the former.
(Principles, p. 123)

In other words, there is a subjective factor in an economizing individual’s valuation

process, and this subjective element establishes the extent to which different satis-
factions have different degrees of importance. Menger emphasized that within the
same class of goods, satisfactions may vary in importance. People try to satisfy their
more urgent before their less urgent needs, but they will also combine the more
complete satisfaction of more pressing wants with the lesser satisfaction of less
pressing wants.
Menger explained his theory with the use of a table, replicated below as table 14-
1. The Roman numerals depict ten classes of wants, represented in descending order
so that want III is less urgent than want II, want IV is less urgent than want III, and so
on. To drive home his point, Menger assumed that an individual is able to rank satis-
factions in a cardinal manner, i.e., assign number indices to them. Thus, the individ-
ual can say that consumption of the first unit of commodity I (e.g., food) yields 10
units of satisfaction, while the first unit of commodity V (e.g., tobacco) gives but 6. To
derive valid conclusions we must assume that satisfactions from consuming, say,
goods IV and VII (or any other two goods) are independent. Furthermore, we assume
that some other resource (other than goods I to X) is being used to obtain units of
these ten goods, and that additional units of each commodity may be obtained with
an equal expenditure of this resource (for convenience, we call this other resource
“money,” and we assume that the unit price of each good purchased is $1).
According to Menger an economizing person would behave in the following
manner. If the individual possessed a limited budget of $3 and spent it all on the com-
modity of highest importance (I), he or she would obtain 27 units of satisfaction (i.e.,
10 + 9 + 8). In this in-
stance, however, the indi-
Table 14-1 The Theory of Value vidual would seek to
combine satisfactions ob-
I II III IV V VI VII VIII IX X tained from commodi-
10 9 8 7 6 5 4 3 2 1 ties I and II. Buying 2
9 8 7 6 5 4 3 2 1 0 units of commodity I and
8 7 6 5 4 3 2 1 0 1 unit of commodity II,
7 6 5 4 3 2 1 0 the individual would ob-
6 5 4 3 2 1 0 tain 28 units of satisfac-
5 4 3 2 1 0 tion (i.e., 10 + 9 + 9).
4 3 2 1 0 With, say, $15 at his or
3 2 1 0 her command, the indi-
2 1 0 vidual would allocate ex-
1 0 penditures so that, at the
0 margin, the satisfaction
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344 Part IV ■ The Neoclassical Era

obtainable from commodities I through V would just equal 6, as can easily be verified
from table 14-1.3 Thus, Menger established an equimarginal principle. That is, given
scarce means (dollars, in our example), the individual will arrange his or her various
consumptions so that at the margin, satisfactions are equal. In doing so, Menger’s
economizing individual maximizes total satisfaction. Paradoxically, Menger estab-
lished the importance of being unimportant.
Accordingly, in every concrete case, of all the satisfactions secured by means of the
whole quantity of a good at the disposal of an economizing individual, only those
that have the least importance to him are dependent on the availability of a given
portion of the whole quantity. Hence the value to this person of any portion of the
whole available quantity of the good is equal to the importance to him of the satis-
factions of least importance among those assured by the whole quantity and
achieved with an equal portion. (Principles, p. 132)

Thus, it is the least urgent satisfaction obtainable from a given stock of goods that
gives value to that good. For example, imagine a given quantity of water available to
an individual. He or she puts the available stock to many uses, from the most urgent
(maintaining life) to the least (watering his or her flower garden). The determina-
tion of the value of any portion of water is in this case subjective—it is in its least
important use, gardening. Any given portion of the good could stand for any other
portion, of course.
In extending value theory this way, Menger also considered the impact of differ-
ences in the quality of goods on their value. He presented a theory of exchange and
its limits, concluding that under certain cases, “If command of a certain amount of
A’s goods were transferred to B and if command of a certain amount of B’s goods
were transferred to A, the needs of both economizing individuals could be better
satisfied than would be the case in the absence of this reciprocal transfer” (Princi-
ples, pp. 177–178). His examples of isolated exchange are copious, eschew mathe-
matical expression, and are often cumbersome—but they broke new ground. In
addition, Menger analyzed the effects of competitive and monopoly structures on
price. Like Jevons, but unlike Dupuit, he did not relate utility (satisfactions, in
Menger’s terms) to the demand curve. Thus, along with Jevons, he ignored con-
sumer surplus. Yet, a survey of Menger’s overall contributions to utility and value
theory reveals a contribution of clear originality in breadth and exposition. More-
over, his originality persisted in his theory of production.

Imputation and Factor Values

One of Menger’s most interesting and important contributions relates to his
attempt to determine the value of productive resources, or what he called “higher-
order goods.” When discussing the value of consumer goods Menger put opportu-
nity cost at the center of his analysis. The value of a particular good to an individual
is equal, he said, “to the importance he attaches to the satisfactions he would have
to forgo if he did not have command of it” (Principles, p. 162). This same principle
extends to the valuation of higher-order goods as well. Menger approached the
problem by means of a thought experiment.
3
What would the economizing individual do if he or she possessed $16 rather than $15? Another
expenditure of $1 on an additional unit of goods I through VI would yield only 5 units of satisfac-
tion, and satisfactions would then not be equal at the margin. Unless units of all commodities were
infinitely divisible (an assumption of mathematical continuity), the individual would be in disequi-
librium. The result is a consequence of Menger’s discrete ordering.
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Chapter 14 ■ Microeconomics in Germany and Austria 345

Suppose a given amount of labor, capital, and land combines to produce some
output (x). On what does the value of any unit of productive resources—say, a unit
of labor—depend? The value of a unit of labor is determined by the net loss of satis-
faction resulting from the reduction in final output attributable to the unit of labor.
The reduction in output depends, of course, on the degree to which the productive
resources are substitutable. Productive relations are generally of two sorts: (1) vari-
able proportions, in which the proportions of different higher-order goods can be
altered to produce a given output, and (2) fixed proportions, in which a fixed
amount of one resource must be combined with a fixed amount of another resource
to produce a given output. An example of the former might be the ability to alter
proportions of fertilizer and land to produce a given amount of agricultural output.
Fixed-proportion relations might be typified by the necessary proportions of hydro-
gen and oxygen required to produce water. Menger clearly understood the impor-
tance of both types of productive relations and their significance for the valuation of
higher-order goods, and, unlike his followers, Wieser and Böhm-Bawerk, he
emphasized the very wide range within which proportions could be varied.
Returning to our example, how would Menger evaluate a unit of labor? He gave
explicit directions:
Assuming in each instance that all available goods of higher order are employed in
the most economic fashion, the value of a concrete quantity of a good of higher
order is equal to the difference in importance between the satisfactions that can be
attained when we have command of the given quantity of the good of higher order
whose value we wish to determine and the satisfactions that would be attained if
we did not have this quantity at our command. (Principles, pp. 164–165)

In the case of variable proportions, the reduction in a unit of labor would mean
that the output of x(x0) would be reduced to some level, say x1. The remaining labor,
capital, and land still produce x. The value of the unit of labor would then be the dif-
ference in total satisfaction when x0 was produced and when x1 was produced (or x0
– x1). This theory, original to Menger, might be characterized as a marginal-value-
productivity theory of input valuation.
But if productive relations are arranged in rigidly fixed proportions, the reduc-
tion of a unit of labor would mean that no x would be produced. Would the value of
a unit of labor (or of any of the other inputs), then, be the whole output of x?
Assuming that resources are originally combined to produce goods for maximum
satisfaction, a recombination of the remaining labor, capital, and land could pro-
duce a different good—say, y—but it would result in lower total satisfaction. Thus,
Menger reasoned that the value of a unit of labor would be the difference between
total satisfaction when the unit was used to produce x(x0) and total satisfaction
when all resources but that unit were used to produce some other good, y. Unfortu-
nately, it is difficult to develop a concept of marginal productivity under such cir-
cumstances, and Wieser and Böhm-Bawerk all but ignored Menger’s insistence on
the applicability of variable proportions. Wieser, however, tackled this same prob-
lem with a different effect, as we shall soon see.

■ FRIEDRICH VON WIESER (1851–1926)

Friedrich von Wieser was born in Vienna in 1851 of aristocratic parents. He
entered the University of Vienna to study law at the age of seventeen. After graduat-
ing in 1872, Wieser was briefly employed in government service, but his strong intel-
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346 Part IV ■ The Neoclassical Era

lectual interests pulled him back into academics, this time to study economics. Armed
with a travel grant and joined by his boyhood friend (and later brother-in-law), Eugen
von Böhm-Bawerk, Wieser studied economics under Karl Knies at the university of
Heidelberg, and he studied at the universities of Jena and Leipzig. Already much
impressed with Menger’s Principles, Wieser wrote a seminal paper on value that
formed the foundation for his later ideas. In 1884, he was appointed professor of eco-
nomics at the German University in Prague. In 1903, he inherited Menger’s position
at the University of Vienna. He became Austrian minister of commerce in 1917, but
owing to the collapse of the Austro-Hungarian Empire, later returned to teaching. A
man of wide-ranging intellect, Wieser maintained his broad interests (among other
interests he was a great fan of opera) by writing on varied topics and by creating, in
his own home, a forum for artistic and intellectual communication.
Wieser’s most important theoretical work was Natural Value (Der naturliche
Werth), published in Vienna in 1889, a book that further probed the themes set forth
by Menger. In a second book, Social Economics, he combined economic theory and
institutional analysis, already foreshadowing his later interests in sociology. His great
sociological study and final work, Das Gesetz der Macht (1926) was an exhaustive
analysis of numerous societal organizations. Despite an incredible range of interests,
Wieser maintained his focus on economics, and he is famous chiefly for his extensions
of Menger’s ideas on utility, value, and input-output valuations. As it turned out, his
emphasis on purely theoretical ideas detoured interest in his later and seminal work
on the interrelationships of economics and institutions. We shall try to restore some
balance in this regard, beginning with a discussion of some of the major theoretical
ideas of Natural Value and proceeding to a review of some of his “institutional” ideas.

Value Theory
Although the idea of marginal utility was at the center of Menger’s analysis, it
was Wieser who coined the actual term “marginal utility” (grenznutzen). Wieser’s
basic statement of the general law of value expanded on Menger’s earlier model.
With the aid of an arithmetic example (see table 14-2) set forth below, Wieser
explained the law in the following fashion. In this table the numbers in each row
interact with the respective numbers in its column. The first row, for example,
depicts the number of goods purchased at alternative prices specified on the second
row (Wieser called these prices “units of value”). Total utility from consuming alter-
native quantities is calculated by adding up successive units of value. Thus, when the
individual is consuming 2 units of the commodity, total enjoyment is 19 utility units,
the sum of 1 unit at 10 and 1 unit at 9. The addition of a third unit of consumption
adds a marginal utility of 8 for a total of 27 units. Note that Wieser, as Dupuit had ear-
lier, identified a good’s price (or units of value) with the marginal utility it conveys.

Table 14-2 Ascending and Descending Branches of Utility

(I) Goods 0 1 2 3 4 5 6 7 8 9 10 11
(II) Prices 0 10 9 8 7 6 5 4 3 2 1 0
(III) Total utility 0 10 19 27 34 40 45 49 52 54 55 55

 
(IV) Total value 0 10 18 24 28 30 30 28 24 18 10 0
(V) Total utility minus total value 0 0 1 3 6 10 15 21 28 36 45 55

Ascending branch Descending branch

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Chapter 14 ■ Microeconomics in Germany and Austria 347

Row IV of the example shows the amount of total value or gross receipts, which
is determined by multiplying the quantity of goods sold by its price (i.e., row I times
row II). Given the negatively sloping demand function, total receipts initially rise,
reach a maximum, and then decline. Row V shows the value lost from indifference,
and it is the difference between total utility and total receipts. Recall that Menger
argued that it is the use to which the last unit of a stock of goods is put that repre-
sents the value of any unit of a homogeneous stock. Wieser argued that the total
value of the stock increases by less than the price paid for additional units of the
good. In adding the second unit of the stock, for example, the individual experi-
ences a 9-unit increase in total utility, but now both units possess a valuation of 9.
Wieser reasoned that since it is the marginal unit that represents value to the con-
sumer, he or she would be unwilling to pay more than 9 for both units. In a compet-
itive market, moreover, only one price for homogeneous goods can prevail. Thus,
total receipts will increase as long as the incremental addition to total utility
exceeds the incremental loss. Wieser called this situation (purchases of goods 0 to 5
in his numerical example) the “upgrade” (or ascending) branch of value, and the
opposite situation the “downgrade” (or descending) branch of value.
The Antinomy of Value: Graphics. A simple graphical model will illustrate
these elementary but crucial points (though Wieser did not provide graphics). Fig-
ure 14-2a depicts total revenue and total utility, while figure 14-2b depicts the corre-
sponding demand, marginal-revenue, and marginal-utility functions. Total revenue
and total utility rise between O and x as quantity consumed increases; and marginal

Total
revenue,
total Total utility
utility

Total revenue

Upgrade Downgrade
(a) of value of value

O x Quantity

Price Figure 14-2 The upgrade

marginal of value is over the range
utility where total utility and total
revenue are rising and mar-
ginal revenue is positive.
Marginal revenue The downgrade of value is
over the range of output
Demand = marginal utility where total utility is still ris-
(b) ing but total revenue is
declining and marginal
O x Quantity revenue is negative.
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348 Part IV ■ The Neoclassical Era

revenue is positive (but declining) in this range, which characterizes the upgrade of
value. Beyond quantity x, total utility continues to rise because marginal utility is
still positive, but total revenue begins to decline (i.e., marginal revenue is nega-
tive).4 This range constitutes the downgrade of value.
Wieser drew the following conclusions from his value theory. He thought that
for the most part society’s production was on the upgrade of value—that is, total
revenue and utility increased together—but he stressed the antinomy (opposition)
between exchange value and utility in the downgrade (i.e., beyond quantity x),
when total utility is still rising but total revenue is falling. Wieser set forth the rea-
sons for this antinomy between value and utility in the downgrade:
In every self-contained private economy utility is the highest principle; but, in the
business world, wherever the providing of society with goods is in the hands of
[entrepreneurs] who desire to make a gain out of it, and to obtain a remuneration
for their services, exchange value takes its place. The private [entrepreneur] is not
concerned to provide the greatest utility for society generally; his aim is rather to
obtain the highest value for himself—which is at the same time his highest utility.
Utility approves itself as the first principle in the [entrepreneur’s] economy; but,
just because of this, in the conflict between exchange value and social utility, it is
exchange value which is victorious—so far at least as the [entrepreneur] has
power to act according to his own interest. (Natural Value, p. 55)

In this fashion Wieser described the deleterious effects of monopoly on social utility.
The antinomy held only insofar as the entrepreneur possessed economic power.
Under free competition, as Dupuit indicated earlier, social utility would be maximized,
and no antinomy between value and utility would exist. In fact, Wieser concluded that
the “economic history of our own time is rich in examples which prove that competi-
tion can press prices far on the down grade of exchange value” (Natural Value, p. 56).
But what of those cases where competition does not prevail? Though he
believed that those instances were too few to justify a full-fledged socialist economy,
Wieser advocated selected governmental interferences. He also noted another
important breakdown in the real economy. In a self-contained, idealized economy,
value in use depends on utility, and goods are produced according to the rank of
their value. In this instance exchange value is the measure of personal acquisition.
But in a real economy exchange value depends not only on utility but also on pur-
chasing power. Exchange value in the real world does not necessarily measure
value in use, or utility. In such a world, production is determined not only by “simple
want” but also by the superior means of a part of the populace. Cognizant of the
radical implications of applying utility theory to a real economy, Wieser wrote:
Instead of things which would have the greatest utility, those things are produced
for which the most will be paid. The greater the differences in wealth, the more
striking will be the anomalies of production. It will furnish luxuries for the wanton
and the glutton, while it is deaf to the wants of the miserable and the poor. It is
therefore the distribution of wealth which decides how production is set to work,
and induces consumption of the most uneconomic kind: a consumption which
wastes upon unnecessary and culpable enjoyment what might have served to heal
the wounds of poverty. (Natural Value, p. 58)

The disparity of purchasing power between demanders leads to yet another anom-
aly. The price of some commodities, such as bread, is determined by the valuation of

4
It might be worthwhile to compare Wieser’s model with Dupuit’s (see chap. 13) on these points.
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Chapter 14 ■ Microeconomics in Germany and Austria 349

the weakest buyers, usually the poorest. But because of “the importance of being
unimportant” wealthy people don’t pay their maximum demand price for bread,
only that price determined by the weakest buyer’s valuation. Wieser claimed, “It is
only where the rich compete among themselves for luxuries . . . that they pay
according to their own ability, and are measured according to their own personal
standard.” Real-world prices, in other words, do not ordinarily reflect the marginal-
utility valuations that would exist if the marginal utility of purchasing power were
the same for all individual demanders (such a condition would not require equality
of income distribution).
Natural Value. In order to bring these ideas into focus, Wieser constructed an
idealized model of value as it would exist in a communistic state. Natural value would
exist where goods were valued simply by the relation between the amount of the
stock and marginal utilities. It would not be disturbed by “error, fraud, force, change,”
or the existence of private property and the consequent disparities in purchasing
power. Utility, or value in use, would be the sole guide to the allocation of scarce
resources in the production of goods. Production decisions would be determined by
highest marginal-utility valuations and not by fragmented income distribution.
Although Wieser’s model is highly abstract, its use led to an important practical
conclusion, which communistic economies have been slow to learn: namely, that
prices play a crucial role in establishing optimum allocation of scarce resources.
Land rent is a case in point. In defense of his theory, Wieser said:
Land rent is, perhaps, the formation of value that is most frequently attacked in our
present economy. Now I believe our examination will show that, even in the com-
munistic state, there must be land rent. Such a state must, under certain circum-
stances, calculate the return from land, and must, from certain portions of land,
calculate a greater return than from others: the circumstances upon which such a
calculation is dependent are essentially the same as those which today determine
the existence of rent, and the height of rent. The only difference lies in this, that, as
things now are, rent goes to the private owner of the land, whereas, in a commu-
nistic state, it would fall to the entire united community. (Natural Value, pp. 62–63)

Thus, the formation of natural value, even in a communistic state, requires a mar-
ket-system type of allocation. Rents and “natural” returns to all factors have to be
recognized in order to ensure an economic distribution of resources. These returns,
however, do not have to be privately received, and even if they are, they could be
taxed away by government.5
In sum, what Wieser demonstrated and argued is that the formation of value is
a neutral phenomenon. An understanding of natural value provides evidence nei-
ther for nor against a socialist organization of society (so that presumably the case
has to rest on other grounds). This neutral precept is the foundation for exchange
value in all societies, irrespective of the fact that natural value is overlaid with many
other factors (such as controls, regulations, fiat, monopoly, and vast differences in
purchasing power). Wieser was the first economist to point out the generality of the
theory of utility valuation and to make explicit the usefulness of the market system
in allocating resources irrespective of social organization. Nevertheless, social orga-
nization remained an abiding concern of Wieser (see the box, The Force of Ideas:
Power, Leadership, and the Social Economy).
5
Henry George, an American economist, said as much in his Progress and Poverty (1879). George
advocated the taxation of urban site rents in order that “productive” factors (labor and capital)
might be encouraged.
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350 Part IV ■ The Neoclassical Era

The Force of Ideas: Power, Leadership, and the Social Economy

Menger showed an early interest in the evolution of economic institutions, but it was his
disciple, Wieser, who made a concerted effort to integrate economic analysis with role and
function of institutions. Despite his concern with the collective goal of economic welfare, Wie-
ser rejected the collectivist approach in favor of an individualistic one. He maintained that
institutions form part of the economic process once they become imbedded in the social
structure, and as such, they subsequently define the constraints on individual decision mak-
ing. Consequently, Wieser bridged the ideas of Menger and Veblen (see chapter 19).
Wieser argued that each individual maximizes his or her utility subject to the constraints
imposed by institutions that represent the collective results of individual human action. These
institutions, although created and destroyed by individual action, acquire power to constrain
individual behavior in recognized and unrecognized ways—and these constraints become
society’s “natural controls.” For Wieser, true freedom lies in the recognition that such controls
(e.g., law, morals, contracts, property rights, habits, and customs) are the basis for further
development, progress, and preservation. If society is ruled by tyrants, however, these “natural
controls” produce discord and repression. Therefore, leadership is a vital social trait.
Wieser saw progress as the consequence of inventive spirit and action; therefore leader-
ship is manifest by economic, political, and moral entrepreneurship. In a market economy,
entrepreneurship takes place within a dynamic process of competition that pits rival against
rival. This process takes inequality for granted. Entrepreneurs are people of superior abilities
and creativity who are better able to utilize the competitive process to the betterment of
themselves and their customers. They are followed by the masses of imitators, who emulate
their successes. The social economy encourages certain alliances, however, in which power
groups perform pivotal roles. These groups, which Wieser described as monopoloidal, stand
in stark contrast to the atomistic economic units of Adam Smith (see chapter 5) and Alfred
Marshall (see chapter 16).
Monopoloidal interest groups emerge as the intermediate result of a competitive process
in disequilibrium. According to Wieser, various power groups form monopoloidal organiza-
tions, which “have in fact traits of monopoly; they confer monopolistic power. But at the same
time they are subject, in other directions, to the pressure of competition or are otherwise
restricted. They are . . . intermediate forms, lying midway between monopoly and competi-
tion. Neither the theory of pure monopoly nor the theory of pure competition, least of all the
theory of attribution, will do them entire justice” (Social Economics, p. 221)
It is tempting to trace the otherwise novel views of E. H. Chamberlin (see chapter 20) on
“mixed” forms of competition to this passage, written almost two decades before Chamber-
lin’s Theory of Monopolistic Competition (1933). But the key point Wieser emphasized is that
the welfare-enhancing effects of rivalrous competition do not depend on the number of firms
but rather on the relative economic power of opposing groups. Thus, long before J. K. Gal-
braith (see chapter 19), who is most readily identified with this argument of “countervailing
power,” Wieser welcomed labor unions as an opposing force against monopoloidal employ-
ers. No monopoloidal organization, unless protected by legal barriers to entry, is immune
from the rigors of competition, Wieser argued.
In the final analysis, Wieser elevated competition to the highest level among social princi-
ples. Competition provides the breeding ground for society’s leaders, who, in turn provide the
model for others to emulate. “In no other of the great fields of human activity,” he wrote,
“where men strive for supremacy through rival efforts, do they find broader scope for self-
assertion. . . . No economic order, without suffering very great disadvantages, may dispense
with the use, in one way or another, of the supreme power of competition towards social suc-
cess” (Social Economics, pp. 210–211).
In this passage and in others derived from his theory of social economy, Wieser affirmed
that a noncoerced competitive system acts better than any other to create a fluid environ-
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Chapter 14 ■ Microeconomics in Germany and Austria 351

ment within which entrepreneurship works as the modus operandi of economic progress. His
great insight, shared by a younger Austrian of later renown, Joseph Schumpeter (see chapter
23), was that self-interested, utility-maximizing individual behavior creates and alters institu-
tions along fairly predictable lines, and that these institutions constrain future economic
actors until forward-looking and creative leader-entrepreneurs are able to break existing
molds and change institutions once more.

Factor Valuation: Wieser’s Theory of Imputation

Wieser admired Menger’s earlier treatment of imputation and clearly built his
system of input and output valuation on it, although he tried to repair a critical
weakness he discovered in his mentor’s approach. Menger had argued that the
value of a complementary production good (i.e., higher-order good) might be deter-
mined by removing it from its highest-valued use and observing the resulting drop
in utility. In the case of fixed proportions, removal of one of the inputs required the
recombination of the others to produce a different product. The value of the
removed factor (which Menger termed the “share dependent upon cooperation”)
was then determined by the difference in value terms between the old product
(before the factor was removed) and the alternative product (made remaining
inputs after the factor is removed). The problem, as Wieser plainly saw, was that
this technique made overvaluation possible.
Wieser’s simple example makes his criticism clear. Suppose the total value pro-
duced by three inputs in their best alternative (highest-marginal-utility product) is 10
units of value. Taking away one of the inputs and recombining the other two might
generate a product with 6 units of value. The value of the removed input is then 4. The
problem, which Wieser recognized, was that all the inputs could be valued in the same
way, giving 12 as the sum of their separate values. But their value in combination was
only 10! Consequently, Menger’s method could lead to overvaluation of inputs.
The Simultaneous Solution. As an alternative method, Wieser suggested that
the productive contribution of the input be the modus operandi of the valuation pro-
cess. As Wieser put it, “The deciding element is not that portion of the return which
is lost through the loss of a good, but that which is secured by its possession” (Natu-
ral Value, p. 85). In order to arrive at this deduction, Wieser assumed that all pro-
duction goods (inputs) are actually employed in an optimum fashion. Returning to
Menger’s example, he assumed that resources are combined in fixed proportions
(although he clearly recognized the existence of variable proportions in the real
world). A hunter, for example, depends on both rifle and cartridge to kill a tiger that
is about to spring on him or her. Valued together, Wieser argued, the value of rifle
and cartridge is the success of the shot. Taken singly, however, the value of each
cannot be calculated. As Wieser pointed out, there are two unknowns (x and y) and
one equation, x + y = 100, where 100 is the value of the successful result.
With more unknowns than equations, the problem cannot be solved. But Wie-
ser’s ingenious solution was to determine the contribution of combined productive
factors in every industry and to set this contribution out in equations. As he directed:
It is possible not only to separate these effects approximately, but to put them into
exact figures, so soon as we collect and measure all the important circumstances
of the matter; such as the amount of the products, their value, and the amount of
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352 Part IV ■ The Neoclassical Era

the means of production employed at the time. If we take these circumstances

accurately into account, we obtain a number of equations, and we are in a position
to make a reliable calculation of what each single instrument of production does.
(Natural Value, pp. 87–88)

As an example of his calculation of the contribution of cooperating productive

inputs, Wieser presented three industry equations with three unknown input values:
x + y = 100
2x + 3z = 290
4y + 5z = 590
Here x, y, and z are productive inputs, and the right-hand side of the equality is the
total value produced by the combined inputs (the combinations are, of course,
fixed). Solving simultaneously, the values of the inputs are determined: x = 40, y =
60, and z = 70. Each input is thus ascribed a definite share in producing total value.
This approach takes account of the interdependencies among inputs, whereas
Menger’s “subtractive” solution did not. Moreover, in a system of simultaneous
equations, the resulting values exactly exhaust the total product.
Resource Allocation. Wieser’s simultaneous solution may be viewed in a
slightly different manner, which illustrates the Austrian view of the whole valuation
process. The issue might be put in the form of a question: Assuming that resources
are properly allocated and that the system is in equilibrium (as we did in the equa-
tions above), what is the value of each input, and how are resources allocated?6
Given that an input is used in the production of a number of final or consumer
goods, its value will be determined by the least valuable good that it produces. This
value is determined at the margin, by the marginal utility of the last unit of the least
valuable good the input is producing. Input value is imputed, and the value of the
input, thus derived, establishes the opportunity cost of utilizing it in all other indus-
try productions requiring it. Given fixed-proportions production functions in all
industries and the rational (profit-maximizing) allocation of resources, the supplies
of all other goods utilizing the input will be determined. Given the marginal utilities
for these other goods, values are determined.
It is important to note that Wieser’s solution to the problem of input and output
valuation, while typical of the Austrian approach, is not like that found in the stan-
dard economics textbook of today or even like that set forth in Marshall’s Princi-
ples. Wieser (and the Austrians generally) did not develop the determinants of
demand and supply that interact to determine value. Rather they emphasized the
role of the marginal utility of final goods as the primary determinant of value. They
assigned supply no independent role in establishing values. Inputs are valued by
imputation in strict, cause-and-effect fashion. Through opportunity cost, values of
inputs and outputs are then determined in the entire system.7

6 Wieser referred to these inputs as “cost means” of production. He contrasted these cost means
with cost-specific means of production. Cost-specific means are those inputs that are scarce or
those that are suited only to the production of one product or a limited number of products. Cost
means of production, on the other hand, are distributed over the entire productive process. As a
general rule, Wieser thought that labor and capital should be regarded as cost means, while land
should usually be classed as cost-specific means.
7
It has been argued that, in at least one sense, this system is circular because it assumes the thing
to be proved. Critics contend that one begins by assuming an optimum distribution of resources
and then, via opportunity cost, “explains” value and the optimum distribution of inputs. On this
point, see G. J. Stigler, Production and Distribution Theories (see references).
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Chapter 14 ■ Microeconomics in Germany and Austria 353

In sum, the marginal utility of final output is presented as the source of value by
Austrian economists. In addition, they discovered a very special kind of input pro-
ductivity theory, one that might best be described as a marginal-utility-product the-
ory of input valuation. In other words, the value of an additional unit of input
applied to production is determined by the marginal utility of the additional units
produced (MUPi = MPi × MUx) rather than by the traditional marginal-value prod-
uct, which is found by multiplying the firm’s marginal revenue by the input’s mar-
ginal product (MVPi = MPi × Px). Conceptual differences in approach aside,
however, it is clear that Austrian value theory reached a high point in Wieser’s Nat-
ural Value.

■ EUGEN BÖHM-BAWERK (1851–1914)

Eugen Böhm-Bawerk, friend and brother-in-law of Friedrich Wieser, was the
third of the great founders of Austrian economics. Some writers consider Böhm-
Bawerk the premier capital theorist of economics. Surely his impact on neoclassical
and postneoclassical theorists, such as Knut Wicksell and Friedrich Hayek, has
been of vast importance. But Böhm-Bawerk enjoyed a variety of achievements
besides being a principal developer of Austrian capital theory.
Born in Brünn, Austria, in 1851, Böhm-Bawerk was the son of a highly placed
government official. He entered government service briefly after graduating from
law school at the University of Vienna, but he soon was attracted to a study of eco-
nomics. Like Wieser, Böhm-Bawerk began his economic studies in Germany, where
he studied under Karl Knies. He was appointed professor of economics at the Uni-
versity of Innsbruck in 1881, and there he completed his first book, which con-
cerned the value of patents as abstract, legal claims. In 1884, Böhm-Bawerk
published the first volume of his three-volume magnum opus, collectively entitled
Capital and Interest (Kapital and Kapitalzins). The first volume is entitled History
and Critique of Interest Theories (1884), the second (and very likely the most impor-
tant) is The Positive Theory of Capital (1889), and the third, which is a collection of
appendixes to the third edition of The Positive Theory of Capital, is entitled Further
Essays on Capital and Interest (1909–1912). All three volumes have been translated
into English.
Böhm-Bawerk also distinguished himself as a statesman. In 1889 he was called
to the Ministry of Finance for the purpose of preparing taxation and currency
reform. He served as Austrian Minister of Finance on three occasions over a span of
almost ten years. His tenure in the position is associated with great stability and
progress in Austrian financial management, an accomplishment achieved without
being associated with any political party. In 1904, he resigned and resumed his aca-
demic career, this time at the University of Vienna.
Though Böhm-Bawerk was a tireless scholar, his economic writings were often
interrupted by civil duties and show signs of undue haste. Thus, his work—difficult
reading at any level of expertise—has been criticized as incomplete or ambiguous.
Assessments differ, however. Böhm-Bawerk’s prize pupil, Joseph Schumpeter (see
chapter 23) compared him to Ricardo and declared that his Positive Theory of Capi-
tal “was an effort to scale the greatest heights that economics permits, and that the
achievement actually reached a level where only a few lofty peaks are to be found”
(Ten Great Economists, p. 153). By contrast, George Stigler (chapter 24) was less
effusive but admitted that Böhm-Bawerk’s influence on later economists out-
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354 Part IV ■ The Neoclassical Era

stripped even that of Menger and Wieser. Moreover, his fame persists in the field of
capital and interest theory. Many contemporary capital theorists believe, not with-
out some justification, that neoclassical capital theory takes its start from Böhm-
Bawerk. Our survey therefore, focuses on his theory of capital and interest. But
first, we shall explore his “subjective” credentials as a member of the Austrian
school. We turn to his lucid exposition of the role of subjective factors in establish-
ing exchange value.

Subjective Value and Exchange

Böhm-Bawerk may have considered that there was little to add to the advances
in value theory made by Menger and Wieser. He and Wieser adopted Menger’s value
theory, and Böhm-Bawerk readily assimilated most of Wieser’s improvements. For
the most part, his assumptions are identical to those made by Wieser, including the
ones concerning fixed-proportions production functions, the theory of imputation,
and an assumption of rigidly fixed supplies of productive inputs.8 Despite his lack of
originality in these areas, Böhm-Bawerk contributed interesting nuances on themes
originally developed by Menger and advanced by Wieser. One of Böhm-Bawerk’s
most interesting and successful variations on the subjective-value theme is of prime
importance both for its clarity and its ingenuity. In The Positive Theory of Capital,
Böhm-Bawerk demonstrated the determination of price with two-sided competition.
His famous example is predicated on ten buyers and eight sellers of horses in a free
market. All the horses offered for sale are assumed of equal quality, and all parties
to the exchange possess perfect knowledge of the market situation.
Böhm-Bawerk set up a table representing ten buyers (A1–A10) and eight sellers
(B1–B8) of horses and their subjective valuations of each horse. An adaptation of
Böhm-Bawerk’s table is presented here as table 14-3. From the table we see that
buyer A1 places a $300 subjective valuation on a horse so that he will demand a
horse at any price at or below $300.9 In like fashion, seller B6 places a $215 valua-
tion on the horse he has for sale, meaning that he will sell his horse at or above
$215. Böhm-Bawerk designated the strength of buyers as decreasing from A1–A10,
and the strength of sellers as increasing from B1–B8. Thus, seller B1 is the weakest
in that he places the lowest of the minimum subjective evaluations on horses, and
buyer A10 is the weakest in that he has the lowest of the maximum subjective valua-
tions upon horses.
How is exchange value determined? Suppose we arbitrarily start with a bid of
$150. What would happen in an auction market? At this bid price all ten willing buy-
ers remain in the market, but only three willing sellers; that is, because of subjective
evaluations, only sellers B1, B2, and B3 would be willing to offer one horse each at
an exchange value of $150. Obviously, the market does not clear since there are ten
buyers and only three sellers at $150. As price rises above $150, however, the horse
market begins to adjust. Weaker buyers—those with lower subjective evaluations—
are eliminated from the market, and as price rises, sellers are added. As price rises
to $210, for example, four buyers are eliminated from the trading (weak buyers A7 –

8 Böhm-Bawerk mentions an interesting exception to rigidly fixed supplies in The Positive Theory of
Capital. Adopting Jevons’s theory of labor supply, he admitted that the disutility of work might
enter as an independent determinant of input supply. But he minimized this independent determi-
nant on the grounds that Jevons’s theory requires a piece-rate system, which, Böhm-Bawerk’s
casual empiricism told him, was unimportant in the modern economy.
9
Note that Böhm-Bawerk expressed the subjective valuations of buyers and sellers in terms of objec-
tive dollar valuations, without alluding to some of the possible theoretical problems raised thereby.
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Chapter 14 ■ Microeconomics in Germany and Austria 355

A10), and five sellers remain (B1–B5). But there is still a disparity between six willing
buyers (A6–A1) and five willing sellers (B5–B1), so the market does not reach equi-
librium at this price. If price rises by $5 to $215, buyer A6 drops out of the market,
but seller B6 enters. Thus, at this price there are five buyers and six sellers. The
market cannot clear at $215.
By now the problem should be obvious. How might one drop buyer A6 from
exchange without simultaneously including an additional seller (in this case B6)?
The answer is simple. Price must rise above $210 to exclude A6, but not as high as
$215, so that B6 is not included. Thus, given the data of table 14-3, the price limits
will be set as follows: price must be greater than $210 but less than $215. A price of
$213 or any intermediate value would therefore clear the market. In this way,
Böhm-Bawerk underscored one of the determining factors in exchange value, the
influence of marginal pairs of buyers and sellers in determining price. In this exam-
ple the main characters that determine price are the successful pair, buyer A5 and
seller B5, coupled with the unsuccessful pair, buyer A6 and seller B6. Alternatively,
we might say it is the evaluations of the weakest of successful buyers (A5) and the
strongest of successful sellers (B5) coupled with the evaluations of the strongest of
unsuccessful buyers (A6) and the weakest of unsuccessful sellers (B6) that set the
limits to exchange value.

Table 14-3 Böhm-Bawerk’s Horse Market

Strong buyers Weak buyers
Buyers A1 A2 A3 A4 A5 A6 A7 A8 A9 A10
Valuation of $300 $280 $260 $420 $220 $210 $200 $180 $170 $150
one horse $100 $110 $150 $170 $200 $215 $250 $260
Sellers B1 B2 B3 B4 B5 B6 B7 B8
Weak sellers Strong sellers

In this manner Böhm-Bawerk established that it is these marginal pairs of buy-

ers and sellers—and these marginal pairs alone—that determine price. Outside
these limits, buyers and sellers might be added indefinitely without affecting equi-
librium price. The addition of buyers or sellers with subjective evaluations within
the limits set by the marginal pairs has the effect of narrowing the upper and lower
limits to price. An infinitely large addition of buyers and sellers would make the
supply and demand functions look like the typical and smooth Marshallian ones we
generally posit today. But Böhm-Bawerk wished to emphasize the discrete and dis-
continuous nature of the functions (imagine stair-step demand and supply functions
from the data of table 14-1). Real-world market situations, in Böhm-Bawerk’s view
(and in the typical Austrian paradigm), were not characterized by smooth and con-
tinuously differentiable demand and supply functions, including infinite numbers of
buyers and sellers. Rather, in the Austrian view, any practical exchange situation
included only a finite number of traders, and the discrete nature of buyer and seller
evaluations must be accounted for. This typically Austrian assumption is a major
point of contrast with the prevailing Marshallian view, which assumes continuity.
The latter (and prevailing) approach is far easier to deal with mathematically, which
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356 Part IV ■ The Neoclassical Era

might account for some of its success. But Austrians would challenge the assump-
tions of the Marshallian view as unrealistic and would argue that economic analysis
should account for this fact.
It is clear that the Austrians had a point. The continuity of many economic func-
tions is taken for granted but may not have much basis in fact. Böhm-Bawerk was
determined to explicate the nature of price determination in a world of discrete
numbers of buyers and sellers. Moreover, the role of subjective evaluations in
exchange was never more clearly described. Though Menger and Wieser had
worked out the essentials of Austrian value theory, Böhm-Bawerk helped to clarify
the process of exchange.

Capital Theory
Perhaps the most important contribution made by Böhm-Bawerk was his poi-
gnant introduction of time considerations into economic analysis. His central and
simple premise was that the production of final (consumers’) goods takes time and
that roundabout methods of producing these goods are more productive than direct
methods. This gain in production, however, is partially offset by the time-consuming
nature of roundabout production methods. Böhm-Bawerk explained that original
means of production (raw materials, resources, labor) could be used in immediate
production (as fictional hero, Robinson Crusoe did, for instance) or could be used to
produce capital (which he called “produced means”), which, combined with labor,
could then be used to produce consumers’ goods. Böhm-Bawerk thought that the
latter method, though it takes longer, was more effective because it allowed the pro-
ductivity of capital to be added
to the productivity of labor.
Moreover something more than
Total Q ‫״׳‬ mere additivity is at work. As
output
hinted at by the imputation
Q‫״‬ problem, combinations of capi-
tal and labor are likely to be
Q‫׳‬ more effective when operating
together than like amounts oper-
ating separately. In other words,
Q
there are interdependencies to
consider among combined fac-
tors of production. This means
that the longer the productive
period (which means using a
more roundabout and capital-
intensive method), the higher
MP the total product would be. In
the Austrian theory of produc-
t t‫׳‬ t‫״‬ t ‫ ״׳‬Time tion time itself becomes an
input, and the length of the pro-
duction period of consumers’
goods is itself a variable.
Figure 14-3 As “roundaboutness” increases from t These points are illustrated
to t, etc., total output also increases, but at a in figure 14-3. Time is measured
decreasing rate. The slope of the ray tQ is the mar- on the horizontal axis, and total
ginal product of capital during period tt. output (Q) is measured on the
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Chapter 14 ■ Microeconomics in Germany and Austria 357

vertical axis. The production period is represented on the time axis. Period tt is lon-
ger than period tt, for instance, and period tt is greater than period tt. It can be
seen that total output grows absolutely with the extension of the period of produc-
tion, whereas marginal output declines with these extensions. Why did Böhm-
Bawerk argue that longer periods of production are more productive? Consider
what happens when the production period is extended. As the production period
lengthens, more capital is used, the ratio of capital to labor increases, and final out-
put is enlarged, albeit at a decreasing rate.
The Discontinuous Production Period. Böhm-Bawerk’s model has certain
affinities to the classical wages-fund doctrine, but there are also some peculiarities
that command our attention. Whereas both models employ a discontinuous produc-
tion period of variable length, the classical model assumed a discontinuous produc-
tion period of fixed duration. Böhm-Bawerk’s period-of-production model is
characterized by continuous inputs and point outputs. That is, inputs are added in a
flow, but outputs “ripen” at some discrete point of time. The important question that
immediately arises concerns the length of the production period. At one point
Böhm-Bawerk suggested that an absolute period of production might be used, but
he soon realized an obvious problem. Assume that a point output produced today is
a silver drinking cup. What is the absolute period of production? Conceivably, the
silver input used in producing the cup might have been mined in Roman times. The
concept of determining a production period for any point output is therefore intrac-
table. Therefore Böhm-Bawerk proposed an alternative approach, the average pro-
duction period, in which inputs are weighted according to their proximity to point
outputs. Inputs are weighted by the number of periods used, and the sum of these
weighted inputs is then divided by the number of inputs in order to obtain an aver-
age production period.
Unfortunately, Böhm-Bawerk’s second approach also contains grave deficien-
cies. One of the chief objections is rather obvious. Inputs are simply not homoge-
neous; yet, Böhm-Bawerk made no provisions for this fact—he simply assumed that
they were. Second, perhaps more importantly, there is the question of assigning the
proper “period” weights. Is output attributable to the most recent inputs or to inputs
from a more distant past? Although these problems were serious, Böhm-Bawerk
retained the assumption of an average period of production as a workable theoreti-
cal constraint.10
Aside from these issues, both the classical wages-fund model and Böhm-
Bawerk’s period-of-production model employed the same immediate determinant
of the length of the production. Böhm-Bawerk’s novel contribution in this area lay
in his close investigation of the interest rate as the major determinant of the size of
the subsistence fund.
The Interest Rate. Böhm-Bawerk regarded interest as a payment for the use
of capital, and the use of capital, as we have seen, means intermediate products
(i.e., roundaboutness). Because roundaboutness involves longer time engaged in
production, interest must be related to time in some logical way. Böhm-Bawerk
based his interest theory on what we now call positive time preference, which main-
tains that present goods are worth more than future goods. He offered three
“proofs” for this fundamental proposition.

10
One of Böhm-Bawerk’s “students” in capital theory, Knut Wicksell, at first adopted the average
period of production but later abandoned it as unworkable.
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358 Part IV ■ The Neoclassical Era

The first cause of the difference in value between present and future goods
derives from the immediacy of present wants. We are not indifferent to the future,
but we live in the present. Future wants are almost always perceived as less pressing
than immediate wants. In general, people find themselves in one of two circum-
stances. Those who are less well provided for in the present than in the future judge
present goods to be more valuable. Those who find themselves better provided for
in the present than they are likely to be in the future still have command over future
goods by the possession of present goods (especially money), which they can store
up as a reserve for the future.
The second cause for the difference in value between present and future goods
is that people systematically undervalue future wants and the means to satisfy
them. Böhm-Bawerk’s argument on this point rests on three corollaries: (1) since
we can’t know the future with certainty, the imaginary picture that we construct of
our future wants will always be fragmentary and incomplete; (2) most people suffer
from a general lack of willpower—faced with the choice between “now” and “then,”
few will postpone gratification of a present want; and (3) given the uncertainty and
shortness of human life, people do not wish to postpone something that they may
never get to enjoy.
The third cause for the difference in value between present and future goods is
the technical superiority of present goods over future goods as a means of satisfying
human wants. This corollary rests on the principle of roundaboutness established
earlier by Böhm-Bawerk. It simply recognizes that present goods (including money)
can be put into production sooner than future goods, so that the flow of output that
will emerge from intermediate products will always be larger, if started now rather
than later.
Of these three causes, Böhm-Bawerk placed the greatest emphasis on the third,
which he claimed was independent of the other two and, moreover, was capable of
explaining positive time preference on its own. More protracted methods of produc-
tion are always more productive than less protracted methods of production, and
therein lies the technical superiority of present goods. From this general discussion,
it was a fairly short leap to the idea that interest is the premium people pay for pres-
ent goods over future goods. From the perspective of the lender, of course, interest
is the compensation required to postpone the higher enjoyment conveyed by pres-
ent goods.
It is noteworthy that Böhm-Bawerk’s theory of interest and capital is deeply
rooted in the subjectivism of Austrian value theory. Indeed, it was on this basis that
he distanced himself most from the classical approach to the subject. With a few
notable exceptions (e.g., Lauderdale and Senior) classical economic theory treated
capital as subservient to labor because it was itself the product of labor. This idea
(which was also held in the extreme by Karl Marx) proved to be a major stumbling
block to meaningful analytical progress in the theory of interest. The fault of classi-
cal interest theory is that it refused to admit that capital was productive apart from
labor. Senior saw the error of this argument, but he remained a “classical” econo-
mist by encasing his new insights within the cost-of-production theory of value.
Thus, Böhm-Bawerk, who credited Senior with overturning certain false ideas
about capital and interest, also criticized him for neglecting time preference and
opportunity costs, two cornerstones of the new subjectivism. In the final analysis,
however, Böhm-Bawerk used Senior’s foundation to build a new edifice rather than
scrap all past ideas to begin anew.
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Chapter 14 ■ Microeconomics in Germany and Austria 359

■ ENTREPRENEURISM IN GERMAN AND AUSTRIAN ECONOMICS

German and Austrian economists of the nineteenth century did more to revive
and nurture the subject of entrepreneurship in economic theory than their counter-
parts in other European countries. By 1814, J. B. Say’s Treatise had been translated
into German and began to circulate among scholars in German and Austrian uni-
versities, giving impetus to an attempt to establish entrepreneurial profit as a dis-
tinctive, functional share in the theory of income distribution. Major advances were
made by von Thünen, Mangoldt, Gottlieb Hufeland (1760–1817), Friedrich Her-
mann (1795–1868), and Adolph Riedel (1809–1872).
In 1815, Hufeland generalized the idea that every wage contains a premium for
scarcity to explain entrepreneurial profit as a special kind of wage consisting of the
rent of ability. Hermann’s theoretical economics undermined the British, classical
wages-fund theory by asserting that all factor returns are ultimately paid from con-
sumers’ income. Like Hufeland, he generalized the concept of rent to all factors,
including the entrepreneur. And like Say, he viewed the entrepreneur as one who
organizes production within the institutional structure of a firm. Riedel extended Can-
tillon’s conception of the entrepreneur as the economic agent who takes on uncer-
tainty so that others may escape risk (e.g., through the establishment of fixed-price
contracts). He perceived that uncertainty is inevitable in the acquisition of income and
that the entrepreneur provides a useful service to income earners who are risk-averse
and who would therefore willingly trade uncertainty for the security of a “sure thing.”
As a supplier of “certainty,” the entrepreneur is rewarded for his foresight or penal-
ized for lack of it. If he sells goods at a price above his contracted fixed-input costs, he
gains; if not, he loses. Riedel also explored the notion of the entrepreneur as innova-
tor, and as organizer of “team production.” By connecting the problems of the organi-
zation of firms with the entrepreneurial function of reducing income uncertainty for
certain inputs, he anticipated (along with Mangoldt) the nature of transaction costs
later expounded by Ronald Coase (see chapters 16 and 26).
Although best known for his location theory, set forth in the first volume of The
Isolated State (1826), it was in the second volume (1850) that von Thünen put forth
an explanation of profit that clearly distinguished the return of the entrepreneur
from that of the capitalist. What he labeled “entrepreneurial gain” is profit minus (1)
interest on invested capital, (2) insurance against business losses, and (3) the wages
of management. This residual represents a return to entrepreneurial risk, which von
Thünen identified as uninsurable, insofar as “there exists no insurance company
that will cover all and every risk connected with a business. A part of the risk must
always be accepted by the entrepreneur” (Isolated State, p. 246). He was also alert
to the relationship between uninsurable risks and opportunity costs. He wrote:
He who has enough means to pay to get some knowledge and education for public
service has a choice to become either a civil servant or, if equally suited for both
kinds of jobs, to become an industrial entrepreneur. If he takes the first job, he is
guaranteed subsistence for life; if he chooses the latter, an unfortunate economic
situation may take all his property, and then his fate becomes that of a worker for
daily wages. Under such unequal expectations for the future what could motivate
him to become an entrepreneur if the probability of gain were not much greater
than that of loss? (Isolated State, p. 247)

Moreover, von Thünen clearly appreciated the difference between management

and entrepreneurship. He maintained that the effort of an entrepreneur working on
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360 Part IV ■ The Neoclassical Era

his own account was different from that of a paid substitute (i.e., “manager”), even
if they have the same knowledge and ability. The entrepreneur is forced to bear the
anxiety and agitation that accompanies his business gamble; he spends many sleep-
less nights preoccupied with the single thought of how to avoid catastrophe;
whereas the paid substitute can sleep soundly at night, secure in the knowledge of
having performed his (minimal) duty. Anyone who has nursed along a new enter-
prise knows the anxiety to which von Thünen referred.
What is especially interesting about von Thünen’s treatment is how he turns the
discussion from the trials of the entrepreneur into a kind of “crucible” theory of the
development of entrepreneurial talent. The sleepless nights of the entrepreneur are
not unproductive; it is then that the entrepreneur makes plans and arrives at solu-
tions for avoiding business failure. Adversity in the business world thereby becomes
a training ground for the entrepreneur. “Necessity is the mother of invention,” von
Thünen wrote, “so the entrepreneur through his troubles will become an inventor
and explorer in his field.” As such, the entrepreneur supplies “greater mental effort
in comparison with the paid manager,” for which he deserves “compensation for his
industry, diligence, and ingenuity” (Isolated State, p. 248). This extra reward is a
justifiable payment to the entrepreneur, no less than that surplus which accrues to
the inventor of a new and useful machine.
What makes this a significant step forward in the theory of entrepreneurship is
the fact that von Thünen successfully married the separate strands of entrepreneur-
ial theory that heretofore, on the one hand, characterized the entrepreneur as risk
bearer (Cantillon) and, on the other, portrayed him as innovator (Bentham). He was
quite explicit about the fact that there are two elements in entrepreneurial income:
a return to entrepreneurial risk and a return to ingenuity. The sum of these two
comprise “business profit,” he said, and drew a sharp distinction between entrepre-
neurship and the mere use of capital:
Capital will give results, and is in the strict sense of the term capital, only if used
productively; on the degree of this usefulness depends the rate of interest at which
we lend capital. Productive use presupposes an industrial enterprise and an entre-
preneur. The enterprise gives the entrepreneur a net yield after compensating for
all expenses and costs. This net yield has two parts, business profits and capital
use. (Isolated State, p. 249)

Hans von Mangoldt, professor at the universities of Göttingen and Freiburg,

pushed farther. Joseph Schumpeter (see chapter 23) judged his work on entrepre-
neurship “the most important advance since Say” (History, p. 556n). Mangoldt
attempted to reform Hermann’s theory, which sought the essential characteristic of
entrepreneurship in the personal activity of entrepreneurs. Hermann maintained
that entrepreneurship entails a certain kind of labor, and if these (entrepreneurial)
tasks are delegated to anyone else, the delegator ceases to be an entrepreneur.
Among these tasks Hermann listed the assembling of capital, the supervision of
business, the securing of credit and trade connections, and the assumption of risk
connected with the prospect of irregular gains.
Mangoldt discarded Hermann’s first three entrepreneurial tasks as inessential
to a “pure” notion of entrepreneurship. He argued that although entrepreneurs cus-
tomarily participate in their own enterprises with their own capital and personal
supervision, these services could be furnished just as well by salaried labor. What
remains from Hermann’s theory after jettisoning the first three elements is risk
bearing. Mangoldt concluded: “That which alone is inseparable from the concept of
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Chapter 14 ■ Microeconomics in Germany and Austria 361

the entrepreneur is, on the one hand, owning the output of the undertaking—con-
trol over the product brought forth, and, on the other hand, assuming responsibility
for whatever losses may occur” (“Precise Function of the Entrepreneur,” p. 41).
Thus, Mangoldt’s theory of entrepreneurship was production-oriented and risk-
centered. He distinguished between “production to order” and “production for the
market.” The former is safe because service and payment are simultaneous, a cir-
cumstance that eliminates the uncertainty of changing market conditions between
the start of production and sale of the final product. The latter is speculative
because the product is destined for exchange on a market of uncertain demand and
unknown price. Even thought this distinction is imprecise, Mangoldt found it useful
because, strictly speaking, “every possibility of a change in the subjective estimate
of the service, or the remuneration [of it], offers such an uncertainty,” and “since
such a possibility is excluded only by a perfect simultaneity of service and payment,
every business which needs for its carrying through any time whatever, could not, in
the strictest sense of the word, be undertaken to order” (“Precise Function of the
Entrepreneur,” p. 37).
Mangoldt’s distinction provides a framework for discussing degrees of risk that
confront the entrepreneur. By his reckoning those enterprises that require the lon-
gest time to bring their products to the point of final sale involve the most uncer-
tainty, whereas those that involve the shortest time require the least amount of
entrepreneurship. Risk and uncertainty go to the heart of the matter. The distinc-
tiveness of the entrepreneur is that he assumes the burden of the fluctuations in
expenditure that must be made in any business, and ultimately in its success or fail-
ure. In this respect Mangoldt stood squarely in the tradition begun by Cantillon.
Following Hufeland and Hermann, Mangoldt represented the entrepreneur as a
separate factor of production, and established entrepreneurial profit as the rent of
ability. He divided entrepreneurial income into three parts: a premium on uninsur-
able risks; an amount to compensate the entrepreneur for interest and wages
(including only payments for special forms of capital or productive effort that did
not admit of exploitation by anyone other than the owner); and entrepreneur rents,
that is, payments for differential abilities or assets not held by anyone else. Alfred
Marshall took special note of this last item, citing Mangoldt approvingly in his
development of the principle of quasi-rent (see chapter 16).
Mangoldt’s theory did not concentrate on an ideal type of entrepreneur but
rather on decisions an entrepreneur must make in an uncertain, competitive envi-
ronment: the choice of techniques, the allocation of productive factors, and the mar-
keting of production. He acknowledged successful innovation as part of
entrepreneurship, but he was more interested in the allocative function of the entre-
preneur. Therefore, his contribution was consistent with a static theory of resource
allocation but mute on the role of the entrepreneur in a dynamic theory of growth
and development.
Wieser closed this gap by stressing the leadership qualities of the entrepreneur.
He tried to bring everything connected with the theory and practice of enterprise
under his umbrella-like definition. He spoke of entrepreneurs as the “great person-
alities” of capitalism: “bold technical innovators, organizers with a keen knowledge
of human nature, farsighted bankers, reckless speculators, the world-conquering
directors of the trusts” (Social Economics, p. 327). On the subject of entrepreneur-
ship Wieser painted with a broad brush, incorporating sociological as well as eco-
nomic elements in his treatment. Not only is Wieser’s multifarious entrepreneur
required to be multitalented, “he must [also] possess the quick perception that
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362 Part IV ■ The Neoclassical Era

seizes new terms in current transactions as his affairs develop; [and] he must pos-
sess the independent forcefulness to regulate his business according to his views.”
Finally, Wieser’s entrepreneur must have the courage to accept risk and be spurred
onward by “the joyful power to create” (Social Economics, p. 324). Later we shall
see how Wieser’s student, Joseph Schumpeter (see chapter 23), absorbed his mas-
ter’s ideas and painted on an even broader canvas, making the entrepreneur the
pivotal figure in the theory of economic development.

■ CONCLUSION
The analytical performance of the Austrians, and indeed of all the neoclassical
writers, amplifies at least one important point. Their ideas demonstrate that the
dawning of neoclassical analysis was a lengthy process. Microanalysis was born in
several countries and in the writings of quasi-isolated individuals, many of which did
not belong to the standard contingent of academic economists. If anything, neoclas-
sical economics was an international invention greatly nurtured by contributors from
allied fields. However, the pace of microanalytic work quickened in the early 1870s,
and the noontime of the neoclassical age was about to arrive in France and England.

REFERENCES
Böhm-Bawerk, Eugen. The Positive Theory of Capital, in George D. Huncke (trans.),
Capital and Interest, vol. II. South Holland, IL: Libertarian Press, 1959 [1889].
George, Henry. Progress and Poverty. New York: Cosimo, 2005 [1879].
Greenhut, M. L. Plant Location in Theory and Practise. Chapel Hill: The University of
North Carolina Press, 1956.
Hutchison, T. W. A Review of Economic Doctrines, 1870–1929. Oxford: Clarendon Press,
1953.
Knight, F. H. Risk, Uncertainty and Profit. New York: Harper & Row, 1965 [1921].
Marshall, Alfred. Principles of Economics, 2d ed. London: Macmillan, 1891.
———. Memorials of Alfred Marshall, A. C. Pigou (ed.). London: Macmillan, 1925.
Mangoldt, H. K. E., von, Die Lehre vom Unternehmergewinn: ein Beitrag sur Volkswirth-
schaftlehre. Leipzig: Teuber, 1855. [A fragment of this work has been translated as:
“The precise function of the entrepreneur and the true nature of entrepreneur’s
profit,” in F. M. Taylor (ed.), Some Readings in Economics. Ann Arbor, MI: George
Wahr, 1907].
———. Grundriss der Volkswirthschaftlehre. Stuttgart: Maier, 1863. [A chapter was trans-
lated as: “The Exchange Ratio of Goods,” International Economic Papers, vol. 11].
Menger, Carl. Principles of Economics, James Dingwall and Bert F. Hoselitz (trans.).
Glencoe, IL: Free Press, 1950 [1871].
Schumpeter, J. A. History of Economic Analysis, E. B. Schumpeter (ed.). New York:
Oxford University Press, 1954.
———. Ten Great Economists: From Marx to Keynes. New York: Oxford University
Press, 1951.
Stigler, George J. Production and Distribution Theories: The Formative Period. New York:
Macmillan, 1941.
Thünen, J. H. von. The Isolated State in Relation to Agriculture and Political Economy,
Vol. 2, in B. W. Dempsey, The Frontier Wage. Chicago: Loyola University Press, 1960.
Wieser, Friedrich, von. Natural Value, A. Malloch (trans.) and William Smart (ed.). New
York: Kelley and Millman, 1956 [1889].
———. Social Economics, A. Ford Hinrichs (trans.). New York: A. M. Kelley, 1967 [1914].
Ekelund-Hebert 6E.book Page 363 Thursday, August 1, 2013 11:03 AM

Chapter 14 ■ Microeconomics in Germany and Austria 363

NOTES FOR FURTHER READING

Eighteenth century German economic thought was associated most closely with
cameralism, a theory in which public revenue was the sole measure of economic pros-
perity. As such, it lagged behind classical economics in building a theoretic core on
which to erect the scaffolding of political economy. For some background on cameralism
and its chief architect, see Hans-Christoph Schmidt am Busch, “Cameralism as ‘Political
Metaphysics’: Human Nature, the State, and Natural Law in the Thought of Johann
Heinrich Gottlob von Justi,” The European Journal of the History of Economic Thought,
vol. 16 (Summer 2009), pp. 409–430. Owing to the spreading of Smith’s and Say’s ideas
through Germany in the nineteenth century, economics took a more theoretic turn.
Kiichiro Yagi, Austrian and German Economic Thought: From Subjectivism to Social
Evolution (London: Routledge, 2011), uses unpublished and archival material collected
over three decades to explore facets of economic thought of leading Austrian and Ger-
man economists of the nineteenth century. T. W. Hutchison, Review of Economic Doc-
trines, 1870–1929, chap. 8 (see references), provides a more limited, but nevertheless
useful, overview of German economics in the nineteenth century. Von Thünen’s work
has been translated into English piecemeal, and is now available in two separate vol-
umes: vol. 1, Von Thünen’s Isolated State, Carla Wartenberg (trans.) and Peter Hall (ed.)
(Oxford: Pergamon, 1966); and vol. 2 The Isolated State in Relation to Agriculture and
Political Economy, is reprinted in B. W. Dempsey, The Frontier Wage (see references).
Various assessments of particular aspects of von Thünen’s economics include but are not
limited to E. Schneider, “Johann Heinrich von Thünen,” Econometrica, vol. 2 (January
1934), pp. 1–12, reprinted in The Development of Economic Thought, H. W. Spiegel (ed.)
(New York: Wiley 1952); A. H. Leigh, “Von Thünen’s Theory of Distribution and the
Advent of Marginal Analysis,” Journal of Political Economy, vol. 54 (December 1946), pp.
481–502; H. L. Moore, “Von Thünen’s Theory of Natural Wages,” parts I and II, Quarterly
Journal of Economics, vol. 9 (April, July 1895), pp. 291–304, 388–408; Colin Clark, “Von
Thünen’s Isolated State,” Oxford Economic Papers, n.s., vol. 19 (November 1967), pp.
370–377; M. L. Nerlove and Efraim Sadka, “Von Thünen’s Model of the Dual Economy,”
Journal of Economics, vol. 54 (1991), pp. 97–124. B. F. Kiker, “Von Thünen on Human
Capital,” Oxford Economic Papers, n.s., vol. 21 (November 1969), pp. 339–343; H. D.
Dickinson, “Von Thünen’s Economics,” Economic Journal, vol. 79 (December 1969), pp.
894–902; and Andreas Grotewold, “Von Thünen in Retrospect,” Economic Geography,
vol. 35 (October 1959), pp. 346–355. Mark Blaug provides a useful guide to von Thünen’s
life and influence in his introduction to a new Italian translation of von Thünen’s Isolated
State, included in the IRPET Classics of the Regional Science Series.
Gossen’s Entwicklung der Gesetz des menschlichen Verhehrs, und der daraus flies-
senden Regeln für menschliches Handeln (1854) has been translated into English as The
Laws of Human Relations and the Rules of Human Action Derived Therefrom, R. C. Blitz
(trans.) (Cambridge, MA: MIT Press, 1983), with an introduction by Nicholas Georgescu-
Roegen. For an enthusiastic endorsement of Gossen by Léon Walras, written in the first
blush of discovery, see “Walras on Gossen,” in The Development of Economic Thought,
H. W. Spiegel (ed.) (New York: Wiley, 1952), pp. 471–488. Also see Spiegel’s entry on
Gossen in the International Encyclopedia of the Social Sciences, vol. 6, pp. 209–210; and
the later entry by Jürg Niehans in The New Palgrave: A Dictionary of Economics, J. Eat-
well, M. Milgate, and P. Newman (eds.) (London: Macmillan, 1987), vol. 2, pp. 550–554.
Other secondary sources on Gossen are as rare as a first edition of his Entwicklung,
but glimpses of his originality can be found in the preface to W. S. Jevons, The Theory of
Political Economy, 2d ed. (London: Macmillan, 1879); and in Maffeo Pantaleoni, Pure Eco-
nomics, T. B. Bruce (trans.) (London: Macmillan, 1898). Also see W. Jaffé, “The Normative
Bias of the Walrasian Model: Walras versus Gossen,” Quarterly Journal of Economics, vol.
Ekelund-Hebert 6E.book Page 364 Thursday, August 1, 2013 11:03 AM

364 Part IV ■ The Neoclassical Era

91 (August 1977), pp. 371–388. Albert Jolink and Jan van Daal, “Gossen’s Laws,” History
of Political Economy, vol. 30 (Spring 1998), pp. 43–50, argue that Gossen’s theoretical con-
struction (i.e., postulates, theorems, and auxiliary assumptions) leads to a suboptimal out-
come. Philippe Steiner, “The Creator, Human Conduct and the Maximisation of Utility in
Gossen’s Economic Theory,” The European Journal of the History of Economic Thought,
vol. 18, (Summer 2011), pp. 353–379, examines Gossen’s emphasis on mathematical rea-
soning in conjunction with his consistent religious references. Steiner concludes that Gos-
sen’s religious views were vital for his historical and theoretical understanding of utility
maximization and the government of rational, selfish human beings.
Translations of Hans von Mangoldt’s works have been made in dribs and drabs. See
Mangoldt, “The Exchange Ratio of Goods,” International Economic Papers, vol. 11
(1962), pp. 32–59; “On the Equations of International Demand,” Journal of International
Economics, vol. 5 (1975), pp. 55–97; and “The precise function of the entrepreneur and
the true nature of entrepreneur’s profit” (see references). Erich Schneider, “Hans von
Mangoldt on Price Theory: A Contribution to the History of Mathematical Economics,”
Econometrica, vol. 28 (1960), pp. 380–392, attempted to “rescue Mangoldt’s work from
oblivion” by exposing his analysis of price formation using joint supply and demand, but
Schneider’s effort was judged incomplete by John Creedy, “Mangoldt and Interrelated
Goods,” Journal of the History of Economic Thought, vol. 13 (Spring 1990), pp. 99–108,
who tried to repair omissions by reinterpreting Mangoldt’s pioneer analysis of price
determination in interrelated markets. For a balanced perspective on Mangoldt’s place in
the history of economics, see K. H. Hennings, “The Transition from Classical to Neoclas-
sical Economic Theory: Hans von Mangoldt,” Kyklos, vol. 33 (1980), pp. 658–682.
For critical reviews of the thoughts of Menger, Wieser, and Böhm-Bawerk, see G. J.
Stigler’s Production and Distribution Theories, chaps. 6–8 (see references); and T. W.
Hutchison’s Review of Economic Doctrines, 1870–1929, chaps. 9–12 (see references). As
always, J. A. Schumpeter, History of Economic Analysis (see references), pp. 843–855,
924–932, is a valuable reference. A. M. Endres, “Menger, Wieser, Böhm-Bawerk, and the
Analysis of Economizing Behavior,” History of Political Economy, vol. 23 (Summer 1991),
pp. 279–299, explores the process of choice and the goals of economizing behavior in
Austrian value theory from the standpoint of biological, ethical, and psychological pre-
cepts; see also, same author, “Carl Menger’s Theory of Price Formation Reconsidered,”
History of Political Economy, vol. 27 (Summer 1995), pp. 261–287. Endres weighs in yet
again on the founding Austrians as neoclassical economists rather than separatists, in
Neoclassical Microeconomic Theory: The Founding Austrian Version (London: Routledge,
1997). But see Gilles Campagnolo, Criticisms of Classical Political Economy: Menger,
Austrian Economics and the German Historical School (London: Routledge, 2009), for an
appraisal of the role of the German Historical school in Menger’s thought. Menger’s
founding role in the development of the Austrian school is also discussed by Frank
Knight in his introduction to the Dingwall translation of Menger’s Principles. Also see F.
A. Hayek, “Hayek on Menger,” in Development of Economic Thought, Henry W. Spiegel
(ed.), cited previously, pp. 526–567; H. S. Bloch, “Carl Menger: The Founder of the Aus-
trian School,” Journal of Political Economy, vol. 48 (June 1940), pp. 428–433; and J. A.
Schumpeter, Ten Great Economists (see references), which contains essays on Böhm-
Bawerk and Wieser as well as on Menger. The entire issue of the Atlantic Economic Jour-
nal, vol. 16 (September 1978), is devoted to papers on Menger and Austrian economics;
see especially the papers by Lawrence Moss, Israel Kirzner, and Ludwig Lachmann.
The (in)famous methodenstreit between Menger and Schmoller has drawn scant
attention in the secondary literature. Many writers regard it solely as an academic “war
of ideas,” but Gary M. Anderson, Robert B. Ekelund, Jr., and Robert D. Tollison,
“Methödenstreit: The Economics of Competing Interests,” The European Journal of Polit-
ical Economy, vol. 8 (1992), pp. 401–418, investigate interest-group concerns that may
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Chapter 14 ■ Microeconomics in Germany and Austria 365

have motivated the debate (i.e., Austrian economists were trying to enter the German
academic cartel managed by Schmoller).
On the development of utility theory in general, see G. J. Stigler, “The Development
of Utility Theory,” Journal of Political Economy, vol. 58 (August–October 1950), reprinted
in Essays in the History of Economics (Chicago: The University of Chicago Press, 1965);
Jacob Viner, “The Utility Concept in Value Theory and Its Critics,” Journal of Political
Economy, vol. 33 (August–September 1925), pp. 369–387, 638–659, reprinted in Viner,
The Long View and the Short (New York: Free Press, 1958); R. S. Howey, The Rise of the
Marginal Utility School, 1870–1889 (Lawrence: The University Press of Kansas, 1960);
Emil Kauder, A History of Marginal Utility Theory (Princeton, NJ: Princeton University
Press, 1965); and the entire issue of History of Political Economy, vol. 4 (Fall 1972), espe-
cially the articles by Blaug, Howey, Streissler, Stigler, and Shackle. An important article
for understanding the differences between the three cofounders of the marginal utility
tradition is William Jaffé, “Menger, Jevons, and Walras De-homogenized,” Economic
Inquiry, vol. 14 (December 1976), pp. 511–524. See also W. N. Butos, “Menger: A Sug-
gested Interpretation,” Atlantic Economic Journal, vol. 13 (July 1985), pp. 21–30.
Two useful sources of information on Menger’s “institutional” economics include A.
M. Endres, “Institutional Elements in Carl Menger’s Theory of Demand: A Comment,”
Journal of Economic Issues, vol. 18 (September 1984), pp. 897–902; and G. P. O’Driscoll,
Jr., “Money: Menger’s Evolutionary Theory,” History of Political Economy, vol. 18 (Win-
ter 1986), pp. 601–616. See also, Gilles Campagnolo, “Carl Menger’s ‘Money as Measure
of Value,” History of Political Economy, vol. 37 (Summer 2005), pp. 233–261, which con-
tains an introduction and English translation of an article written by Menger in 1892 on
the theoretical aspects of money (previously available only in French). Mikael Stenkula,
“Menger and the Network Theory of Money,” The European Journal of the History of
Economic Thought, vol. 10 (2003), pp. 587–606, shows that Menger was aware of the net-
work characteristic of money and some of the problems associated with this.
Wieser’s social economics is described in vol. 2 of W. C. Mitchell’s Lecture Notes on
Types of Economic Theory (New York: A. M. Kelley, 1969); and in R. B. Ekelund, Jr.,
“Power and Utility: The Normative Economics of Friedrich von Wieser,” Review of Social
Economy, vol. 28 (September 1970), pp. 179–196. An instructive description of Wieser’s
system (and of the Austrian system generally) of input and output pricing can be found
in chap. 12 of M. Blaug’s Economic Theory in Retrospect, 4th ed. (London: Cambridge
University Press, 1985). The Austrian system also spread to England. See William Smart,
An Introduction to the Theory of Value (New York: A. M. Kelley, 1966).
Böhm-Bawerk’s theory of value and capital is capably explicated by Klaus H. Hen-
nings, The Austrian Theory of Value and Capital. Studies in the Life and Works of Eugen
von Böhm-Bawerk (Cheltenham, UK: Edward Elgar, 1997), which also contains corre-
spondence between Böhm-Bawerk and Wicksell (see chap. 22) previously unpublished.
Beginning with an interchange between Böhm-Bawerk and J. B. Clark in the Quarterly
Journal of Economics in the 1890s and early 1900s, Böhm-Bawerk’s theory of capital and
interest has been the subject of continual debate. The original debate is the subject of an
unpublished doctoral dissertation by David E. R. Gay entitled Capital and the Production
Process: A Critical Evaluation of the Böhm-Bawerk–Clark Debate and Its Relation to
Current Capital Theory (College Station: Texas A & M University, 1973). For another
assessment of Böhm-Bawerk in light of his engagement with several contemporaries on
the theory of interest, see Jürg Niehans, “Böhm-Bawerk versus John Doe: The Interest
Controversies,” History of Political Economy, vol. 23 (Winter 1991), pp. 567–586. Among
the economists Niehans considers in regard to Böhm-Bawerk are Alfred Marshall, J. B.
Clark, T. N. Carver, F. A. Fetter, Adolphe Landry, Ladislaus von Bortkiewicz, and Irving
Fisher. An overview of Böhm-Bawerk’s period-of-production model based on a subsis-
tence fund and its role in capital theory is presented in Donald Dewey, Modern Capital
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366 Part IV ■ The Neoclassical Era

Theory (New York: Columbia University Press, 1965); and F. A. Lutz, The Theory of Cap-
ital, chap. 1 (London: Macmillan, 1965).
Avi J. Cohen, “The Kaldor/Knight Controversy: Is Capital a Distinct and Quantifiable
Factor of Production?” The European Journal of the History of Economic Thought, vol. 13
(Winter 2006), pp. 141–161, examines the capital-theory dispute between Nicholas Kal-
dor and Frank Knight (see chapter 15), in light of Böhm-Bawerk’s problem. Cohen
argues that this controversy is important for understanding disputes regarding periods
of production vs. production functions on the one hand, and roundaboutness vs. dimin-
ishing returns on the other. According to Cohen the Kaldor/Knight dispute underscores
Knight’s role as a “precursor” of new growth theory and Kaldor’s turning point in his
interest in Austrian theory.
The mechanics of Böhm-Bawerk’s theory of interest is analyzed graphically and
mathematically by Robert Dorfman, “A Graphical Exposition of Böhm-Bawerk’s Interest
Theory,” Review of Economic Studies, vol. 26 (February 1959), pp. 153–158; J. Hirshlei-
ffer, “A Note on the Böhm-Bawerk/Wicksell Theory of Interest,” Review of Economic
Studies, vol. 34 (April 1967), pp. 191–200; and D. E. R. Gay, “The Aggregate Factor-Price
Frontier in Böhm-Bawerk’s Period of Production Capital Model: A Graphical Deriva-
tion,” Eastern Economic Journal, vol. 3 (July 1975), pp. 205–211. It should be noted, at
least in passing, that Böhm-Bawerk’s protégé, Knut Wicksell, attempted to clarify Böhm-
Bawerk’s theory of capital in Value, Capital and Rent (New York: A. M. Kelley, 1970).
A. M. Endres, “The Origins of Böhm-Bawerk’s Greatest ‘Error’: Theoretical Points
of Separation from Menger,” Journal of Institutional & Theoretical Economics, vol. 143
(June 1987), pp. 291–309, explores Böhm-Bawerk’s departure from Menger. In a similar
vein, Endres again, “Some Microfoundations of Austrian Economics: Böhm-Bawerk’s
Version,” The European Journal of the History of Economic Thought, vol. 3 (Spring 1996),
pp. 84–106, attempts to establish “precisely what was distinctive about Böhm-Bawerk’s
version of Austrian microeconomic theory.”
In addition to everything else, Böhm-Bawerk was a formidable historian of eco-
nomic thought. His History and Critique of Interest Theories, first published in 1884, is an
unmatched masterpiece. The first English translation, by William Smart, appeared in
1890; it has been re-translated by George D. Huncke and Hans F. Sennholz (South Hol-
land, IL: Libertarian Press, 1959). Like Wieser, Böhm-Bawerk was interested in the soci-
ology of power and its effects on production and exchange. See, “Control of Economic
Law,” in R. Mez (trans.), Shorter Classics of Eugen von Böhm-Bawerk, vol. I (South Hol-
land, IL: Libertarian Press, 1962 [1914]). See also Emil Lederer, “Social Control versus
Economic Law: An Old Dogma and a New Situation,” Social Research, vol. 51 (Spring/
Summer 1983), pp. 91–110.
The Austrian tradition was carried on by a second generation of writers, including
Oskar Morgenstern and Joseph Schumpeter. But F. A. Hayek and Ludwig von Mises, in
particular, carried the seeds to England and America, where they fell on somewhat rocky
soil. More detail on this subject will have to wait until chapter 23.
Ekelund-Hebert 15.fm Page 367 Thursday, August 1, 2013 2:22 PM

15

Microeconomics in
England and America
W. S. Jevons and J. B. Clark

The climate of economic opinion in England was of a distinctly stormy nature in

the late 1850s, 1860s, and 1870s. Mill’s recantation of the wages-fund doctrine in
the Fortnightly Review in 1869 (see chapter 8) was thought by many to be the
death knell of classical economics. But, in truth, the reasons for the decline of cre-
dence in the classical paradigm may be laid at many doors. An interest in labor
problems, socialist and “progressive” philosophies, and Darwinian evolutionist
ideas, as well as the historicists’ reactions to classical political economy (see chap-
ter 11) and Mill’s eleventh-hour misgivings about laissez-faire, all contributed to
rising doubt of the adequacy of classical economics in England. If widespread dis-
satisfaction with an old paradigm is, as many intellectual historians believe, the
prerequisite for the emergence of a fundamentally new (but not necessarily con-
tradictory) system of thought, then a ready explanation for the emergence in Eng-
land of Jevons’s Theory of Political Economy in 1871 is at hand. Furthermore,
while Jevons and other economists in England and Europe were cementing the
foundation of neoclassical economics, the American economist John Bates Clark
was independently discovering the marginal-utility and marginal-productivity the-
ories of value and distribution.

■ W. S. JEVONS
William Stanley Jevons (1835–1882) was one of the most interesting and enig-
matic characters in the history of British economic thought. A man of rare (often
esoteric) powers of analysis, he was also one of the most practical professional
economists who ever lived. Although his ideas were profound and original, he had
no students or disciples of consequence—in spite of the fact that he held a major
university post in political economy (at Manchester).

367
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368 Part IV ■ The Neoclassical Era

Jevons was born in England and raised in an educated (but nonacademic) Uni-
tarian environment in which economic and social problems were often discussed.1
At the age of eighteen, he moved to Australia, where a remunerative job offer as
assayer at the Sydney Mint promised to alleviate family financial problems at home.
He remained there for five years, during which time his biographer, J. M. Keynes,
claims he was struck with all the original ideas on economics that he later devel-
oped and expanded on his return to England.
With his interest in political economy awakened by his experiences at the mint,
Jevons returned to England in 1859 to continue his studies at the University of Lon-
don, where he obtained a degree in 1865. Besides political economy, his early train-
ing was technical (including mathematics, biology, chemistry, and metallurgy), and
the subjects it encompassed permeated his entire intellectual career. This early
period was especially fecund for Jevons. In 1862, in several communications to the
British Association, he outlined (1) the skeletal structure of utility theory (Notice of
the General Theory of Political Economy) and (2) the scenario for his statistical
studies of fluctuations (On the Study of Periodic Commercial Fluctuations, with Five
Diagrams), both of which are discussed in this chapter. In 1863 Jevons published a
book entitled Pure Logic (one of the most significant and presently neglected areas
of his interests), and in 1865 he published The Coal Question, a book that brought
him to prominence in economic circles.
The Coal Question was based on a questionable analogy between the role of
corn in Malthus’s theory of population and that of coal in the industrial progress of
Britain. Nevertheless, the book attracted a good deal of attention in political and
intellectual circles, including that of Prime Minister Gladstone. From this point
onward, Jevons’s interests fluctuated from pure logic to economics and back again.
His economic interests ran the gamut from statistical analyses of prices and gold
(and significant institutional studies of money markets) to pure theory and commer-
cial fluctuations, of which his controversial sunspot theory was one (The Solar
Period and the Price of Corn [1875]). In 1871 Jevons published his most enduring
work, Theory of Political Economy, a book based on his early ideas on utility theory
communicated to (but ignored by) the British Association in 1862.
In 1876, after numerous bouts of nervous and physical exhaustion (at the age of
thirty-six he was obliged to give up all work for a time), Jevons left Manchester for a
professorship in political economy at University College in London. He resigned
this post in 1880 due to a return of ill health and a pressing desire to complete a
massive treatise tentatively titled Principles of Economics. Although fragments
remain, this last work was never completed. In August 1882 an enfeebled Jevons,
just short of his forty-seventh birthday, drowned while swimming off the south coast
of England.
Jevons’s untimely death deprived the world of an original economic mind. But
this assessment has been formed mostly in retrospectives of his work. During his
life and immediately afterward, Jevons seems to have had little impact on the
course of economics. As noted above, he left no serious students or disciples. His
books did not sell well. (J. M. Keynes calculated that by 1936 only 39,000 copies of

1
A lifelong music lover, Jevons became enchanted, following an early devotion to Beethoven, with
the experimental music of Berlioz and Wagner, who he believed were writing the “music of the
future.” His knowledgeable and laudatory descriptions of the innovative nature of these compos-
ers are clear evidence that the quest for rearrangement and changes in form was a deeply
engrained habit of his thought. It is interesting to note that Jevons’s early conviction about his
own genius and originality almost exactly parallels Wagner’s.
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Chapter 15 ■ Microeconomics in England and America 369

Jevons’s nine major works in economics and logic had been sold!). Moreover, the
person who came to dominate British economics near the end of the century, Alfred
Marshall, displayed an ungenerous attitude toward him.
How might one account for the distinctly mediocre impact of a writer whose pow-
ers of originality have been favorably compared to Marshall’s? A retrospective by one
of his admirers, John Maynard Keynes, gives us some insights into Jevons’s character.
What sort of man was Jevons in himself? There is no strong personal impression of
him which has been recorded, and 54 years after his death it is not easy to find a
definite imprint on the minds of the few now left who knew him. My belief is that
Jevons did not make a strong impression on his companions at any period of his
life. He was, in modern language, strongly introverted. He worked best alone with
flashes of inner light. He was repelled, as much as he was attracted, by contact
with the outside world. He had from his boyhood unbounded belief in his own
powers; but he desired greatly to influence others whilst being himself uninflu-
enced by them. He was deeply affectionate towards the members of his family but
not intimate with them or with anyone. (“William Stanley Jevons,”, p. 304)

This character portrayal by one who was anything but introverted is reinforced by
Jevons’s self-assessment, as expressed in a letter to his beloved sister Lucy.
I cannot say of course that my disposition for reserve and loneliness was originally
intentional on my part; it probably originated in bashfulness, which other people
think, and which, no doubt, is, a very silly thing. Yet I ascribe to this disposition
almost everything I am, and believe that a certain amount of reserve and solitude is
quite necessary for the information of any firm and original character. This is in
fact almost self-evident, for if any one were brought up in continual intercourse
with the thoughts of a number of other people, it follows almost necessarily that
his thoughts will never rise above the ordinary level of the others. . . . Solitude, no
doubt, produces one class of minds and characters, and society another; the latter
may give quickness of thought and some other showy qualities, but must tend to
interrupt longer and more valuable trains of thought, and gradually destroy the
habit of following them, while solitude promotes reflection, self-dependence, and
originality. These, I believe, I possess to a greater or less extent, and I therefore, on
principle, do not altogether regret that my habits have been as you know them.
(Letters and Journal, pp. 85–86)

So Jevons defended his aloofness. He bragged to Lucy that, with one “slight excep-
tion,” he had never gone to a party; and that he had at last succeeded in “impressing
upon all friends the fact that it is no use inviting me.” Traits that would be consid-
ered weaknesses in others were regarded as strengths by Jevons.
From an early age Jevons was confident that he would revolutionize the science
of economics. In 1858 he wrote from Australia to his sister Henrietta (who was read-
ing Adam Smith’s The Wealth of Nations at the time):
There are a multitude of allied branches of knowledge connected with man’s con-
dition; the relation of these to political economy is analogous to the connection of
mechanics, astronomy, optics, sound, heat, and every other branch more or less of
physical science, with pure mathematics. I have an idea, which I do not object to
mention to you, that my insight into the foundations and nature of the knowledge
of man is deeper than that of most men or writers. In fact, I think that it is my mis-
sion to apply myself to such subjects, and it is my intention to do so. You are desir-
ous of engaging in the practically useful; you may feel assured that to extend and
perfect the abstract or the detailed and practical knowledge of man and society is
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370 Part IV ■ The Neoclassical Era

perhaps the most useful and necessary work in which any one can now engage. . . .
There are plenty of people engaged with physical science, and practical science
and arts may be left to look after themselves, but thoroughly to understand the
principles of society appears to me now the most cogent business. (Letters and
Journal, p. 101)

Despite his clearly perceived mission, however, Jevons’s “habits” of isolation, shy-
ness, aloofness, and social inhospitality carried over into his later academic life.
Keynes quotes Jevons’s colleague, Professor Herbert Foxwell, as saying that
“‘There never was a worse lecturer, the men would not go to his classes, and he
worked in flashes and could not finish anything thoroughly,’ and then after a pause
with a different sort of expression [Foxwell continued], ‘the only point about
Jevons was that he was a genius’” (“William Stanley Jevons,” p. 307). A look at
Jevons’s entire lifework bears out Foxwell’s opinion. Jevons’s legacies to economics
are indeed fragmentary, but they are the leavings of genius.

■ JEVONS’S THEORY OF VALUE

Jevons’s major contribution to economic theory was to establish consumer
behavior on the basis of utility judgments. From this foundation he constructed a
theory of exchange and a theory of labor supply and capital. Many of these ideas,
which were expressed chiefly in his Theory of Political Economy, were not new.
Indeed, Jevons very generously noted that many of the features of his economic the-
ory had been developed previously by others. Two of his most important precursors
were Dionysius Lardner, who developed a theory of the firm in his Railway Econ-
omy of 1850, and Fleeming Jenkin, who established a graphical presentation of the
laws of supply and demand in 1870. (See the box, The Force of Ideas: Engineers as
Precursors). Nevertheless, many of Jevons’s theoretical contributions were original
and important. His discovery of marginal utility was made independently of all
other writers, and thus reflects his original cast of mind.

The Force of Ideas: Engineers as Precursors

Unlike many an economic pioneer, Jevons was perennially gracious in mentioning his pre-
cursors. Two writers, both engineers, are mentioned in the first edition of Jevons’s Theory of
Political Economy as having directly influenced his thought: Dionysius Lardner (1793–1859)
and Fleeming Jenkin (1833–1885). Lardner was an engineer, astronomer, and essayist on
numerous scientific topics, but he often ventured into other fields. Railway Economy (1850;
see references), his only work that relates to economics, was filled with facts, but it also
exposed a theory that drew Jevons’s attention. Jevons read the book in 1857 and claimed that
it inspired him to investigate economics in mathematical terms.
Based on empirical studies of railroad costs and revenues, Lardner developed a fully
formed theory of a profit-maximizing railroad. He depicted the point of optimal profit by
means of a diagram. In this diagram Lardner made “price” (in the form of a railway rate) the
independent variable (the one free to change), and “quantity” the dependent variable. He
showed that unit costs fall (up to some point) with the amount of traffic carried. But fixed
costs are invariant, and would remain to be paid even if the price were so high as to eliminate
all traffic. Total costs are thus the sum of fixed and variable costs. Lardner’s diagram also
showed a railway total revenue function, which he expressed mathematically. Indeed, the
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Chapter 15 ■ Microeconomics in England and America 371

mathematical expression of total revenue by Lardner may have been the stimulus to Jevons’s
interest in using mathematics to express economic theory.
Lardner’s function took the following simple form. Let r = the tariff imposed by the railroad
per mile on each ton carried; D = the average distance in miles to which each ton of goods is
carried; N = the number of tons booked; and R = the gross receipts from goods transport. It
follows that total receipts may be expressed as R = NDr. As the tariff is lowered, the average
distance of each ton of freight carried, D, and the number of tons booked, N, increase. Total
receipts will increase to some maximum and then (due to increasing elasticity of demand
unnoted by Lardner) decline to zero at a zero tariff rate. In effect, Lardner identified the profit
maximizing quantity as that output at which marginal cost equals marginal revenue. The pre-
cise effect this kind of theorizing had on Jevons is difficult to know, but it is curious that
Jevons did not take the logical step of deriving a demand curve from Lardner’s total receipts
expression, nor did he present a model of profit maximization in his own writings.
A second, and possibly more direct, influence on Jevons came from Fleeming Jenkin, an
engineer whose 1870 publication, “The Graphic Representation of the Laws of Supply and
Demand,” induced Jevons to hurry his Theory of Political Economy into print. Jenkin set out to
refute W. T. Thornton’s bizarre assault on the wages-fund theory and the laws of supply and
demand (see chapter 8). In the process he presented a persuasive, but wholly graphical, expla-
nation of the principles of supply and demand in his essay, exposing the circularity of many
previous discussions of price determination. He claimed that both demand and supply “may
be said to be functions of price,” and he correctly represented demand as identifying the
“quantity which, then and there [i.e., at a price], buyers would purchase at that price.”* Jenkin
defined supply in essentially the same way, so that he presented both quantity demanded
and quantity supplied as functions of price. His graphical representation clearly established
equilibrium price and quantity at the junction of his demand and supply schedule. In fact, his
explanation of how market equilibrium is established by competitive forces would compare
favorably with any modern textbook discussion of the subject.
Although Jenkin had a clear understanding of the equilibrating market process, he mud-
dled his analysis of what caused changes in the two curves or functions. For example, he iden-
tified no income parameter when discussing demand. It therefore appears that Jenkin’s
theoretical statement of the demand function did not surpass earlier expositions (Mill’s for
instance) in terms of completeness or importance, even though he alluded to the concept of
elasticity of demand and suggested the possibility of establishing statistical demand estima-
tions (which he did not undertake). It may have been Jenkin’s penchant for graphical exposi-
tion of economic principles that influenced Jevons (and Alfred Marshall). Be that as it may,
Jenkin’s essay remains, at least for its day, a benchmark in the development of the graphics of
partial equilibrium price analysis in England.
It is another curious episode in the history of economic ideas that Jevons, who had a clear
appreciation for both Lardner’s and Jenkin’s work, did not undertake a formal analysis of the
profit-maximizing firm or of supply and demand. He skipped over the mutual interdepen-
dence of supply and demand even though the idea was there for the taking in his predeces-
sors’ work. Nevertheless, the force of graphical presentation to clarify economic principles was
manifest in Lardner and Jenkin, and once adopted by Jevons, passed into the mainstream of
economic analysis.
*”Graphic Representation,” p. 77.
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372 Part IV ■ The Neoclassical Era

Utility Theory
The actual discovery of utility theory, and specifically marginal-utility theory,
was made by Jules Dupuit, as we have seen in chapter 13. There had been essen-
tially adventitious statements of the same principle by Nassau Senior, William
Lloyd, and Montifort Longfield. Dupuit, however, had developed the theory in an
empirical milieu and had based his argument on empirical facts. Jevons, although
possibly looking to the practical concerns of Lardner for inspiration, based his rea-
soning partially on physiological theory. In this connection Jevons specifically noted
the Weber–Fechner studies of stimulus and response.
In his establishment of utility theory, Jevons’s background in science and scien-
tific measurement was much on his mind. He considered economics fortunate in
that some of its important quantities (prices and so forth) were capable of exact
measurement. He had early and unbounded faith in the future of mathematics and
statistics as indispensable aids to discovery in economics. Yet, he placed a subjec-
tive maximand—utility—in the starring role in economic analysis. Jevons admitted
that the calculus of pleasure and pain (or utility theory) had subjective features,
although he expressed hopes that the effects of utility might somehow be ascer-
tained in a scientific sense. In 1871 he wrote:
A unit of pleasure or of pain is difficult even to conceive; but it is the amount of
these feelings which is continually prompting us to buying and selling, borrowing
and lending, labouring and resting, producing and consuming; and it is from the
quantitative effects of the feelings that we must estimate their comparative
amounts. We can no more know nor measure gravity in its own nature than we can
measure a feeling; but, just as we measure gravity by its effects in the motion of a
pendulum, so we may estimate the equality or inequality of feelings by the deci-
sions of the human mind. (Theory of Political Economy, p. 11)

Immediately, then, Jevons acknowledged that one could, at best, obtain only ordinal
estimates of the quantity around which the entire economic system revolves. In his
Theory (unless otherwise noted, all citations for Theory refer to the 1871 edition),
Jevons noted that utility is basically introspective, and he recognized explicitly that
interpersonal comparisons from one individual or group to another are impossible
(although he may have failed to heed his own warnings in the concept of a “trading
body,” as we shall see). Nevertheless, despite all these difficulties, Jevons set out the
new core of economics in utility terms.
Marginal Utility. Following Bentham’s lead (see chapter 6), Jevons main-
tained that the value of pleasure and pain varies according to four circumstances:
(1) intensity, (2) duration, (3) certainty or uncertainty, and (4) nearness or remote-
ness. Jevons discussed each of these at length. Pain is simply the negative of plea-
sure, and in individual calculations the algebraic sum (i.e., net pleasure) is the
meaningful quantity. Like Bentham before him, Jevons injected a probabilistic ele-
ment into economic analysis when he discussed the ways in which the uncertainty
of future events and future “anticipated feelings” affect behavior. In one especially
telling passage, Jevons suggested how time preference and anticipation permeate
economic quantities:
The cares of the moment are but ripples on the tide of achievement and hope. We
may safely call that man happy who, however lowly his position and limited his
possessions, can always hope for more than he has, and can feel that every
moment of exertion tends to realize his aspirations. He, on the contrary, who
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Chapter 15 ■ Microeconomics in England and America 373

seizes the enjoyment of the passing moment without regard to coming times, must
discover sooner or later that his stock of pleasure is on the wane, and that even
hope begins to fail. (Theory, p. 35)

Paradoxically, however, Jevons never incorporated this all-important element

directly into his theory of utility.
The object of economics, Jevons asserted, is maximization of pleasure, or in
his own words, humans seek to procure the “greatest amount of what is desirable
at the expense of the least that is undesirable” (Theory, p. 37). However, he strove
to make this proposition more objective by attaching it to something concrete, such
as commodities.
According to Jevons a commodity is an “object, substance, action, or service
which can afford pleasure or ward off pain; and utility is the abstract quality
whereby an object serves our purposes, and becomes entitled to rank as a commod-
ity” (Theory, p. 38). Eschewing any pretensions of direct measurability, Jevons
claimed that individual behavior would reveal a person’s utility and preferences and
that the investigator must accept these without making value judgments. As he
clearly noted, “Anything which an individual is found to desire and to labour for
must be assumed to possess for him utility” (Theory, p. 38). Thus, flagpole sitters,
astronauts, kamikaze pilots, heroin addicts, and suicides might simply be regarded
as maximizing utility (under certain constraints, of course).
Jevons’s theory of marginal utility is basically simple and straightforward, and
he used elementary arithmetic and geometry to illustrate the basic nature of his
argument. Unlike any of his predecessors, he clearly specified that a utility function
is a relation between the commodities an individual consumes and an act of individ-
ual valuation. Utility is not an intrinsic or inherent quality that things possess.
Instead, utility has meaning only in the act of valuation.
Jevons’s vast improvements over Bentham’s utility theory consist in the follow-
ing features of his formal utility analysis: (1) his clear distinction between total util-
ity and marginal utility, (2) his discussion of the nature of marginal utility, and (3)
his establishment of the equimarginal principle, as it relates to alternative uses of
the same commodity and to choices between commodities. By clearly distinguishing
between total utility and what he called the “degree of utility,” Jevons resolved
Adam Smith’s water–diamond paradox. For our purposes, Jevons’s “degree of util-
ity” may be regarded as identical to marginal utility. Both total and marginal utilities
were related to the quantities of goods possessed, and only to those quantities.
Graphical Analysis. In algebraic notation, Jevons’s utility function is
expressed as U = f(X), which should be read as “the utility of commodity X (food) is
a function of the quantity of X the individual holds.” It should be noted that all other
goods are left out of the picture; that is, it may be assumed that either they are non-
existent or their quantities are held constant. Assuming that one could add tiny por-
tions of food to the individual’s store—that is, “continuously,” in the language of
arithmetic—one might derive a utility function as depicted in figure 15-1a (on the
following page). Here the total utility of food (the quantities of other things held
constant) may be seen to rise as quantities are added up to X0, reach a maximum at
that point, and then decline. But the utility of an additional unit of food, which
Jevons called the “degree of utility,” declines as units of food are added to the indi-
vidual’s consumption. Mathematically, Jevons wrote du/dx, to be read as “the ratio
of a small change in utility to a small change in X (food).” Figure 15-1b, which is
derived from figure 15-la, demonstrates this idea. Further, he assumed that the mar-
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374 Part IV ■ The Neoclassical Era

Total
utility

Total utility

(a)

O X0 Units of X (food)

Marginal
utility or
degree of
utility

Figure 15-1 Total utility

rises continuously up to
(b) X0 units of food, but mar-
ginal utility declines con-
O X0 Units of X (food) tinuously as additional
units of food are con-
Marginal utility sumed per unit of time.

ginal utility (used synonymously with “degree of utility”) of food was declining after
the very first unit taken, although he was undoubtedly aware that this might not
always be the case. Jevons’s law may then be stated as follows: The degree of utility
for a single commodity varies with the quantity possessed of that commodity and
ultimately decreases as the quantity of that single commodity increases.
The Equimarginal Principle. Jevons presented a clear understanding of the
individual’s maximizing behavior in discussing a person’s allocation of any given
commodity among alternative uses. If an individual starts with a fixed stock S of a
commodity X, and the uses of that commodity are represented by x and y, then the
stock must be divided up between those uses such that S = x + y. Now Jevons, in
effect, asks the question: How does an individual decide how to allocate his fixed
stock among the two uses? The simple and intuitively logical answer is that the
quantity of X should be allocated to the two uses so that the increase in utility from
adding an additional unit of X in use x just equals the increase in utility from adding
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Chapter 15 ■ Microeconomics in England and America 375

an additional unit of X in use y. In Jevonian terms, the equimarginal condition

implies that
du du
= or MU x = MU y
dx dy
where MUx stands for the degree of utility of commodity X in use x, and similarly
for y.
The equimarginal principle, first clearly explained by Jevons, also holds for the
allocation of scarce, fixed means (say, income) among all goods in the individual
consumer’s budget. If x represents number of beers and z represents packs of ciga-
rettes, then the consumer will allocate scarce income y such that the MUx = MUz,
assuming that beers and cigarettes are the same price and that all y is expended on
these two goods. A more general formulation of the equimarginal principle, one
that does not appear in Jevons but that accounts for different prices of n goods, is
the one familiar to every student of basic economics:
MUx MUz MUn
= =
Px Pz Pn
In order to ensure that all income is allocated among the individual’s consump-
tions (which could include a savings account), an additional condition is needed:
Px X + Pz Z + . . . + Pn N = Y

where Px X represents the individual’s expenditure on X, Pz Z represents the expen-

diture on Z, etc. The sum of all these expenditures equals income Y. Although
Jevons did not work out the details, his argument underlies the whole development
of the theory of individual maximization behavior, which is at the core of contempo-
rary theory.

Theory of Exchange
Jevons developed a theory of exchange (i.e., an explanation of why and how
goods trade between individuals in a market) by combining the theory of utility dis-
cussed in the previous section with his law of indifference. The law of indifference
states that in any free and open market, at any given time, there cannot be more
than one price for the same (homogeneous) commodity. Another element of his
exchange theory is the idea of a “trading body,” a concept that, as we shall see, is
not without some difficulties. By a trading body Jevons meant “any body of either
buyers or sellers,” which could mean anything from two individuals to an entire
population. Jevons insisted that every trading body “is either an individual or an
aggregate of individuals, and the law in the aggregate must depend upon the fulfill-
ment of the law in the individuals” (Theory, pp. 88–89). Neglecting, for the moment,
any problems with the concept, let us assume, with Jevons, that there is one trading
body (A) possessing a stock of beef (a) and another trading body (B) possessing a
stock of corn (b). How does exchange take place? Jevons presented a graphical and
symbolic solution.
Let the marginal-utility functions for corn and beef be represented as in figure
15-2 (on the following page), which we here adapt, with slight alterations, from
Jevons’s own diagram.
Let an increase (decrease) in the quantity of corn (beef) be read from left to
right on figure 15-2 and an increase (decrease) in the quantity of beef (corn) be read
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376 Part IV ■ The Neoclassical Era

MU beef

MU corn
f
d k
g

c
h e
j MU corn
MU beef

Quantity of corn a‫ ׳‬a m b‫ ׳‬b Quantity of beef

Figure 15-2 If trader A has an initial endowment of a corn and beef, he can improve
his situation by exchanging beef for corn with trader B. At all points to the left of m,
trader A receives a net gain of utility by exchanging beef for corn, whereas at all points
to the right of m, trader B receives a net gain of utility by exchanging corn for beef.

from right to left in the same figure. Units of both commodities must be represented
by equal lengths, of course.
Consider trading body A and assume that it holds a quantity a of corn. An
increase in A’s holding of corn, represented by the little line aa, simultaneously rep-
resents a decrease in A’s holdings of beef. But the important point is that A gains by
the trading of beef for corn. Why? Because it would gain more utility by acquiring
corn (i.e., adga) than it would lose by giving up beef (i.e., ahca). With reference to
figure 15-2, A would receive a net gain of area hdgc.
A would continue to trade until equilibrium is reached at point m, which repre-
sents, in this simple case, the intersection of the marginal-utility curves. B does the
same. (It is left for the reader to trace out B’s maximizing behavior.) At m, no further
gains from trade can be realized by either trading body, and trade ends.2 Thus,
Jevons concluded that freedom of exchange, projecting these results, must be to the
advantage of all. Laissez-faire thus received a boost from this aspect of utility theory.

Theory of Labor Supply

One of Jevons’s most interesting applications of utility theory was to the theory
of labor supply. With labor, as with all other activities, two quantities were of primary
importance to Jevons in explaining behavior: cost incurred and utility gained (prox-
ies for pain and pleasure). Jevons defined labor as “any painful exertion of mind and
body undergone partly or wholly with a view of future good” (Theory, p. 168). The

2
Jevons also expressed the condition arithmetically. If we let MUAa represent the final degree of
utility of trading body A for commodity a (corn) and so on, then Jevons’s equilibrium equations of
exchange may be expressed as
A B
MU a MU b a ( total quantity of beef retained )
= =
A B b ( total quantity of corn retained)
MU b MU b
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Chapter 15 ■ Microeconomics in England and America 377

reader may object that many people at least claim to like their work. Jevons, how-
ever, was thinking of some concept of net pain—a balance of the painfulness and the
pleasure of working. He also implicitly assumed that workers were on a piecework
system and that they could alter the amount of work performed. This latter assump-
tion, except perhaps over a long-run period, does not present a very accurate picture
of present conditions or even of those that existed in Jevons’s time. Nevertheless, his
idea has some applicability wherever the conditions he assumed are relevant.
In analyzing the work decision, Jevons focused on three quantities: net pain
from work, amount of production, and amount of utility gained. Graphically, the
combination of these quantities may be analyzed as in figure 15-3. In a piecework
system the worker’s real wage and income depend on his or her rate of production.
The curve pq may be regarded as the degree of utility weighted by the worker’s pro-
duction or output. The reward for labor, in other words, may be regarded as the
product of the rate of production and the degree of utility. The costs of labor are rep-
resented by the curve traced out by ed. Here Jevons assumed that the act of begin-
ning work is onerous (getting up in the morning for some of us?) and produces net
pain. But as work continues, it becomes more and more pleasurable on balance,
until a point is reached where painfulness begins to overwhelm the pleasure of
working. Thus, the net-pain-of-labor curve peaks out and turns downward, becom-
ing negative.

Pleasure p
Degree of utility
of real wages
+
Figure 15-3 In this q
analysis based on
hedonic calculus, a O x = Real wages,
worker will offer labor b c m
amount of
services in the amount d product
m, because at that –
point the cost of work- Net-pain-of-
ing, md, equals the labor curve
Pain e
reward of work, mq.

Applying the equimarginal principle in this context means that the worker will
stop producing when the net pain of working is equivalent to the degree of utility of
the real wages produced. That occurs at point m in figure 15-3. At point m, where
the cost of working md (net pain) equals the reward from working mq (the utility
reward), the worker would cease work. To go beyond this point would bring greater
costs than rewards. Thus, Jevons established a theory of labor supply based on his
notions concerning utility.

■ JEVONS AS A PURE THEORIST

Our investigation of some of Jevons’s purely theoretical ideas is necessarily
incomplete. For example we have not reviewed in detail his theory of rent and his
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378 Part IV ■ The Neoclassical Era

productivity theory of capital and interest. However, our discussion of his utility
approach to value, exchange, and labor should leave little doubt in the reader’s
mind that Jevons was an innovative, original thinker.
Although utility theory revolutionized value theory, Jevons’s own ideas on
exchange value were curiously lopsided. Though he never relied on supply and
demand curves, he was aware of Fleeming Jenkin’s effective use of these concepts
in explaining market value. He conceded, therefore, that “Our theory is perfectly
consistent with the laws of supply and demand; and if we had the functions of utility
determined, it would be possible to throw them into a form clearly expressing the
equivalence of supply and demand” (Theory, p. 101). Yet, he seemed targeted on
deeper origins of value, noting that, “The laws of supply and demand are thus a
result of what seems to me the true theory of value or exchange” (Theory, p. 101). It
wasn’t results that interested him so much as root causes. He zeroed in almost
exclusively on utility as the source of value and aptly summarized his “final” posi-
tion in the form of a catena that spells out the chain of connections between impor-
tant economic variables:
Cost of production determines supply;
Supply determines final degree of utility;
Final degree of utility determines value. (Theory, p. 165)

Hence, labor value, and presumably the value of all inputs, is determined by the
utility or value of the product it produces, and not vice versa. Independent altera-
tions in supply due to alterations in costs of productive inputs are not taken into
account. Supply of goods, as in the theory of exchange shown in figure 15-2, is pre-
sumed fixed.
Jevons believed that utility theory effectively refuted the labor theory of value,
which he (erroneously) identified as the sole determinant of value in Ricardo’s Prin-
ciples. His independent discovery of utility analysis led him to reject the earlier cost-
of-production emphases of classical writers such as Smith and Mill as well. What
Jevons failed to recognize in his economic analysis was that supply and demand
mutually determine prices. Fleeming Jenkin had suggested as much in 1870 or ear-
lier, but it was Alfred Marshall (see chapter 16) who most clearly and completely set
forth the co-impact of independently determined supply and demand upon price
determination two decades later.
In spite of this fundamental criticism of his value theory, Jevons’s decision not
to formally link demand curves with marginal-utility curves has been lauded by
many economists, most notably by Léon Walras (see chapter 17). As we have seen,
Jevons looked forward to the day when these “functions of utility” could be empiri-
cally determined, at least in an ordinal (ranking) sense. But until that day, he was
unwilling to link demand and utility functions in partial equilibrium, as Dupuit had
done before him and as Marshall was to do later.
Very restrictive assumptions must be imposed for the demand curve of even a
single individual to represent a utility measure (i.e., for price and marginal utility to
be equated, as Dupuit did—see figure 13-4). The marginal utility of money must be
held constant with respect to the prices or quantities of all other goods; goods in the
consumer’s budget must be assumed to be unrelated; and so forth. These conditions
are not apt to be met in any real-world case, and it is to Jevons’s credit that he rec-
ognized this important point.
As befits his ambivalent nature, however, Jevons erred in a related matter.
Recall that he had defined a trading body as any body of buyers and sellers. We dis-
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Chapter 15 ■ Microeconomics in England and America 379

covered in connection with his theory of exchange that Jevons presumably believed
that an aggregate degree-of-utility function could be constructed in order to analyze
trade. Such a construction is manifestly illegitimate, however, since it would require
the summing up of different individuals’ degree-of-utility functions for some good.
Since incomes, tastes, and preferences vary, there is no reason to expect that the
MU’s of these individuals would be comparable. The fact that Jevons required only
ordinal ranking is of no help to him in this dilemma. An interpersonal summation of
rankings would not avoid the problem.
In the final analysis Jevons’s theoretical apparatus contains several ambigui-
ties. His analysis of utility was pathbreaking, and it contains an essential key to
value theory, but his performance on the microeconomic stage lacked the sophisti-
cation and the completeness of Marshall’s. Still, many pioneering bits of analysis
are contained in his Theory of Political Economy. Had he lived to complete his pro-
jected Principles, Jevons might have left economic science far richer; however, as it
stands, his contributions to pure theory, though piecemeal, were solid. Keynes
(Alfred Marshall’s most renowned student) described Jevons’s Theory as “simple,
lucid, unfaltering, chiseled in stone where Marshall knits in wool” (“William Stanley
Jevons,” p. 284).

■ JEVONS AND STATISTICAL SCIENCE

Jevons’s pioneer efforts in utility analysis were more than matched by his
efforts in empirical and statistical science. In 1862, after publishing early works on
scientific meteorology, Jevons set out to apply scientific principles to commercial
statistics.3 He sent his first statistical paper, “On the Study of Periodic Commercial
Fluctuations,” to the British Association in 1862, along with his earliest theoretical
paper on utility. In it Jevons analyzed variation in the following magnitudes: aver-
age rate of discount, 1845 to 1861 and 1825 to 1861; total number of bankruptcies,
1806 to 1860; average price of government bonds, 1845 to 1860; and average price
of wheat, 1846 to 1861. Jevons presented his data diagrammatically, and concluded
that data should be arranged in such a way as to best elucidate the most interesting
aspects for the purposes of the investigator. As an early discoverer of seasonal fluc-
tuations, Jevons noted:
Every kind of periodic fluctuation, whether daily, weekly, monthly, quarterly, or
yearly must be detected and exhibited, not only as a subject of study in itself, but
because we must ascertain and eliminate such periodic variations before we can
correctly exhibit those which are irregular or non-periodic, and probably of more
interest and importance. (Investigations, p. 4)

Thus, Jevons offered various explanations for the seasonal fluctuations in his vari-
ous data, applying the process of scientific abstraction used in his theoretical work.

Price Series and Index Numbers

One of Jevons’s most important statistical papers was “A Serious Fall in the
Value of Gold Ascertained and Its Social Effects Set Forth” (1863). In it Jevons
applied the general proposition “that an article tends to fall in value as it is supplied

3
Most of Jevons’s statistical studies were collected after his death by his wife, Harriet, and pub-
lished by his friend Foxwell. These studies can be found in Jevons’s Investigations in Currency
and Finance.
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380 Part IV ■ The Neoclassical Era

more abundantly and easily than before” to the then-recent gold discoveries in Aus-
tralia and California. The French economist Michel Chevalier had predicted such a
fall, but others, including William Newmarch and John Ramsay McCulloch, had
doubted Chevalier’s argument.
In order to understand Jevons’s achievement better it must be recognized that
economists of this period had only vague and ambiguous notions of what a fall in
value was. Thus, Jevons had to begin with an introductory lesson in logic applied to
statistics. He had to explain the meaning of an average rise of prices, and, most
importantly, the method of constructing price indexes. In this latter effort, he was
clearly a pathbreaker. He discussed at length the compilation of price tables, com-
putation of arithmetic and geometric means, the problem of weighting, and the
selection of the sample commodities. Then with statistics gathered from various
periodicals, including The Economist, the Gazette, and The Times, Jevons con-
structed an average annual price of thirty-nine commodities for the years 1845 to
1862. After assessing the statistics and painstakingly plotting them, he concluded:
It is hardly necessary to draw attention to the permanent elevation of prices since
1853. . . . The lowest average range of prices since 1851 has indeed happened in
the last year 1862; but prices even then stood 13 percent above the average level of
1845–50. . . . Examine the yearly average prices at any point of their fluctuations
since 1852, and they stand above any point of their fluctuations before then within
the scope of my tables. There is but one way of accounting for such a fact, and that
is by supposing a very considerable permanent depreciation of gold. (Investiga-
tions, pp. 44–45)

Jevons also discussed the depreciation of silver and the rate of fall in the value of
gold, relating the total fall in gold value to the quantity in use.
Finally, Jevons investigated the effects of gold depreciation (price increase) on
debtors, creditors, and various other classes. Throughout he displayed a keen practi-
cal knowledge of credit institutions and commerce. He concluded that creditors,
those injured by gold depreciation, have no equitable claim to compensation, but he
failed to discuss the distributional effects of gold depreciation. He recognized, how-
ever, the indirect effects of gold discovery, such as the creation of new colonies, the
dissemination of the English people and language, and the invigoration of commerce.
Several years later, Jevons continued and expanded his statistical study of price
movements in “The Variation of Prices and the Value of the Currency Since 1782,”
published in the Journal of the Statistical Society of London (June 1865). In this
paper Jevons reduced data from Tooke and Newmarch’s History of Prices into price
indexes of all commodities and individual classes of commodities. He evaluated the
theoretical foundations of all commonly used price indexes, favoring the geometric
mean over the arithmetic mean and the harmonic mean. On the merit of these alter-
native calculations, Jevons observed, “It is probable that each of these is right for its
own purposes when these are more clearly understood in theory” (Investigations, p.
114). The geometric mean presented some calculational advantages, such as the
ability to correct results by the continual use of logarithms. Also, Jevons wanted a
ratio that would underestimate variations by comparison with the arithmetic mean.
As in his previous paper, Jevons meticulously explained his construction of the
index from Tooke’s data, including methods for “correcting” the data over various
intervals and for the classifications of commodities. For example, the price data
between 1800 and 1820 had to be corrected to reduce prices and their variations to a
gold standard, because the Bank of England sponsored a paper standard during this
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Chapter 15 ■ Microeconomics in England and America 381

period (see chapter 6). The quality of Jevons’s study, in short, was extremely high,
and the results, multiple price indexes between 1782 and 1865, mark the most
important early attempt at systematic price indexing in economic literature.
Jevons’s instinct for order and his readiness to raise questions concerning the qual-
ity of his raw data and his statistical methods make his contributions to price-index
construction not only above the level of his time but considerably ahead of his time.

Sunspots and Commercial Activity

Jevons’s romance with statistical investigations carried him to the most fanciful
and, ultimately, the most ridiculed idea of his life—the explanation of commercial
crises on the basis of the periodic alteration of spots on the sun. The “sunspot the-
ory” integrated Jevons’s earlier work on prices with his lifelong interest in astro-
nomical and meteorological phenomena. In “The Solar Period and the Price of
Corn” (1875), he put the matter succinctly:
If the planets govern the sun, and the sun governs the vintages and harvests, and
thus the prices of food and raw materials and the state of the money market, it fol-
lows that the configurations of the planets may prove to be the remote causes of
the greatest commercial disasters. (Investigations, p. 185)

From his meteorological research Jevons initially calculated the length of the
sunspot cycle at 11.11 years. Parts of James E. Thorold Rogers’s great work, A His-
tory of Agriculture and Prices in England, had begun to appear, giving Jevons a
source of raw data. But in 1875, Jevons was not convinced that the information he
had in hand justified a firm belief in a causal relation between sunspots and com-
mercial activity. Still, in noting that the electric telegraph was a favorite dream of
sixteenth- and seventeenth-century physicists, Jevons pointed out:
It would be equally curious if the pseudo-science of astrology should, in like man-
ner, foreshadow the triumphs which precise and methodical investigations may yet
disclose, as to the obscure periodic causes affecting our welfare when we are least
aware of it. (Investigations, p. 186)

In 1878 Jevons returned to the subject of sunspots with renewed vigor, first in a
paper to the British Association (“The Periodicity of Commercial Crises and Its
Physical Explanation”) and then in an article in Nature (“Commercial Crises and
Sun-Spots”). At this time Jevons was convinced by new evidence that the duration
of the sunspot cycle was 10.44 years instead of 11.11, a dating that more closely cor-
related with the commercial cycle of crises. The coincidence was just too much for
Jevons, and he leaped to a conclusion:
I can see no reason why the human mind, in its own spontaneous action, should
select a period of just 10.44 years to vary in. Surely we must go beyond the mind to
its industrial environment. Merchants and bankers are continually influenced in
their dealings by accounts of the success of harvests, the comparative abundance
or scarcity of goods; and when we know that there is a cause, the variation of the
solar activity, which is just of the nature to affect the produce of agriculture, and
which does vary in the same period, it becomes almost certain that the two series
of phenomena, credit cycles and solar variations, are connected as effect and
cause. (Investigations, p. 196)

Did Jevons allow mere coincidence to drag him into an untenable and rigid posi-
tion? How were alterations in harvests transmitted into commercial cycles? Although
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382 Part IV ■ The Neoclassical Era

he had dealt with European experience in the earlier paper, Jevons now argued that
the impact on money and commercial markets in England was exerted through for-
eign trade with India and the Orient. Periodic crises in Indian harvests would alter
prices of raw produce and the nature of England’s trade balance. In his 1875 paper,
Jevons had emphasized the “psychic” determinants—optimism, despondency, panic,
and so forth—of the trade cycle, and he had tried to relate them to oscillations in the
price of food. Now Jevons abandoned these psychic effects in explaining the “trans-
mission mechanism” and emphasized merely the coincidence of high prices in India
and commercial crises in England. But Jevons admitted the major problem with such
an argument: that if the cause of commercial crises in England was the high price of
agricultural produce in India, a lag between high prices and crises would be
expected or even required. None could be observed. In short, some explanation of
the relation or transmission was needed, but Jevons offered none. The theory he
deduced from his study of the available data was simply incomplete. Astronomers
returned to an 11.11–year sunspot cycle, moreover, and while the idea probably had
some merit in primarily agrarian societies, it is now believed that the determinants of
the trade cycle are far more complex than Jevons (or other early writers) thought.4
In spite of the “sunspot episode,” Jevons’s overall statistical work deserves very
high marks. The scientific spirit manifest in the attempt to discuss the causes of
economic phenomena permeates Jevons’s empirical work, and his study of price
series will forever stand as a monument and as an example to those concerned with
economics and empiricism. In fact, Jevons is recognized as one of the spiritual fore-
fathers of nonprobabilistic econometrics.

■ JEVONS AND THE INTERNATIONAL SPREAD OF ECONOMIC IDEAS

Jevons’s contributions to economic theory and statistics are almost matched by
his role in the spread of economic analysis. Seldom has a writer been more gener-
ous in acknowledging the priority of other writers, both previous and contemporary.
In May of 1874 a correspondence began between Jevons and the French economic
theorist Léon Walras (see chapter 17). Walras published his Elements of Political
Economy in that year, setting out a framework of utility and general equilibrium
analysis. In the interest of propagating his ideas, Walras initiated a monumental
correspondence with a large number of economists from all over the world. The
result of that correspondence, among other mutual benefits, was the establishment
of a list of “mathematico-economic” works drawn up by Jevons and later amended
by Walras. In his preface to the second edition of his Theory of Political Economy,
Jevons described this list:
With the progress of years, however, my knowledge of the literature of political
economy has been much widened, and the hints of friends and correspondents
have made me aware of the existence of many remarkable works which more or
less anticipate the views stated in this book. While preparing this new edition, it
occurred to me to attempt the discovery of all existing writings of the kind. With
this view I drew up a chronological list of all the mathematico-economic works
known to me, already about seventy in number, which list, by the kindness of the
editor, Mr. Giffen, was printed in the Journal of the London Statistical Society for
June 1878. (p. xix)
4
It is interesting to note here that another famous scientist, Newton, spent years trying to convert
base metals into gold, a process known as alchemy.
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Chapter 15 ■ Microeconomics in England and America 383

Jevons forwarded this list to all the leading economists of the time, and Walras had
it published in Paris in the Journal des Économistes.
Jevons used his 1879 preface to promote his confidence in the mathematical
approach to economic analysis; and for this reason he brought to the attention of
other economists the theoretical efforts of Cournot, Dupuit, Ellet, Gossen, Auguste
and Léon Walras, von Thünen, Jenkin, and Lardner, together with a host of other
lesser-known writers, such as Beccaria, Lang, Bordas, Minard, and Boccardo. Many
of these writers remain virtually unknown today, and some deservedly so, but at the
seed time of neoclassical analysis, the recognition and critical evaluation of the
work of other theorists were of profound importance.
In the process of classifying and identifying earlier writings, Jevons realized and
admitted that his own work was not very original. Cournot had pioneered in mathe-
matical expression; Cournot, Lardner, and Dupuit established the theory of the firm;
and Dupuit and Gossen discovered utility theory, the latter going so far as to estab-
lish clearly the equimarginal principle. But in spite of the obvious disappointment
Jevons must have felt on making these discoveries, he graciously recognized and
honored those he considered his predecessors, however small the prior contributions
might have been. In doing so, he set a sterling example of what a scholar should be,
and at the same time he encouraged an open-door policy on economic ideas, which
eventually enriched the neoclassical tradition in England and elsewhere.5

■ JOHN BATES CLARK AND MARGINALISM IN AMERICA

American economic theory in the nineteenth century generally lagged behind
that of England and Europe. In 1880, the British economist T. E. Cliffe-Leslie
observed that “American political economy is in the main an importation from
Europe, not an original development” (in Hollander’s Economic Essays, p. 2). But in
the years following Leslie’s remark, a group of able young scholars returned from
post-graduate study in German universities and sparked a new awakening in Amer-
ican economic thought. Among these young scholars was John Bates Clark (1847–
1938), who, prior to traveling to Germany and studying under Karl Knies, graduated
from Amherst College in 1875. On his return, Clark taught economics, history, and
other subjects at Carleton, Smith, and Amherst Colleges and Johns Hopkins Univer-
sity. In 1895, he obtained a position as a professor of political science at Columbia
University, where he was also editor of Political Science Quarterly.
The young American scholars returning from Germany were inclined toward
the historical, inductive method of the German historical school (see chapter 11).
Consequently, they aimed their investigative efforts at concrete problems. Among
other matters, they considered American protectionism, fiscal studies, the labor
movement, the development of transportation, and public finance. Clark was an
exception, however. His mind was more inclined toward deductive reasoning. While
his colleagues were collecting and interpreting statistics on economic and social
problems, Clark systematically thought his way through mass and detail. The result
was a stellar contribution to economic theory and a unified philosophy that had hith-
erto been absent from American economic thought. Jacob Hollander paid tribute:

5
T. W. Hutchison, in an interesting paper on the international flow of ideas, “Insularity and Cosmo-
politanism in Economic Ideas” (see references), suggests that this new door was slammed shut in
England mainly by the hegemony and dominance of Marshall’s Principles. After 1890, in other
words, insularity, if not downright chauvinism, again characterized British economic thought.
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384 Part IV ■ The Neoclassical Era

Clark began his systematic work at a time when Roscher and Jevons, from quite
different directions, had given shattering blows to the classical theory. Even after a
quieting interval, the effect of the impact was to revive in acute form the old oppo-
sition in economic approach, extending as far back as the controversies of Malthus
and Ricardo. . . . Marshall [see chapter 16] in England and Clark in the United
States adjusted the situation in fine spirit of scientific continuity. (Economic
Essays, p. 5)

Clark’s economic analysis was essentially static, although it was he who intro-
duced the division of “statics” and “dynamics” into economics, thereby giving future
economists a convenient taxonomy to partition their work. Clark himself hoped to
further the development of economic dynamics, but unfortunately he got no further
than comparative statics. His (static) system of theory was based on five postulates
that, taken together, ally him with the philosophy of utilitarianism and also bind him
to a fairly rigid set of assumptions. His five postulates (reproduced here from
Homan, Contemporary Economic Thought, pp. 35–36) are:
1. Private property is a basic social institution.
2. Individual freedom of activity operates through active competition in all gainful
pursuits.
3. Government interferes in the economy only for the protection of property,
enforcement of contracts, and maintenance of competition.
4. Capital and labor are freely mobile.
5. Economic activity is motivated by man’s attempt to satisfy wants.

The Marginal-Utility Theory of Value

Clark’s mature views on value and distribution are contained in The Distribu-
tion of Wealth (1899), although he formulated his marginal-productivity theory ten
years earlier. His theory of value, based on the primacy of the marginal-utility prin-
ciple, dates back to a series of articles and monographs appearing between 1877
and 1882. This series was eventually published in 1886 as The Philosophy of Wealth.
In his private correspondence, Clark admitted that his theory of value was essen-
tially the same as Jevons’s, although he approached the problem from a different
angle and worked independently of the earlier marginalists. In comparing his own
theoretical advances to Jevons’s, Clark observed:
The Jevons theory assumes that increments of some commodity are offered in suc-
cession to a consumer and that, as his desire for them is gradually satiated, he
attaches less and less importance to them, and the last or “final” increment con-
sumed is the one that figures in the adjustment of values. I had not myself made
use of just this supposition, but had thought of the consumer as measuring the
importance to himself of different articles already in his possession and adjusting
his purchases in such a way that articles of the same cost have the same “effective
utility” to him and this may be measured, either by working to replace one that is
worn out or lost, or by going without it and measuring the reaction on his enjoy-
ments so occasioned. It amounted to a final utility theory, but was cast in a some-
what different form. (in Dorfman, Economic Mind, Appendix, p. iii)

Clark did, however, expand the marginalist theory of value by considering the
effects of qualitative increments rather than merely quantitative increments in con-
sumers’ goods and in producers’ goods. In an analysis that is reminiscent of Dupuit
(see chapter 13), he contended that most economic goods and services are not sim-
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Chapter 15 ■ Microeconomics in England and America 385

ple utilities but “bundles of utilities.” Each good is made up, in other words, of a
composition of different elements, one or more of which enter into the purchaser’s
preference pattern. The following passage elaborates:
What a man does, as his means increase, is, before anything else, to demand new
qualities in the articles that he uses. Often he does not add at all to their number;
but he causes them to be made of finer material or to be larger and handsomer. He
adds to his wealth for consumption, not new things, but new utilities; and these are
mainly attached to things of the kind formerly consumed. . . . The literal effect of
spending his last dollar consists in the substituting of a good article for the cheap
one, with which he would have contented himself if his available means had been
smaller. (Distribution of Wealth, p. 214)

This view is one of Clark’s most important insights, because it goes further than
the earlier theories of marginal utility in singling out the “proper” increment that
adjusts value. In essence, Clark focuses on how price is determined by increments
within increments. The last increment of a good does not alone determine price in
every instance, but an increment of quality in that incremental good usually does.
Secondly, and perhaps most presciently, Clark recognizes that goods possess multi-
ple qualities, and in different proportions. Driving an old heap of a car might pro-
vide basic transportation, but driving a new Jaguar or Mercedes provides
transportation plus prestige, status, and so forth. Some contemporary microecono-
mists, such as Kelvin Lancaster (see chapter 26), have built consumer theory
around the fact that individuals do not demand market goods per se, but rather the
characteristics and attributes provided by market goods. Additionally, Clark seemed
to be teetering on the brink of a statement of the role of product differentiation in
the theory of price. However, he didn’t go that far, and economics waited for many
decades for the pivotal importance of product differentiation and the “demand for
qualities” to become a part of microeconomic theory.

The Marginal-Productivity Theory of Distribution

Ricardo provided the first great economic treatise on income distribution, and
in it, he established the theory of land rent based on the marginal productivity of
land. Ricardo’s theory maintains that land rent is determined by the productivity of
the last unit of land in cultivation (see chapter 7). Therefore, he might be considered
an “incumbent marginalist,” in possession of a vital principle, but not fully aware of
its possibilities. Oddly enough, despite all the feverish activity of a so-called “mar-
ginal revolution” in value theory around 1870, economists were extremely slow in
generalizing the marginalism inherent in Ricardo’s rent theory to factors of produc-
tion other than land. Clark deserves credit for correcting this oversight, although he
shares that credit with Philip Wicksteed (1884–1927), an Englishman, and Knut
Wicksell (1851–1926), a Swede. These three showed that wages and interest are
likewise determined by the same principle as Ricardo’s rent, whereas the fourth fac-
tor payment, profit, generally disappears under conditions of pure competition.6
Throughout The Distribution of Wealth, Clark affirmed and reaffirmed the prin-
ciple that final productivity is the regulator of the value of each factor of production.
For example, in chapter 7 of that work he observed that marginal workers set the

6
Clark defined “profit” as a residual income (i.e., the remaining share after rent, interest, and wages
are paid). His definition is synonymous with the modern concept of pure profit, which, of course, is
driven to zero under conditions of free and open competition. Normal profits, in Clark’s view, were
simply another form of wage and therefore would be included in labor’s share of total income.
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386 Part IV ■ The Neoclassical Era

standard for wages, just as marginal bushels of wheat set the standard for the value
of the total crop. In chapter 8 of Distribution he explained why competition pro-
duces this result:
It is by assuming perfectly free competition among employers that we are able to
say that the man on the intensive margin of an agricultural force of laborers will
get, as pay, the value of his product. When such a man offers himself to an
employer, he is virtually offering an addition to the farmer’s crop. If one farmer
will not pay the market price of the additional produce, another will pay it, pro-
vided that competition does its work quite perfectly. (Distribution of Wealth, pp.
99–100)

Clark also assumed a homogeneous workforce and active competition among work-
ers for jobs, so that the wage received by one worker of a given type would be the
same as that received by all workers of the same type. He extended the same princi-
ple of marginal productivity to capital and to land as well.
Using Clark’s principle of factor-price determination, we may now show graph-
ically the distribution of total product between rent and wages, when land is fixed in
supply. Since we are limited to two dimensions in the following figure, assume that
land and labor are the only two productive factors in use. In figure 15-4, let BC rep-
resent the marginal product of land, and AD the number of laborers added to land.
BC is downward-sloping because of the law of diminishing returns. The area under
the marginal-product curve represents total product (ABCD).
To Ricardo, rent was a differential surplus. In figure 15-4, rent may be identified
as the difference between the value of the total product (ABCD) and the share of
total product going to labor. Since each laborer receives the value of the last
worker’s marginal product as his wage (that is, CD), the total wage bill is AECD.
Thus, the differential surplus, called “rent,” is equal to EBC. This is derived as fol-
lows: Value of total product ABCD minus payments to labor AECD, so that ABCD –
AECD = EBC, or rent.
Clark recognized that the returns to labor and to capital could also be
expressed as a differential surplus. In figure 15-5, for example, let BC be the mar-

Total and
marginal
products B

Rent

C
E MP (land) Figure 15-4 Rent is
the differential return
when labor and land
Wages are the only two fac-
tors in use and units of
Labor
labor are added to
A D production.
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Chapter 15 ■ Microeconomics in England and America 387

ginal product of capital instead of land. Once again the wage bill for AD workers
will be AECD, and EBC will now be the differential surplus that goes to capital in
the form of interest. Finally, in figure 15-6, let BC be the marginal product of labor,
and AD the number of capital inputs in production. According to Clark’s marginal-
productivity theory of factor returns, each capital input will receive CD as payment.
The total return to capital in the form of interest will therefore be AECD, with labor
receiving the differential surplus EBC. In other words, the same principle of mar-
ginal productivity determines each factor return.
In this way, Clark succeeded in integrating the theory of distribution with the
theory of value. He established the fact that the same marginal principle is perfectly
capable of explaining the valuation of goods and of factors. The Austrians, it will be

Total and
marginal
products B

Figure 15-5 Interest

Interest, the return
to capital, is the dif- C
ference between E MP (capital)
total product (ABCD)
and the amount
paid to labor when Wages
production inputs
are limited to labor
Labor
and capital. A D

Total and
marginal
products B

Figure 15-6 If BC is Wages

the marginal product
of labor and AD is the C
E MP (labor)
number of capital
units used in produc-
tion, wages may be
calculated as the dif- Interest
ference between total
product at AD and the Capital
cost of capital. A D
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388 Part IV ■ The Neoclassical Era

remembered, especially Menger and Wieser, had taken the first step toward such
integration with their theories on imputation (see chapter 14). The imputation prin-
ciple was a straightforward extension of Menger’s subjective value theory insofar as
the value of higher-order goods was attributed to the contribution made by those
goods to consumer utility.
By contrast, in Clark’s analysis marginal-productivity theory is an extension of
the Ricardian rent principle. It asserts that the value of each factor in production is
determined by its marginal contribution to total output. It is based on the principle
of diminishing returns and a full recognition that any factor, not just land, may be
the fixed factor.

■ ASSESSING CLARK’S CONTRIBUTION

Clark’s principle of marginal productivity is useful in explaining employment
decisions by an individual competitive firm, but as a theory of factor-price determi-
nation it leaves something to be desired. It is not a supply-and-demand theory of
price. In fact, its independence from considerations of supply and demand consti-
tutes a major weakness. As microeconomic theory, the principle of marginal pro-
ductivity explains that a competitive firm will hire factors up to the point where
each factor’s marginal product is just equal to its income payment. But in so doing,
the theory accepts the supply of the named factor as given. It does not relate the
price of the factor to supply; nor does it relate the price of the factor to the demand
for goods. The Austrians, at least, were on the right track in this respect because
their theory of imputation recognized the interdependence between product
demand and factor demand. By itself, therefore, the marginal-productivity principle
is not a satisfactory explanation of factor price.
In addition, Clark worked out his theory under purely static, competitive condi-
tions where uncertainty and risk are absent. In 1921, another American, Frank
Knight, offered an alternative explanation of factor pricing under conditions of
uncertainty. Knight maintained that uncertainty on the part of the entrepreneur
about the demand for and price of his product induces him to hire factors of produc-
tion on the basis of the expected value rather than actual value of each factor’s mar-
ginal product. While Knight’s argument is not a criticism of Clark per se, it
nevertheless underscores the limited applicability of the marginal productivity prin-
ciple in its naive formulation.
Inexplicably, Clark chose to wrap his marginal-productivity theory in normative
clothing. He implied in no uncertain terms that there is something inherently just in
each factor’s receiving no more and no less than the value of its marginal product.
As a result, he used the marginal-productivity theory to justify income distribution
under competition. Clark was severely criticized for injecting ethical principles into
his theory, and even his son, John Maurice Clark—an eminent economist in his own
right—rejected this part of the theory while defending the core principle of mar-
ginal-productivity. However, Clark’s normative judgments need not detain us here,
since they are in no way central to the theoretical principle he established.

■ CLARK ON ENTREPRENEURSHIP
Having studied in Germany, Clark was familiar with Mangoldt’s work and
accepted the idea that “men do not hazard their capital for an amount of annual
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Chapter 15 ■ Microeconomics in England and America 389

gains that in a long term of years will just offset their losses. They demand more
than this and they get it” (“Insurance,” p. 45). However, Clark refused to accept that
risk-bearing is part of the entrepreneurial function, arguing (as Schumpeter did at a
later date) that all risk is borne by the capitalist. Clark used the term entrepreneur
“in an unusually strict sense, to designate the man who coordinates capital and labor
without in his own proper capacity furnishing either of them.” It was his view that
“the entrepreneur, as such, is empty-handed,” a phrase evocative of Israel Kirzner’s
(chapter 23) “pure and penniless entrepreneur” (“Insurance,” pp. 45–46). In other
words, the entrepreneur cannot risk anything because he has nothing to risk.
In later works, Clark couched his discussion in terms of statics and dynamics,
giving support to the distinction that inclined Schumpeter (chapter 23) to a more
dynamic view of entrepreneurship. In Clark’s analysis the static state is a situation
where demand, capital, and technology are given. Static conditions do change over
time, however: populations grow, wants change, and improved production technol-
ogies are discovered and implemented. But in Clark’s world, departures from static-
state equilibria are evolutionary. The mobility of labor and capital is requisite to the
restoration of new, albeit temporary, equilibria.
In the dynamic economy Clark made the entrepreneur responsible for the coor-
dination that restores the economy to an equilibrium position.7 According to Clark
(Essentials, pp. 82–83), this coordinator (entrepreneur) may perform several func-
tions: “He may, for example, both labor and furnish capital, and he may, further,
perform a special coordinating function which is not labor, in the technical sense,
and scarcely involves any continuous personal activity at all, but is essential for ren-
dering labor and capital productive.” This notion of the entrepreneur as the
dynamic force that moves the economy back to equilibrium after some disturbance
is still very much alive in contemporary theory, but it was challenged in the twenti-
eth century by Schumpeter’s counter claim that the entrepreneur is the agent that
causes disequilibrium. On the related matter of insurance, Clark recognized the dif-
ferences between insurable and uninsurable risks (which he termed “static” and
“dynamic”), but he did not go so far as to integrate this distinction into a general
theory that based profit on risk as well as dynamic change. That task fell onto the
shoulders of Frank Knight.
Despite its shortcomings, Clark’s contribution was substantial, particularly on
the American scene, where he rose to prominence as the leading economic theorist
of his day. As such, he provided inspiration and leadership to a growing cadre of
competent American economists. He was active in forming the American Economic
Association in 1885, and he served as its third president. Even at this late date, John
Bates Clark is one of the most honored and revered of early American economists.8
He provided a powerful impetus to the eventual acceptance of marginalism, lending
support in the Anglo-Saxon world to Jevons’s pioneering contributions.

7 On the deficiencies of the argument that the entrepreneur is a mere coordinator, see Hawley
(1900, pp. 84–89).
8
The John Bates Clark Award, given every other year to the most distinguished economist under 40
years of age, is granted by the American Economic Association. Clark was also blessed with bril-
liant students—Thorstein Veblen, for example (see chapter 19). The fact that Veblen rejected the
type of economic inquiry that Clark helped advance did not lessen the sense of pride Clark felt in
his prize pupil.
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390 Part IV ■ The Neoclassical Era

■ CONCLUSION
The prescient insights of Jevons and J. B. Clark (joined by a chorus of insights
from Cournot, Dupuit, von Thünen, Menger, and others in Europe) set the stage for
a growing consensus of what constituted economic theory. Multiple and diverse ele-
ments constituted the expansive, multifaceted body of microeconomics. Utility the-
ory as a basis for consumer behavior, productivity theory as the foundation for a
generalized theory of rent, and marginalism as the glue to hold it all together, were
the necessary elements for the construction of a holistic partial equilibrium analysis
by Alfred Marshall and general equilibrium theory by Léon Walras. Importantly, the
neoclassical paradigm, one that remains a guide to economic investigation, did not
arrive in a neat package as the contribution of a single individual. It was, as most
advancement in human thought, the product and evolution of many minds. It is also
useful to remember that the evolution of economic ideas did not end with neoclassi-
cal economics but continues as a process that builds on a fruitful and complex past.

REFERENCES
Clark, J. B. “Insurance and Business Profits,” Quarterly Journal of Economics, vol. 7
(October 1892), pp. 45–54.
———. The Distribution of Wealth. New York: Macmillan, 1899.
———. Essentials of Economic Theory. New York: Macmillan, 1907.
Dorfman, Joseph. The Economic Mind in American Civilization, vol. 3. New York: The
Viking Press, 1949.
Hawley, F. B. “Enterprise and Profit,” Quarterly Journal of Economics, vol. 15 (November
1900), pp. 75–105.
Hollander, J. H. (ed.). Economic Essays Contributed in Honor of John Bates Clark. New
York: The Macmillan Company, 1927.
Homan, Paul T. Contemporary Economic Thought. New York: Harper, 1928.
Hutchison, T. W. “Insularity and Cosmopolitanism in Economic Ideas, 1870–1914,” Amer-
ican Economic Review, vol. 45 (May 1955), pp. 1–16.
Jenkin, Fleeming. “The Graphic Representation of the Laws of Supply and Demand, and
Their Application to Labour,” in The Graphic Representation of the Laws of Supply
and Demand, and Other Essays on Political Economy, 1868–1884. London: London
School of Economics and Political Science, 1931 [1870].
Jevons, W. S. Theory of Political Economy. New York: Kelley and Millman, 1957 [1871].
———. Theory of Political Economy, 2d ed. New York: Kelley and Millman, 1879.
———. Letters and Journal, H. A. Jevons (ed.). London: Macmillan, 1886.
———. Investigations in Currency and Finance, H. S. Foxwell (ed.). London: Macmillan,
1909.
Keynes, J. M. “William Stanley Jevons, 1835–1882: A Centenary Allocution on His Life as
Economist and Statistician,” Essays in Biography (New York: W. W. Norton, 1963).
Originally published in Journal of the Royal Statistical Society, vol. 99 (1936), pp.
516–548.
Lardner, Dionysius. Railway Economy. New York: A. M. Kelley, 1968 [1850].

NOTES FOR FURTHER READING

Bert Mosselmans, William Stanley Jevons and the Cutting Edge of Economics (Lon-
don: Routledge, 2006), attempts to situate Jevons within the history of economic thought
in relation to his logic, ethics, religion, and aesthetics. But perhaps the best source on
Jevons is Jevons himself. Few economists have led more interesting, albeit truncated,
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Chapter 15 ■ Microeconomics in England and America 391

lives. Furthermore, Jevons had few peers as an observer of life and a commentator on
ideas. His Letters and Journal, capably edited by his wife, Harriet, is a must in gaining an
appreciation of Jevons’s incisive views on every conceivable subject from himself to sci-
ence, music, statistics, political economy, and a multitude of other topics. In letters to his
sister Lucy, his brother Herbert, and many others, Jevons chronicled his sojourn in Aus-
tralia and his travels to the United States in 1859. These letters also tell of his growing
interest in social science and of his decision to apply mathematics to economics. His life
and entire career are laid bare in his correspondence with members of his family and
with other economists, including his friends H. S. Foxwell and Léon Walras. For a look at
Jevons through his personal correspondence, see R. D. C. Black (ed.), Papers and Corre-
spondence of William Stanley Jevons, (New York: A. M. Kelley, 1977). Additional bio-
graphical material is contained in H. W. Jevons, “William Stanley Jevons: His Life,”
Econometrica, vol. 2 (July 1934), pp. 225–231; and H. S. Jevons, “William Stanley Jevons:
His Scientific Contributions,” Econometrica, vol. 2 (July 1934), pp. 231–237.
Jevons’s Theory of Political Economy, Coal Question, and Investigations in Currency
and Finance are indispensable in reconstructing his contributions to economic theory
and statistics. His theories of labor, capital, rent, and interest are forthrightly analyzed
by G. J. Stigler in Production and Distribution Theories: The Formative Period (New
York: Macmillan, 1941). On Jevons’s methodology, see his trenchant essay entitled “Eco-
nomic Policy,” read before Section F (on statistics) of the British Association for the
Advancement of Science, reprinted in R. L. Smyth (ed.), Essays in Economic Method
(New York: McGraw-Hill, 1962).
Jevons’s debt to Bentham and the means by which Bentham’s notion of utility was
transmitted into neoclassical economics are discussed by Tom Warke, “Mathematical Fit-
ness in the Evolution of the Utility Concept from Bentham to Jevons to Marshall,” Journal
of the History of Economic Thought, vol. 22 (March 2000), pp. 5–27. Rhead S. Bowman,
“Jevons’s Economic Theory in Relation to Social Change and Public Policy,” Journal of
Economic Issues, vol. 23 (December 1989), pp. 1123–1147, explores the intersection
between Jevons’s ideas on theory and policy, emphasizing Jevons’s view of economics as
social ethics. In a second article, “Policy Implications of W. S. Jevons’s Economic Theory,”
Journal of the History of Economic Thought, vol. 19 (Fall 1997), pp. 196–221, Bowman
concludes that Jevons believed that he had essentially established the theoretical founda-
tion for public-sector analysis. Sandra J. Peart, “W. S. Jevons’s Methodology of Econom-
ics: Some Implications of the Procedures for ‘Inductive Quantification,’” History of
Political Economy, vol. 25 (Fall 1993), pp. 435–460, probes Jevons’s views on determinism
and the connection of his methodology to Mill’s. For a more comprehensive study, see
same author, The Economics of W. S. Jevons (London: Routledge, 1996).
J. M. Keynes, “William Stanley Jevons, 1835–1882,” written on the occasion of the
centennial of Jevons’s birth and reprinted in Keynes’s Essays in Biography (London:
Macmillan, 1933), provides penetrating insights into Jevons’s life and talents. See also
Lionel Robbins, “The Place of Jevons in the History of Economic Thought,” The Man-
chester School of Economics and Social Studies, vol. 7 (1936), pp. 1–17; and R. D. C.
Black, “W. S. Jevons and the Foundation of Modern Economics,” History of Political
Economy, vol. 4 (Fall 1972), pp. 364–378. Also by Black, see “Jevons, Marginalism and
Manchester,” The Manchester School of Economics and Social Studies, vol. 40 (March
1972), pp. 2–8. This entire issue of The Manchester School contains a compendium of
papers devoted to Jevons on the 100th anniversary of the publication of his Theory of
Political Economy.
John Creedy, “Jevons’s Complex Cases in the Theory of Exchange,” Journal of the
History of Economic Thought, vol. 14 (Spring 1992), pp. 55–69, extends Jevons’s simple
case of two trading bodies to the more complex case of three traders and three goods.
On a narrower topic, the affiliation of Jevons and the eminent astronomer George Dar-
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392 Part IV ■ The Neoclassical Era

win, see K. H. Hennings, “George Darwin, Jevons and the Rate of Interest,” History of
Political Economy, vol. 11 (Summer 1979), pp. 199–212. The affinity between Jevons and
Böhm-Bawerk regarding interest and capital theory is explored by Klaus Hamberger,
“Böhm-Bawerk, Jevons and the ‘Austrian’ Theory of Capital: ‘A Quite Different
Relation,’” The European Journal of the History of Economic Thought, vol. 8 (Spring
2001), pp. 42–57.
The academic and intellectual milieu in England before and after Jevons is the sub-
ject of discussion by S. G. Checkland, “Economic Opinion in England as Jevons Found
It,” The Manchester School of Economics and Social Studies, vol. 19 (May 1951), pp. 143–
169; N. B. deMarchi, “The Noxious Influence of Authority: A Correction of Jevons’s
Charge,” Journal of Law & Economics, vol. 16 (April 1973), pp. 179–190; and T. W.
Hutchison, “The Marginal Revolution and the Decline and Fall of English Classical Politi-
cal Economy,” History of Political Economy, vol. 4 (Fall 1972), pp. 442–468. Ian Steedman,
“Jevons’s Theory of Political Economy and the ‘Marginalist Revolution,’” The European
Journal of the History of Economic Thought, vol. 4 (Spring 1997), pp. 43–64, attempts to
put Jevons’s main economic treatise within the context of the marginalist revolution.
Cournot’s influence on Jevons’s theory of demand is raised by Sam Bostaph and Y.
N. Shieh in “W. S. Jevons and Lardner’s Railway Economy,” History of Political Economy,
vol. 18 (Spring 1986), pp. 49–64, which also serves as an excellent introduction to Lard-
ner’s work. The same authors further amplify this theme in “Jevons’s Demand Curve,”
History of Political Economy, vol. 19 (Spring 1987), pp. 107–126, which contrasts
Jevons’s performance with that of Fleeming Jenkin. Finally, an alternative interpretation
of Jevons’s formulation of value theory is given by R. B. Ekelund, Jr., and Yeung-Nan
Shieh in “Jevons on Utility, Exchange, and Demand: A Reassessment,” Manchester
School of Economics and Social Studies, vol. 57 (March 1989), pp. 17–33. Ekelund and
Shieh argue that Jevons worked out certain partial and general equilibrium concepts
independently of Marshall and Walras and that he was far more creative in both of these
areas than is commonly thought. Michael V. White, “Strange Brew: The Antinomies of
Distribution in W. S. Jevons’ Theory of Political Economy,” The European Journal of the
History of Economic Thought, vol. 2, (Fall, 2005), pp. 583–608, tries to explain why
Jevons abandoned much of his explanatory framework in the second edition of his The-
ory. Same author, “In the Lobby of the Energy Hotel: Jevons’s Formulation of the Post-
classical ‘Economic Problem,’” History of Political Economy, vol. 36 (Summer 2004), pp.
227–271 argues that the key contours of Jevons’s theory of value and distribution can be
reformulated in terms of the conservation of energy.
Jevons’s mathematical approach to microeconomic theory originally met with stiff
resistance. Margaret Schabas, “Some Reactions to Jevons’ Mathematical Program: The
Case of Cairnes and Mill,” History of Political Economy, vol. 17 (Fall 1985), pp. 337–354,
maintains that Cairnes and Mill first stood together against the use of mathematics in
economic theory but eventually came around to Jevons’s position. The same author pres-
ents a more in-depth study of Jevons’s contributions to mathematical economics in A
World Ruled by Number: William Stanley Jevons and the Rise of Mathematical Econom-
ics (Princeton, NJ: Princeton University Press, 1990), which details how Jevons parlayed
beginning studies on logic into economics and the prominence he gave to inductive
inference and probability in his theory. Jevons’s early and skillful attempts to introduce
statistical techniques to economic analysis are appraised by John Aldrich, “Jevons as
Statistician: The Role of Probability,” Manchester School of Economics and Social Stud-
ies, vol. 55 (September 1987), pp. 233–256, who concludes that although Jevons did not
contribute materially to the development of theoretical statistics per se, he set the pat-
tern for the economist as consumer of statistical techniques.
One of the few authors to take Jevons’s sunspot theory seriously, S. J. Peart, “Sun-
spots and Expectations: W. S. Jevons’s Theory of Economic Fluctuations,” Journal of the
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Chapter 15 ■ Microeconomics in England and America 393

History of Economic Thought, vol. 13 (Fall 1991), pp. 243–265, concludes that periodicity,
not meteorology, was the central issue of Jevons’s concern, and that the transmission
mechanism (from sunspots to economic cycles) is more sophisticated than Jevons’s crit-
ics realize.
For an assessment of J. B. Clark by his economist son, see John Maurice Clark,
“John Bates Clark,” International Encyclopedia of the Social Sciences, vol. 2 (New York:
Macmillan, 1968). For an older appraisal, see J. M. Clark’s article on J. B. Clark in H. W.
Spiegel (ed.), The Development of Economic Thought (New York: John Wiley & Sons,
1952). See also A. H. Clark and J. M. Clark, John Bates Clark: A Memorial (New York:
Columbia University Press, 1938). The standard reference on Clark’s marginal-produc-
tivity theory is G. J. Stigler, Production and Distribution Theories (New York: Macmillan,
1941). Frank Knight offered criticism and alternative formulations in Risk, Uncertainty
and Profit (New York: Harper & Row, 1965 [1921]). Four letters from Alfred Marshall to
J. B. Clark, expressing Marshall’s admiration for the American’s work, appear in Alfred
Marshall, Memorials of Alfred Marshall, A. C. Pigou, ed. (New York: A. M. Kelley, 1966),
pp. 412–418.
Until recently Clark was pretty much ignored by historians of economics. Making
partial amends for this neglect are: John Henry, John Bates Clark: The Making of a Neo-
classical Economist (New York: St. Martin’s Press, 1995); Mary Morgan, “Marketplace
Morals and the American Economists: The Case of John Bates Clark,” in Higgling:
Transactors and Their Markets in the History of Economics, Neil de Marchi and Mary
Morgan (eds.), History of Political Economy, vol. 26 (1994) Supplement, pp. 229–252;
Joseph Persky, “The Neoclassical Advent: American Economics at the Dawn of the 20th
Century,” Journal of Economic Perspectives, vol. 14 (Winter 2000), pp. 95–108; and
Thomas C. Leonard, “Clark as a Pioneering Neoclassical Economist,” History of Political
Economy, vol. 35 (Fall 2003), pp. 521–558.
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16

Alfred Marshall and

the Neoclassical Synthesis

The foundations of neoclassical economics were clearly established in England and

Europe by 1870, as the abundance of evidence presented in the last three chapters
suggests. But the consolidation of piecemeal efforts to replace classical economics
was not yet at hand until the nineteenth century neared its end. It was then that the
seminal and cohesive works of Alfred Marshall (1842–1924) and Léon Walras
(1834–1910)—the twin founders of modern neoclassical analysis—made their
impact. Fundamental differences in the scope and method in the approach of these
two writers are detailed in the following chapters and will help to place each in per-
spective. Since there is a clear progression between the ideas of Jevons and Mar-
shall, however, we begin our discussion of neoclassicism with Marshall, and follow
it in the next chapter with Walras.
Alfred Marshall was born in Clapham, England, in 1842. Many of his ancestors
were clerics, and Alfred’s father, William, though a career banker, wanted his son to
follow in the ancestral tradition. William Marshall was a stern disciplinarian who
often pushed his intelligent though overworked son to his mental and physical lim-
its. It was not at all uncommon for him to drill young Alfred on his schoolwork until
almost midnight. Later, Alfred recalled that only annual summer visits to a distant
aunt saved him in his youth from mental and physical exhaustion. At prep school
Marshall acquired the name “Tallow Candles” for his pallor, ill dress, and over-
wrought appearance. He did not make friends easily, and his two most enjoyable
intellectual pursuits—mathematics and chess—were forbidden by his authoritarian
father. In 1861, a rebellious Marshall refused a scholarship at Oxford (which would
have led to the ministry) because, as he put it, he could not abide further study of
dead languages. His father could not afford to send him to college without scholar-
ship, but with the help of a wealthy uncle, Marshall was able to enroll at Cambridge
University, where he indulged his taste for mathematics and distinguished himself
as an honor student.
Marshall’s passion for mathematics served him well in two respects. First, he
saw it as an expression of independence from his domineering father. Second, the
money he earned from tutoring in mathematics enabled him to support himself at
Cambridge and repay his uncle. After satisfying the debt to his uncle Marshall wrote:
“Mathematics had paid my arrears. I was free for my own inclinations” (Memorials
of Alfred Marshall, p. 5). Those inclinations ultimately led him to political economy
in 1867, but only after several detours, which he later described in his memoirs.

394
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 395

From Metaphysics I went to Ethics, and thought that the justification of the exist-
ing condition of society was not easy. A friend, who had read a great deal of what
are now called the Moral Sciences, constantly said: “Ah! if you understood Political
Economy you would not say that.” So I read Mill’s Political Economy and got much
excited about it. I had doubts as to the propriety of inequalities of opportunity,
rather than of material comfort. Then, in my vacations I visited the poorest quar-
ters of several cities and walked through one street after another, looking at the
faces of the poorest people. Next, I resolved to make as thorough a study as I could
of Political Economy. (Memorials, p. 10)

Having settled on economics, Marshall approached its study with a personal dedica-
tion that he maintained to the end—a dedication that in no small measure accounts
for his sizable contributions to economic analysis.
While his father still vainly hoped that his son would take holy orders, Marshall
married a former student, Mary Paley, in 1877. Rules of his fellowship at Cambridge
forced him to resign his fellowship upon marriage. The Marshalls left Cambridge
for Bristol, where both Alfred and Mary lectured on political economy at newly
founded University College, and collaborated on The Economics of Industry, which
was first published in 1879. Their years at Bristol were spent happily enough, save
for an extended period of illness on Marshall’s part. In 1884, when a faculty position
at his former school opened up, Marshall returned to Cambridge with his health
restored. There the Marshalls spent the rest of their years in what Alfred called “a
small cultured society of great simplicity and distinction.”
Fifty years of writing by Alfred Marshall yielded eighty-two publications,
including books, articles, lectures, conferences, and testimony before three Royal
Commissions. His immensely popular and influential Principles of Economics
(1890) has gone through nine editions to date; Industry and Trade (1919) through
five editions; and The Economics of Industry (1879) through two editions and ten
printings. Only his Money, Credit and Commerce (1923), which was published a
year after his death, has not appeared in multiple editions.
Marshall’s biographers agree, however, that his impact on economics cannot be
measured by his publications alone. Much more important for the progress of eco-
nomic theory was his practice of transmitting his original ideas to a generation of
able students long before those ideas appeared in print. The strong oral tradition
that Marshall began at Cambridge constitutes an extremely important chapter in
the history of economic analysis, particularly in monetary theory (see chapter 22).
As early as 1888, Herbert Foxwell wrote of Marshall: “Half the economic chairs in
the United Kingdom are occupied by his pupils, and the share taken by them in gen-
eral economic instruction in England is even larger than this” (“Economic Move-
ment,” p. 92). Marshall’s students and protégés, among whom were J. M. Keynes
(see chapter 21) and A. C. Pigou, nurtured this “Cambridge tradition” and extended
it in many directions.
Marshall’s incessant delay in putting his ideas into print was a frequent source
of frustration to students and friends alike. To his credit, Marshall was an
extremely cautious and meticulous writer who hesitated to publish anything until
he had thought through the implications of its content and perfected its presenta-
tion. The same caution caused Marshall to be a late expositor of marginal-utility
analysis, although historical evidence indicates that he derived the principle of
marginal utility independently of Jevons, Menger, and Walras, and at about the
same time. As a better mathematician, moreover, Marshall rose above Jevons and
Walras. Despite his mathematical skill and proclivity for the subject, his approach
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396 Part IV ■ The Neoclassical Era

to the use of mathematics in economics remained circumspect. In his youth he had

translated the works of Ricardo and Mill into mathematical symbols, but appar-
ently he did so as a matter of personal convenience. Later, in the preface to his
famous Principles, Marshall justified the use of mathematics in economics as a kind
of personal “shorthand”:
The chief use of pure mathematics in economic questions seems to be in helping a
person to write down quickly, shortly and exactly, some of his own thoughts for his
own use. . . . It seems doubtful whether anyone spends his time well in reading
lengthy translations of economic doctrines into mathematics, that have not been
made by himself. (Principles, pp. x–xi)

In Principles, Marshall confined his use of diagrams and other mathematical

notations to footnotes and appendixes so as not to allow the mathematics to detract
from the economics. He was interested above all in plain communication—with
businesspeople as well as with students. Moreover, he was acutely aware that over-
reliance on mathematics “might lead us astray in pursuit of intellectual toys, imagi-
nary problems not conforming to the conditions of real life: and, further, might
distort our sense of proportion by causing us to neglect factors that could not easily
be worked up in the mathematical machine” (Memorials, p. 84).
Had Marshall in fact foreseen the subsequent development of mathematical
economics in all its intensity, he might have wished to publish his own rules on the
subject in a more conspicuous place than in a letter to his friend and colleague,
Arthur Bowley. On February 27, 1906, Marshall offered this retrospective:
I had a growing feeling in the later years of my work at the subject that a good
mathematical theorem dealing with economic hypotheses was very unlikely to be
good economics: and I went more and more on the rules—(1) Use mathematics as
a shorthand language, rather than as an engine of inquiry. (2) Keep to them till you
have done. (3) Translate into English. (4) Then illustrate by examples that are
important in real life. (5) Burn the mathematics. (6) If you can’t succeed in 4, burn
3. This last I did often. (Memorials, p. 427)

Marshall’s doubts as to the usefulness of the techniques of theoretical mathematics

and statistics should not, however, be misinterpreted. He continuously counseled
deep historical and statistical knowledge of any matter under investigation. He con-
sidered command of empirical facts a prerequisite to reasonable conclusions. In
sum, Marshall was a master economist because he possessed a combination of tal-
ents. Keynes best underscored Marshall’s gifts when he wrote:
His mixed training and divided nature furnished him with the most essential and
fundamental of the economist’s necessary gifts—he was conspicuously historian
and mathematician, a dealer in the particular and the general, the temporal and
the eternal, at the same time. (quoted in Marshall, Memorials, p. 12)

Finally, Marshall was an economist’s economist—an acknowledged and undis-

puted leader of colleagues and students alike. He believed that economics required
the cooperation of many people with many different talents. Like his contemporary
Walras, Marshall helped advance the professionalization of economics. The differ-
ence was that Marshall was able to exert his influence from the firm footing of a
long-standing tradition at Cambridge University, whereas Walras was forced to
operate from a lonely outpost in Switzerland.
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 397

■ MARSHALL AND HIS METHOD

It is in the way Marshall viewed things that we find some of his most interest-
ing and enduring contributions to economic science. In other words, the key to
Marshall’s partial equilibrium approach to economic theory and to applied eco-
nomics is contained in his statements on method. Although Marshall’s method was
derived from several interrelated ideas, we shall discuss them separately. First, we
shall consider Marshall’s definition of economics and economic laws. Next we shall
describe his brilliant conception of the role of time in economic analysis. Finally,
we shall discuss how Marshall related time to markets and market processes.
These themes pave the way for a discussion of his famous conception of competi-
tive equilibrium.

Marshall’s Definition of Economics

In the first place, Marshall viewed the science of economics circa 1890 as
merely an extension—really a continuation—of the ideas espoused by Adam Smith.
He believed that neoclassical economics was a modern version of old classical doc-
trines. A new age and new problems changed the emphasis of economic analysis,
but he believed that the relatively simple analyses of Ricardo and Mill were still rel-
evant. Marshall “filled in” where the gaps in classical economics were greatest,
helping to build a body of microeconomic analysis to complement the macroeco-
nomics of his forebears. But what is the nature of economic science, as he saw it?
Again and again, throughout Principles, Marshall explicated his conception of
economic science. In defining the scope and purpose of his book, he noted in the
preface to the first edition that:
In accordance with English tradition, it is held that the function of the science is to
collect, arrange and analyse economic facts, and to apply the knowledge, gained
by observation and experience, in determining what are likely to be the immediate
and ultimate effects of various groups of causes; and it is held that the Laws of
Economics are statements of tendencies expressed in the indicative mood, and not
ethical precepts in the imperative. Economic laws and reasonings in fact are
merely a part of the material which Conscience and Common-sense have to turn to
account in solving practical problems, and in laying down rules which may be a
guide in life. (Principles, pp. v–vi)1

Marshall’s method, then, rests essentially on refined common sense. Economic sci-
ence is but the working out of rational behavior refined by organized analysis and
reason. Facts and history are essential to the economic theorist, but as Marshall
noted, facts alone teach us nothing. Given institutional and ethical constraints regu-
larities and tendencies of human actions must be observed and extracted from his-
torical and empirical data. Analysis, in this view, is shorthand for common sense: if
given sufficient regularities, it allows general rules or theories to be developed and
applied in particular situations.
One of the central reasons many historical and other heterodox thinkers
rejected traditional economic analysis is because it allegedly neglected the com-
plexity of human actions. Aware of the vulnerability of economics to this criticism,
1
Unlike certain writers in the classical tradition, Marshall did not adhere to an extreme view of eco-
nomic man, i.e., one uninfluenced by altruistic motives. Indeed, one of the unique characteristics
of his book is that Marshall is willing to take ethical forces into account, provided they occur with
sufficient regularity within economic life.
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398 Part IV ■ The Neoclassical Era

Marshall provided brilliant defenses. He compared the abstract method of econom-

ics to the method of the physical and natural sciences:
Economic laws are statements with regard to the tendencies of man’s action under
certain conditions. They are hypothetical only in the same sense as are the laws of
the physical sciences: for those laws also contain or imply conditions. But there is
more difficulty in making the conditions clear, and more danger in any failure to
do so, in economics than in physics. The laws of human action are not indeed as
simple, as definite or as clearly ascertainable as the law of gravitation; but many of
them may rank with the laws of those natural sciences which deal with complex
subject-matter. (Principles, p. 38)

Economic theory, Marshall thought, was facilitated because the economic facts of
human behavior could be segmented from general facts. Economics was concerned
with measurable motives, that is, money and prices. Though not a perfect measure,
“With careful precautions money affords a fairly good measure of the moving force
of a great part of the motives by which men’s lives are fashioned” (Principles, p. 39).

Time and Ceteris Paribus

Roughly, then, Marshall’s method consisted of commonsense abstraction from
economic facts and behavior through general analysis and reason. The science of
economics resulting from the application of this method, moreover, had the twin
purposes of knowledge for its own sake and use in solving practical problems. But
of what, precisely, did this method consist? If nature’s riddles are complex and the
human mind is limited, as Marshall asserted, how can we acquire knowledge about
economic subjects? Specifically, for a particular market, how can we adequately
analyze prices and profits when tastes, income, technology, and costs are continu-
ously changing through time?
In reality, time enters the analysis of economic facts and quantities at every
step, and it was perhaps one of Marshall’s greatest contributions to recognize its
importance. Even better, he worked time into his entire method of approaching eco-
nomic analysis, noting at the start that it was the “centre of the chief difficulty of
almost every economic problem” (Principles, p. vii). Marshall explained how time is
to be handled in economic analysis by means of his famous discussion of normal
demand-and-supply equilibrium.
The element of time is a chief cause of those difficulties in economic investigations
which make it necessary for man with his limited powers to go step by step; break-
ing up a complex question, studying one bit at a time, and at last combining his
partial solutions into a more or less complete solution of the whole riddle. In
breaking it up, he segregates those disturbing causes, whose wanderings happen
to be inconvenient, for the time in a pound called Ceteris Paribus. The study of
some group of tendencies is isolated by the assumption other things being equal:
the existence of other tendencies is not denied, but their disturbing effect is
neglected for a time. The more the issue is thus narrowed, the more exactly can it
be handled: but also the less closely does it correspond to real life. Each exact and
firm handling of a narrow issue, however, helps towards treating broader issues, in
which that narrow issue is contained, more exactly than would otherwise have
been possible. With each step more things can be let out of the pound; exact dis-
cussions can be made less abstract, realistic discussions can be made less inexact
than was possible at an earlier stage. (Principles, p. 366)
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 399

Thus, Marshall proposed to handle the problem of continuous change (time)

through the judicious use of ceteris paribus assumptions, or conditioning clauses.
Other writers had implied “other things being equal” in constructing theories, but it
was Marshall who explicitly outlined the procedure and consistently applied it
throughout his microeconomic studies, including cost-of-production analysis and
value theory.

Time and Markets

The use of ceteris paribus, necessitated by inevitable effects of time on eco-
nomic quantities, is a most useful fiction for modern microeconomics. Perhaps
nowhere is this better illustrated than in Marshall’s example of how the market for
fish operates. Marshall considered three hypothetical circumstances or problems
that would affect the fishing trade. First, there are very quick changes, such as
vagaries of the weather, which cause very short-term fluctuations in the price of
fish. Second, Marshall posited changes of moderate length, such as an increase in
the demand for fish owing to an extended cattle plague that reduces the supply of
beef (a substitute good). Finally, he formulated a long-period problem for the fish-
ing trade over a whole generation, perhaps caused by a change in consumer tastes.
When considering short-run market conditions, the very quick day-to-day
changes in demand and supply can be neglected. Temporary changes in the catch of
fish, in the weather, or in the availability of substitutes or complements for fish obvi-
ously cause temporary oscillations around what Marshall called the normal short-
term price of fish. Very short-term shifts in supply and demand—some of them can-
celing out—can easily be imagined. But the key to understanding Marshall’s
method lies in the relation between changing demand and production conditions
through time and the concept of normal price. In order to get a clear understanding
of Marshall’s method, we must first look at the effects of time on the production
conditions of the firm (in this case, a fishing firm).
The Short Run. Marshall posited the existence of a representative, or aver-
age, firm operating in a competitive market. The concept is ambiguous, even by
Marshall’s own definition: “Our representative firm must be one which has had a
fairly long life, and fair success, which is managed with normal ability, and which
has normal access to the economies, external and internal, which belong to that
aggregate volume of production; account being taken of the class of goods pro-
duced, the conditions of marketing them and the economic environment generally”
(Principles, p. 220). Mark Blaug attributes this invention to Marshall’s “restless
quest for realism,” but in fact the representative firm “is an abstraction; it is neither
an arithmetic average, nor a median, nor even a modal firm. It is representative, not
with respect to size, but with respect to average costs” (Economic Theory in Retro-
spect, p. 391). Aside from the difficulties associated with the concept, such a firm
might be depicted as in figure 16-1a on the following page. (Ignore for the moment
the curves of figure 16-lb.) Specifically, figure 16-1a depicts the short-run produc-
tion conditions of the representative fishing firm. In the short run (one or two years
in Marshall’s view) the ability of the fishing industry to supply fish is not indefi-
nitely expansible. In figure 16-1a, this limit to additional production is represented
by the rising marginal-cost and average-cost functions beyond quantity qi. The fish-
ing firm, in other words, cannot alter all its inputs in a short period of time, and
some of its inputs must be regarded as fixed. It takes time, for example, to build
new boats and to train a new and larger generation of fishermen. The firm can, of
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400 Part IV ■ The Neoclassical Era

Representive firm (short run) Industry (short run)

n
SRS = Â MCi
Price Price i =1

D‫׳‬ SRS ‫׳‬

MCi ATCi AVCi D
P‫׳‬
P‫׳‬
C
P LRS
P

D‫׳‬
AFC D
O qi q i‫׳‬ Quantity O n Q‫ ׳‬Q‫״‬ Quantity
Q = Â qi
i =1

(a) (b)

Figure 16-1 A short-run increase in market demand from DD to DD raises the mar-
ket price from P to P  and industry output from Q to Q. Each firm will earn economic
profits because the average revenue P  exceeds average costs C at quantity qi . In the
long run, as new firms enter the industry, the supply curve will shift to the right, from
SRS to SRS , pushing the equilibrium price back to P, but there will be more output, Q.

course, increase other inputs. In the short run, which assumes the existence of fixed
or quasi-fixed capacity, when a firm adds more variable inputs, its average total
costs and average variable costs will diverge from each other. The difference
between average total cost and average variable cost is average fixed cost, which
declines over the whole range of output (the dashed function in figure 16-1a). This
difference between the AVCi and AFC functions would not exist but for fixed costs.
If all inputs are variable, then average total cost and average variable cost would be
identical at all levels of output.
It is also important to note the reason why the average-cost functions of figure
16-1a are U-shaped. As variable inputs—say, fishermen, deckhands or nets—are
added to the “plant” capacity of fishing boats, returns in the form of the number of
fish caught per unit of input increase. Average costs, both total and variable,
decline. But as variable units are added, average productivity of those inputs in
terms of fish caught will decline beyond a point. Therefore, the average cost of sup-
plying fish declines over some range of output but must inevitably rise. Likewise,
the marginal cost to the fishing firm, that is, the change in total cost as output is
increased one unit, may fall at first but must inevitably rise. Clearly, as a result of a
simple law of arithmetic, marginal cost must equal average total cost when the lat-
ter is at a minimum.
We now turn our attention to the effect of Marshall’s long-run/short-run distinc-
tion on the condition of market demand. Marshall posited an increase of moderate
length in the demand for fish due to a cattle plague and used the ceteris paribus tool
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 401

to predict the resulting price and output in the fish market. Now included in ceteris
paribus are variations that affect the fishing industry but whose effects take place
too slowly to have an appreciable influence in the short run. This left Marshall free
to focus on the factors that would affect the market for fish given a short-run
increase in demand. Thus, he wrote:
We give our full attention to such influences as the inducements which good fish-
ing wages will offer to sailors to stay in their fishing homes for a year or two,
instead of applying for work on a ship. We consider what old fishing boats, and
even vessels that were not specially made for fishing, can be adapted and sent to
fish for a year or two. The normal price for any given daily supply of fish, which we
are now seeking, is the price which will quickly call into the fishing trade capital
and labour enough to obtain that supply in a day’s fishing of average good fortune;
the influence which the price of fish will have upon capital and labour available in
the fishing trade being governed by rather narrow causes such as these. This new
level about which the price oscillates during these years of exceptionally great
demand will obviously be higher than before. Here we see an illustration of the
almost universal law that the term normal being taken to refer to a short period of
time, an increase in the amount demanded raises the normal supply price. (Princi-
ples, p. 370)

The example perfectly illustrates Marshall’s method. Very short-run and long-run
factors affecting the fishing trade are ignored or assumed constant, while those
influences having direct bearing on the market over the relevant time period are
given full play in explaining market price and quantity. Marshall put operational
time, not chronologic time, at the center of the analysis. The “capital and labour
available in the fishing trade” are obviously a function of different variables in the
short and long run since it takes time to construct new capacity and to induce addi-
tional workers to enter the fishing trade. As a result, normal supply price will differ
in both periods, as we shall see presently.
Competitive Equilibrium. Competitive equilibrium occurs over time as the
forces described by Marshall come into play. Supply decisions follow demand
changes to propel competitive markets to new equilibria. Again, consider figure 16-1.
The fishing-industry demand and supply curves are depicted in figure 16-1b, where,
under purely competitive conditions the positively sloped short-run supply function
(SRS) is simply the horizontal summation of all the marginal-cost curves of the firms
constituting the industry. Initially the industry demand function for fish is DD, and
industry equilibrium exists at the intersection of SRS and DD, resulting in equilib-
rium values of price and output at P and Q (the sum of the quantities produced by all
the firms). The representative firm is a price taker under competitive conditions. We
assume that, initially, price P, or average revenue, is equal to minimum average total
costs of production, and that total costs (qi × ATCi) equal total revenue (qi × P).
Thus, no economic profits exist in the industry before the alteration in demand.
Now consider Marshall’s supposition that a cattle plague causes a temporary
increase in the demand for fish, so that demand shifts to DD. After a period of
adjustment (during which demand price exceeds supply price), the price of fish
rises to P and industry output rises to Q, which is the summation of the now larger
outputs (qi  of the individual firms. The firms are maximizing profits at output qi
since marginal cost is equal to marginal revenue (in competition, price is equal to
marginal revenue). Thus, as Marshall explained, the short-term normal supply rises
with an increase in the demand for fish.
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402 Part IV ■ The Neoclassical Era

The important point is that, given sufficient information on the part of potential
competitors, a price of P could not ordinarily persist in the fish market. At quantity
qi each firm earns economic profits because average revenue (P) exceeds average
cost (C). If the increase in fish demand becomes permanent because of a change in
tastes (a long-run adjustment), then normal supply price will be governed by a dif-
ferent set of causes. In short, a permanent long-term increase in the demand for fish
engenders long-term production adjustments by firms in the industry. In a regime of
competition economic profits (or losses) signal that a long-term adjustment is in
order. The nature of the adjustment can vary, however, and in a passage of brilliance
and clarity Marshall described the possibilities:
The source of supply in the sea might perhaps show signs of exhaustion, and the fish-
ermen might have to resort to more distant coasts and to deeper waters, Nature giv-
ing a Diminishing Return to the increased application of capital and labour of a given
order of efficiency. On the other hand, those might turn out to be right who think that
man is responsible for but a very small part of the destruction of fish that is con-
stantly going on; and in that case a boat starting with equally good appliances and an
equally efficient crew would be likely to get nearly as good a haul after the increase in
the total volume of the fishing trade as before. In any case the normal cost of equip-
ping a good boat with an efficient crew would certainly not be higher, and probably
be a little lower after the trade had settled down to its now increased dimensions than
before. For since fishermen require only trained aptitudes, and not any exceptional
natural qualities, their number could be increased in less than a generation to almost
any extent that was necessary to meet the demand; while the industries connected
with building boats, making nets, etc. being now on a larger scale would be organized
more thoroughly and economically. If therefore the waters of the sea showed no signs
of depletion of fish, an increased supply could be produced at a lower price after a
time sufficiently long to enable the normal action of economic causes to work itself
out: and, the term Normal being taken to refer to a long period of time, the normal
price of fish would decrease with an increase in demand. (Principles, pp. 370–371)

Long-Run Conditions. Returning to figure 16-1, consider Marshall’s second

possibility, i.e., that additional capital and labor applied to the fishing trade would
yield a proportionate increase in the catch. Economic profits might cause firms to
react in several ways: Existing firms might increase their scale of operations to
increase output, and/or new fishing firms might join the market. If for convenience
we eliminate the first possibility, the short-run industry supply curve will shift to the
right (to SRS) with the entry of new firms. Since we are assuming that the normal
cost of “equipping a good boat with an efficient crew” remains the same as at lower
levels of total output, the representative firm’s cost functions do not shift. After all
adjustments take place, the market is again in long-term equilibrium with zero eco-
nomic profits at price P but at a higher level of output. The long-run supply price of
fish is constant (at P in figure 16-1), and the long-run supply function (LRS) may be
traced out by connecting the two intersections of supply and demand after all
adjustments have taken place. If the LRS function is horizontal, as in figure 16-1, we
say that fishing is a constant-cost industry. Proportionate increases in inputs of cap-
ital and labor yield proportionate increases in output of fish.
Actually, we have been assuming that the fishing firm was in long-run equilib-
rium before the increase in demand took place. Figure 16-1a does not depict a long-
run equilibrium for the firm, however. The long-run situation of the representative
firm after all adjustments have taken place is as shown in figure 16-2. Since there
are no fixed costs in the long run, all costs to the firm are variable. This is reflected
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 403

Price SRMCi
LRMC
SRACi
LRAC

A
P

Figure 16-2 Long-run equilibrium

for the firm is where the lowest point
of the LRAC and a particular SRAC
curve are tangent to the market price. O qi Quantity

in figure 16-2 by the fact that there is no distinction between average total cost and
average variable cost. The long-run average-cost curve is commonly called an “enve-
lope” or a “planning” curve, and it was first developed by Jacob Viner, not by Mar-
shall (see notes for further reading at the end of this chapter). The envelope curve is
really drawn as a series of tangencies of many possible short-run curves. Only one of
these short-run curves (SRACi) is tangent at the point of minimum long-run average
cost (point A in figure 16-2). It is the same average cost (ATCi) we assumed in figure
16-1a. Given price P, the representative fishing firm will produce output qi. At this
long-run equilibrium for the firm, quantity qi is produced with an optimum scale of
plant, i.e., at minimum long-run average costs. Quantity qi is also an optimum rate of
output in that the scale of plant represented by SRACi is utilized at its most efficient
level, i.e., at minimum costs. The important point is that competition and freedom of
entry or exit in the fishing industry guarantee that output (given the cost conditions
assumed) will be produced at minimum long-run average costs.
Thus, a review of Marshall’s fishing example yields insights into his method of
utilizing time-period analysis and ceteris paribus assumptions. The same example
provides a springboard for discussing Marshall’s concept of competitive equilib-
rium and market adjustments. So far we have considered only the most common
representation of competitive market adjustment: the constant-cost case. We now
turn to two other cases alluded to by Marshall in his discussion of the fishing trade,
i.e., the increasing- and decreasing-cost-industry cases. We shall see that the latter
concept was the more important and controversial since it shaped some of Mar-
shall’s other ideas, especially those on welfare economics, which in turn shaped the
course of twentieth-century microeconomics.

■ INDUSTRY SUPPLY AND THE ECONOMICS OF PRODUCTION

It is a simple matter to demonstrate the two other long-run supply conditions
implied by Marshall in his example of the fishing trade. Unfortunately, some of the con-
cepts usually associated with these supply conditions are not clear in the Principles and
caused difficulties for the theory of competition, as we shall see in chapter 20. Graphi-
cally, however, cases of increasing and decreasing cost may be depicted simply. Con-
sider figures 16-3 and 16-4, for example, in which only industry curves are represented.
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404 Part IV ■ The Neoclassical Era

Increasing and Decreasing Costs

In the increasing-cost case, contrary to the one described by figure 16-1, the
firm’s cost curves rise as industry output expands. That is, with reference to figure
16-3, the LRS function is positively sloped. Full long-run adjustment to the increase
in demand (e.g., from D to D) will take place only at higher costs (at B). In the fish-
ing example, for instance, Marshall noted the possibility that the supply of fish in
the sea might become somewhat depleted, so that fishermen would have to resort to
fishing in more distant areas. Such activity would become more costly in that pro-
portionate applications of homogeneous capital and labor would yield less than pro-
portionate returns in the catch.
But Marshall noted a more interesting possibility—that of a downward-sloping
long-run supply function for the industry. With reference to figure 16-4, decreasing
LRS implies that additional output will be produced at lower unit costs to the firm.
Here, an increase in demand (from D to D), which increases firm output, causes the

Price SRS

SRS ‫׳‬
LRS
B

D‫׳‬
Figure 16-3 Increasing long-run
supply costs result when a repre-
sentative firm’s unit costs rise as a
D
consequence of output expansion
to meet an increase in market
O Quantity demand.

SRS
Price

SRS ‫׳‬

Figure 16-4 Decreasing

LRS long-run supply results
when a representative firm’s
D‫׳‬
D unit costs decline as a con-
sequence of output expan-
sion to meet an increase in
O Quantity market demand.
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 405

short-run supply function (SRS) to intersect the new demand curve at a price lower
than at the previous output level. This would happen if the firm’s average-cost
curves shift downward as output increases, which could occur, Marshall suggested,
because of lower input prices. Better organization and larger operations in boat-
building and net making could drive down factor prices resulting in lower unit costs
to the fishing firm. If this happened, the long-run industry supply of fish would be
negatively sloped as in figure 16-4.
Internal and External Economies. Although Marshall did not develop a full-
blown theory of a firm’s cost functions,2 he discussed two types of economies in
production that might explain industry supply behavior. Specifically, he divided
economies associated with increased production into those external to the firm and
those internal to the firm. Marshall defined external economies as those “dependent
on the general development of the industry” and internal economies as those
dependent on the organization and efficiency of the management within the individ-
ual firms.
An increase in output may generate internal economies from the division of
labor and improved use of machinery within the firm. Some capital (e.g., special-
ized machinery) is indivisible and can be utilized only in large-scale production, so
that full economic efficiency of both capital and labor can be attained only with
increases in production. As output expands, long-run average cost declines, but
after some level of output, average cost must again rise owing to inefficiencies of
management and the difficulties of marketing the product. Internal economies and
diseconomies are simply an explanation for the typical U-shaped long-run average-
cost curve.
External economies occurring with increased output, as Marshall identified
them, are production economies that are external to the firm but internal to the
industry. Marshall linked external economies to the location of industry, but his dis-
cussion contains very few examples. Among others, he mentions the following
external economies from the agglomeration of firms in a given locale:
1. Better information and skills
2. Availability of skilled labor
3. Economies in the use of specialized machinery
In explaining the first, Marshall (somewhat cryptically) noted that, after an industry
has chosen a locale, “The mysteries of the trade become no mysteries; but are as it
were in the air, and children learn many of them unconsciously.” Moreover:
Good work is rightly appreciated, inventions and improvements in machinery, in
processes and the general organization of the business have their merits promptly
discussed: if one man starts a new idea, it is taken up by others and combined with
suggestions of their own; and thus it becomes the source of further new ideas. And
presently subsidiary trades grow up in the neighborhood, supplying it with imple-
ments and materials, organizing its traffic, and in many ways conducing to the
economy of its material. (Principles, p. 271)

Additionally, Marshall argued that localized industry provides a “constant,”

orderly market for skilled and specialized labor. Presumably, industries are
attracted to regions where scarce labor inputs (in the firm’s production functions)

2
In his famous paper entitled “Cost Curves and Supply Curves” (see notes for further reading at the
end of this chapter), Jacob Viner developed the envelope, or long-run, cost curve for the firm.
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406 Part IV ■ The Neoclassical Era

are readily available. Simultaneously, of course, labor is attracted to regions where

the demand for its services is high. As the industry “grows up” in a given area, the
availability of specialized labor is expanded and enhanced.
Marshall suggested that as an industry matures, economies in the use of spe-
cialized machinery become realizable. He also hinted that the growth of supportive,
subsidiary industries creates external economies for firms within the industry.
The economic use of expensive machinery can sometimes be attained in a very
high degree in a district in which there is a large aggregate production of the same
kind, even though no individual capital employed in the trade be very large. For
subsidiary industries devoting themselves each to one small branch of the process
of production, and working it for a great many of their neighbors, are able to keep
in constant use machinery of the most highly specialized character, and to make it
pay its expenses, though its original cost may have been high, and its rate of depre-
ciation very rapid. (Principles, p. 271)

External Economies, Graphically Considered. In figure 16-5, the costs and

revenues of the representative firm are depicted in figure 16-5a, and the industry
curves are shown in figure 16-5b. Initial industry and firm equilibriums occur at
price P, formed by the intersection of short-run industry supply SRS (which equals
MC) and short-run industry demand DD. If we assume that demand increases
from DD to DD, short-term economic profits accrue to firms within the industry
(note that these profits are not shown in figure 16-5, but the process is totally analo-
gous to that described in reference to figure 16-1). Each firm’s rate of output is
increased (as always, up to the point where price equals marginal cost of produc-
tion), but profits signal the entry of new firms into the market. As new firms enter,
external economies are realized. The economies, which shift the long-run cost

Firm Industry

Price Price ΣMC = SRS

D‫׳‬
D ΣMC ‫ = ׳‬SRS ‫׳‬
LRMC LRAC
A
P P
LRMC ‫ ׳‬LRAC ‫׳‬

P‫׳‬ P‫׳‬ B

LRS
D‫׳‬
D
O Quantity O Quantity
(a) (b)

Figure 16-5 A short-run increase in market demand, from DD to DD, causes expan-
sion of output by existing firms and attracts new firms to the industry. The presence of
external economies lowers the LRAC and LRMC of each firm, and the result is a long-run
downward-sloping supply curve (LRS).
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 407

curves of each of the firms downward, are, by definition, external to each of the
firms but internal to the industry.
Thus, the positions of the long-run cost curves of the firm are not independent
of changes in industry output, as they are in the constant-cost case.3 With reference
to figure 16-5, the firm’s long-run cost curves shift downward to LRAC and LRMC
when new firms enter the industry. A new industry equilibrium is reached at price P
(point B), where short-run supply SRS (or MC) is equal to the new industry
demand DD. Connection of the loci of the two equilibrium sets of price and quan-
tity (represented at points A and B in figure 16-5) traces out a downward-sloping
long-run industry supply curve.4 The decreasing function LRS appears to represent
the analytical substance of what Marshall meant by the term “decreasing-cost
industry,” although there could be some debate on the issue. Clearly, the concept is
fraught with difficulties, not only in interpretation but also in substance. However,
far from being simply a theoretical curiosity, Marshall’s discussion of external econ-
omies and decreasing costs is of prime importance on several counts. First, the lim-
itations of his partial equilibrium method are exposed by the concept of the
decreasing-cost industry. Second, a whole new area of microanalysis—the study of
imperfect competition—was in large part initiated in the 1920s and 1930s through a
questioning of the compatibility of decreasing costs with the theory of competition.5
Before discussing Marshall’s analytical use of his alternative-cost assumptions, it
will be instructive to look at each of these issues briefly.

Long-Period Supply: Analytical Difficulties

The limits of Marshall’s method—which he clearly understood—are revealed in
the case of external economies and decreasing costs. We have argued that the long-
period supply function, as depicted in figure 16-5b, is negatively sloped as a result
of external economies. One might argue that the long-run costs curves of the firm
shift downward because of a fall in input prices with increases in industry output.
Unfortunately, as Mark Blaug has suggested (Economic Theory in Retrospect, p.
381), such reasoning merely shifts the explanation a step away. Why, for instance,
do input prices fall? If the fall is due to external economies in the supplying indus-
tries, we are still at pains to describe the nature of these economies. Consequently,
we have left a fall in input prices off our list of external economies.
But we encounter difficulties even when confronted with the list Marshall
described (better use of machinery, better methods, etc.). Specifically, it becomes
extremely doubtful whether partial equilibrium analysis, such as that described by
figure 16-5, can handle the problem. The long-run supply curve is drawn up on the
assumption that technology is constant. A change in technology would cause a shift
in the curve. In the list of external economies given by Marshall, it would be difficult
to find a single economy that did not, in some way, alter technology. This is espe-
cially true as the period considered lengthens.

3 We skirt the more complex question of whether the representative firm’s rate of output (qi in fig-
ure 16-1a) will be larger, smaller, or the same with changes in industry output.
4
The short-run supply functions of figure 16-5b are positively sloped, nevertheless, since they are
the sum of positively sloped firms’ marginal-cost functions.
5
Marshall’s concept of external economies and diseconomies was generalized by his successor, A.
C. Pigou, into a theory relating to “uncompensated services or disservices.” Pigou also related
these externalities to competitive market failure, but the force of his arguments has been consid-
erably diluted by the modern theory of externalities developed by Frank Knight and Ronald Coase
(see text below and notes for further reading at the end of this chapter).
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408 Part IV ■ The Neoclassical Era

One important question related to the analysis, then, concerns the reversibility
of the long-run supply curve. Economies and/or technological advances in an indus-
try are ordinarily not destroyed when demand declines in that industry. Therefore,
the long-run industry supply curve (as in figure 16-5) would not be reversible. If
economies are not reversible and alterations in technology occur, partial equilib-
rium analysis may be used only as a very rough approximation in explaining prices
and conditions in the market. Marshall himself recognized and pinpointed these dif-
ficulties. As he incessantly warned:
Violence is required for keeping broad forces in the pound of Ceteris Paribus dur-
ing, say, a whole generation, on the ground that they have only an indirect bearing
on the question in hand. For even indirect influences may produce great effects in
the course of a generation, if they happen to act cumulatively; and it is not safe to
ignore them even provisionally in a practical problem without special study. Thus,
the uses of the statical method in problems relating to very long periods are dan-
gerous; care and forethought and self-restraint are needed at every step. The diffi-
culties and risks of the task reach their highest point in connection with industries
which conform to the law of Increasing Return; and it is just in connection with
those industries that the most alluring applications of the method are to be found.
(Principles, pp. 379–380n)

But, significantly, Marshall was unwilling to throw out the baby with the bath water.
Noting that it is true that his method treated “variables provisionally as constants,”
he correctly indicated that it is also the case that his method is the only one “by
which science has ever made any progress in dealing with complex and changeful
matter, whether in the physical or moral world” (Principles, p. 380n).
A second point concerns the compatibility of decreasing-cost conditions and
the existence of competitive equilibrium. Far from being a matter of esoteric inter-
est, this issue spawned debate that was a major factor leading to the development of
the theory of imperfect competition in the 1930s (see chapter 20). Briefly stated, can
perfect competition coexist with external economies and decreasing costs? A
moment’s reflection clearly reveals that it cannot. Given that the firm’s long-run
cost curves are inversely related to industry output (as would exist at least for
increases in output when external economies are present), any firm would have the
incentive to purchase all other firms because any single firm would wish to internal-
ize the external economies within the industry. A monopoly, with multiplant produc-
tion, would be the likely outcome. Clearly, one must choose between the theory of
competitive equilibrium and the theory of decreasing costs. The recognition of this
fact by several of Marshall’s disciples led to the extensive development in the twen-
tieth century of a theory of imperfect competition.
Thus far we have examined Marshall’s theory of competitive equilibrium, a the-
ory that employs his partial equilibrium method. We have also examined his discus-
sion of external economies and decreasing costs, as well as some of the theoretical
difficulties that these concepts present. Before returning to these concepts and to
the analytical use to which Marshall put them, we must look at another side of his
massive contribution to competitive analysis, i.e., the theory of demand and con-
sumer surplus.6

6
Some of Marshall’s contributions to value theory have already been previewed, i.e., the Mill–Mar-
shall theory of joint supply presented in chapter 8.
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 409

■ DEMAND AND CONSUMER SURPLUS

In our discussion of competitive equilibrium we have assumed the existence of
an industry demand function. Just what is a demand function, how is it constructed,
and what is it used for? More than any other economic theorist before or since, Mar-
shall provided lengthy, though not always clear, answers to these questions. He was
influenced, perhaps even to a large extent, by the demand analyses of Cournot and
Dupuit, and it is clear that J. S. Mill’s formulation of demand theory (see chapter 8)
left its mark. As we have seen, Marshall added a clear graphical treatment of Mill’s
concepts of joint supply and reciprocal demand. But in the case of demand theory,
Marshall enlarged the concept significantly—so significantly, in fact, that the adjec-
tive “Marshallian” is often used to denote a whole tradition in demand theory. One of
the reasons for Marshall’s great emphasis on demand in his Principles was to coun-
teract the classical emphasis on costs of production as the sole determinant of value.

Marshall’s Demand Curve Specification

Marshall stated the law of demand in the following manner: “There is then one
general law of demand: The greater the amount to be sold, the smaller must be the
price at which it is offered in order that it may find purchasers; or, in other words,
the amount demanded increases with a fall in price, and diminishes with a rise in
price” (Principles, p. 99). However, Marshall, unlike most of his predecessors, recog-
nized that before one can draw up a demand schedule, a number of assumptions
must be specified. Marshall’s ceteris paribus assumptions that support the functional
relation between price and quantity demanded may be summarized as follows:
1. The time period for adjustment
2. The subject’s tastes, preferences, and customs
3. The amount of money (income or wealth) at the subject’s command
4. The purchasing power of money
5. The price and range of rival commodities
Time in Demand Analysis. As he did in the case of his treatment of cost, Mar-
shall applied time and the ceteris paribus method to demand theory. Time is a nec-
essary element in demand theory because “time is required to enable a rise in the
price of a commodity to exert its full influence on consumption” (Principles, p. 110).
As we learned in the example of the fishing trade, tastes may change over time and
tastes are related to use. People can acquire a taste for something with repeated
use. This presents a problem for demand theory, of which Marshall was fully cogni-
zant. Given that time is required to obtain the full effects on quantity demanded of a
price change and that protracted use of a substitute good may alter tastes for both
the original good and its substitute, doesn’t this change one of the bases on which a
demand schedule is drawn up? Marshall replied:
While a list of demand prices represents the changes in the price at which a commod-
ity can be sold consequent on changes in the amount offered for sale, other things
being equal; yet other things seldom are equal in fact over periods of time sufficiently
long for the collection of full and trustworthy statistics. There are always occurring
disturbing causes whose effects are commingled with, and cannot easily be separated
from, the effects of that particular cause which we desire to isolate. This difficulty is
aggravated by the fact that in economics the full effects of a cause seldom come at
once, but often spread themselves out after it has ceased to exist. (Principles, p. 109)
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410 Part IV ■ The Neoclassical Era

Marshall’s solution to the problems time introduced to demand theory was to

specify a parameter in demand theory for the time period of adjustment. Because
alteration of the time period of adjustment (say, the duration of the cattle plague)
could change the demand curve significantly, it is essential to specify a period for
which the demand function is constructed. He was aware of the need to place
human tastes or customs, as well as the price of closely related goods, in his pound
of ceteris paribus:
The demand prices in our list are those at which various quantities of a thing can
be sold in a market during a given time and under given conditions. If the condi-
tions vary in any respect the prices will probably require to be changed; and this
has constantly to be done when the desire for anything is materially altered by a
variation of custom, or by a cheapening of the supply of a rival commodity, or by
the invention of a new one. (Principles, p. 100)

The Income Parameter. When the price of a good falls, two things happen.
First, the good is cheaper relative to all other goods in the consumer’s budget, and
the consumer will substitute that good for others (the substitution effect of a price
change). Second, the consumer’s real income rises as the purchasing power of
money increases, causing the consumer to buy more of all normal goods in his or
her budget (the real-income effect of a price change).7 Because the introduction of a
real-income effect rotates the demand function, Marshall had to indicate the kind of
income he wished to hold constant along the demand curve. Although one can find
statements that offer a contrary interpretation, in the main it appears that he wished
to ignore alterations in the purchasing power of money. In his analysis of marginal
diminishing price, Marshall invoked a constant-real-income assumption:
The larger the amount of a thing that a person has the less, other things being
equal (i.e., the purchasing power of money and the amount of money at his com-
mand being equal), will be the price which he will pay for a little more of it: or in
other words his marginal demand price for it diminishes. (Principles, p. 95)

Marshall underscored the necessity of correcting for changes in the purchasing

power of money. Whether the Marshallian demand curve falls into the category of
the modern constant-money-income or the modern constant-real-income formula-
tion depends on the interpretation given to the assumed constancy of the purchas-
ing power of money and the importance that is attached to it. According to Milton
Friedman’s interpretation, the only way the purchasing power of money can remain
constant as the price of the good under analysis changes is for the purchaser to be
compensated by changes in money income or countermovements in the prices of
other goods he or she consumes to maintain the constancy of real income in utility
terms (“Marshallian Demand Curve,” pp. 463–465). However, the traditional inter-
pretation proffered by J. R. Hicks (and others) claims Marshall’s assumption of the
constancy of the purchasing power of money is a simplifying tactic that is, in rigor-
ous terms, inconsistent with the rest of his formulation (Hicks, Theory of Wages, pp.
38–41).
Viewed in retrospect, both interpretations appear correct, though each refers to
a different point on a continuum of Marshall’s levels of abstraction. The possibility
of two distinct interpretations results from Marshall’s failure to specify explicitly at
what level of abstraction he was operating in various facets of his analysis. In the
7
A normal good is one whose consumption increases as income increases (steak, for example);
consumption of an inferior good (beans, perhaps) declines as income increases.
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 411

theoretical formulation of the demand curve, Marshall’s exposition fits the con-
stant-real-income classification, and Friedman’s interpretation appears valid. In
practical applications such as consumer surplus, the constant-money-income inter-
pretation, which assumes that Marshall simply ignored changes in the purchasing
power of money, seems more fitting. The apparent ambiguity can be resolved to
some extent by remembering that Marshall intended his Principles to be not only a
clarifying exposition of economic analysis but also of practical use in everyday life.

Consumer Surplus
In terms of operational concepts (i.e., those that are useful in the real world),
the most important of Marshall’s principles may be his notion of consumer surplus.
Marshall’s measure has been in and out of favor with economists, and it is certain
that there are many difficulties connected with it. But whether Marshall’s measure
(or refurbishments of it) surmounts these difficulties is not really relevant. Many
policy decisions require a measure of the benefits produced by goods (and particu-
larly by public goods in cost-benefit calculations), and consumer surplus is among
the best that economics offers. Moreover, the concept of consumer surplus exists
irrespective of whether a Marshallian demand curve measures it correctly. At any
rate, Marshall applied the concept to analyze several real-world problems, such as
monopoly and taxation.
The concept of consumer surplus originated with Jules Dupuit (see chapter 13),
who also applied it in innovative ways, especially to public goods. But Marshall pop-
ularized the concept and gave it the name we now attach to it. He described con-
sumer surplus as follows:
The price which a person pays for a thing can never exceed, and seldom comes up
to that which he would be willing to pay rather than go without it: so that the satis-
faction which he gets from its purchase generally exceeds that which he gives up
in paying away its price; and he thus derives from the purchase a surplus of satis-
faction. The excess of the price which he would be willing to pay rather than go
without the thing, over that which he actually does pay, is the economic measure of
this surplus satisfaction. It may be called consumer’s surplus. (Principles, p. 124)

The Case of Tea. To further understand this concept and its operational signif-
icance, Marshall provided a numerical example. He posited a consumer’s demand
schedule for an unimportant commodity (i.e., one that accounts for a small portion
of his total expenditures), such as tea. Table 16-1 replicates Marshall’s example.
Let us suppose that the consumer purchases 1 pound of tea at a price of 20 shil-
lings. According to Marshall this establishes that the consumer’s total enjoyment or
satisfaction derived from consuming
that amount is “as great as that which he
could obtain by spending 20s. on other Table 16-1 Price of Tea per Pound
things” (Principles, p. 125). Now sup-
pose that the price falls to 14s. The Shillings Quantity Demanded
buyer could still purchase 1 pound of 20 1
tea, obtaining a surplus satisfaction of 14 2
6s., or a consumer surplus of at least 6s. 10 3
But if he buys an additional pound, the 6 4
utility of this additional amount must be 4 5
at least equivalent to 14s., so that he 3 6
now obtains for 28s. a quantity of tea 2 7
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412 Part IV ■ The Neoclassical Era

that is worth to him at least 34s. (20s. + 14s.). Thus, consumer surplus, in Mar-
shall’s calculation, is at least 6s.
We may view the situation graphically as in figure 16-6, which depicts the con-
sumer’s demand for tea. Successive price declines clearly increase the surplus util-
ity that the individual receives from consuming tea, so that when the price falls to 2
shillings, he buys 7 pounds, which “are worth to him not less than 20, 14, 10, 6, 4, 3,
and 2s. or 59s. in all.” This sum of 59 shillings measures the total utility to the con-
sumer (utilité absolue, in Dupuit’s terms) of the 7 pounds of tea. But the consumer
must pay only 14 shillings for 7 pounds, so that he receives a sum of utility equiva-
lent to (at least) 45 shillings from consuming 7 pounds of tea. Marshall called this
amount “excess satisfaction” as consumer surplus.

Price
(tea)

20s.

14s.

10s.

6s.
4s.
3s.
Figure 16-6 As price declines
2s.
D from 20s. to 2s., the total utility of
the consumer increases to a value
of 59s. (20 + 14 + 10 + 6 + 4 + 3 + 2).
Since the consumer must pay only
O 1 2 3 4 5 6 7 Quantity 14s. for 7 pounds, his consumer
(tea) surplus is equivalent to 45s.

The Marshallian Measure. The concept of consumer surplus is clear and logi-
cal, but problems arise when the surplus is measured by an area under the Marshal-
lian demand curve. In order to appreciate this let us suppose that the demand curve
of figure 16-6 is Marshallian in the sense that it is drawn up under the assumptions
listed earlier in this chapter. It will be recalled that one of those assumptions is the
constancy of the purchasing power of money. But as price falls for our consumer of
tea, the purchasing power (real value) of his or her money will increase, and an
increase in the purchasing power of money is equivalent to an increase in the con-
sumer’s real income. The problem is that as real income increases its marginal util-
ity decreases, just as the marginal utility of any good decreases as its quantity
increases. With respect to the consumption of tea this means that a shilling is not a
shilling in utility terms as the consumer moves down his or her demand curve. The
marginal utility of shillings is not the same when the consumer is buying 1 pound at
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 413

20s. as when he or she is buying 7 pounds at 2s. Marshall expressed consumer sur-
plus in money terms, but the units of money (say, 45s. when 7 pounds at 2s. are con-
sumed) do not carry the same utility value because the real income of the consumer
is altered. Without getting into unnecessary complexities, we can confidently state
that the Marshallian (constant-money-income) demand curve will either overesti-
mate or underestimate the surplus.
Marshall tried to avoid being cornered by the constant-marginal-utility-of-
money assumption. One reason he selected tea, an “unimportant” commodity, is
because real-income changes would be negligible for small purchases. But even
though it can be minimized, the problem does not go away in any rigorous theoreti-
cal treatment of consumer surplus. The ambiguity of Marshall’s “final” position left
the theory in some disarray, but in all likelihood he was merely seeking a rough
approximation to guide certain kinds of public policy. He declared that his purpose
in devising the notion of consumer surplus was primarily to provide “an aid in esti-
mating roughly some of the benefits which a person derives from his environment”
(Principles, p. 125).8
Before turning to specific applications Marshall gave to consumer surplus, it is
necessary to clear up a different kind of ambiguity. Note that throughout the text we
have used the generalized term consumer surplus, which can apply to one or more
individuals. But Marshall, on the one hand, wrote of consumer’s surplus, while on
the other, he developed market demand curves that summed up the functions of
many individuals and attempted to determine consumers’ surplus. We might call it
the “problem of the apostrophe”—when demands (as utility functions) of many indi-
viduals are added up, we speak of consumers’ surplus and treat the monetary value
of the surplus as a utility value. But clearly, individuals’ incomes, tastes, and prefer-
ences must differ, so that 5 pounds of tea at 4 shillings for individual A does not nec-
essarily convey the same utility as 5 pounds at 4 shillings for individual B. To be
sure, money demands can be added up to form market demand curves, but illegiti-
mate interpersonal comparisons of utility are involved when these money amounts
(areas under the market demand curve) are used to express utility. Nevertheless,
certain assumptions could be invoked (such as equal income of the separate
demanders) that would make approximations more plausible. Importantly, Marshall
was aware of most of the difficulties. But, after acknowledging them, he proceeded
to put his imperfect approximation to use in discussions of monopoly and optimum
public policies of taxation and subsidization.

■ MARSHALL ON OPTIMUM PRICING AND MONOPOLY

Utilizing a market demand curve as an approximation of the utility produced by
a commodity, Marshall embarked on a theoretical excursion that allowed govern-
ment interference in free markets in order to promote maximum social satisfaction.
Coupling his marginal-utility/demand curve with the theories of long-run supply,
Marshall sought to determine whether social welfare (i.e., aggregate utility) could
be improved by a system of government taxes or subsidies. He considered the wel-
fare effects of taxes and “bounties” (subsidies) on industries characterized by
decreasing, increasing, and constant long-run supply functions.

8
Some (but not all) of the problems of utility measurement are avoided by using ordinal (indiffer-
ence-curve) analysis. The ordinal approach requires the consumer to indicate more or less satis-
faction rather than to make a numerical specification in cardinal (1, 5, 20, etc.) terms.
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414 Part IV ■ The Neoclassical Era

The Increasing-Cost Case

Marshall analyzed the effects of taxing or subsidizing an increasing-cost indus-
try in graphical terms, as depicted in figure 16-7. Output for the increasing-cost
industry originally takes place at quantity OH (and at price OC), where demand
curve DD intersects industry supply SS. At this quantity consumer surplus is repre-
sented by CDA, the total area under the demand curve (ODAH) less the amount that
consumers actually pay (OCAH). Now suppose that the government enacts a per-
unit tax on production in the amount TA per unit of output. The effect of this tax
would be to shift the market supply curve (which, remember, is the summation of
each firm’s marginal-cost functions) to the left by the amount of the tax. In our case,
the supply function decreases to ss. After the tax is levied, the quantity of the com-
modity sold is reduced to Oh, and price rises to Oc (determined at the intersection
of ss and DD). Now consumers pay Ocah for a quantity of the commodity that
yields them ODah in utility. Consumer surplus is reduced to cDa. The government’s
proceeds from the tax are equal to the amount of the tax aE (= TA) multiplied by
the output produced after the tax, FE (= Oh). In other words the tax produces reve-
nue equal to FcaE.

s‫׳‬
Price
S‫׳‬
D

R T

a
c

Figure 16-7 At initial equilibrium A,

s K
C A consumer surplus is the area CDA. A
per-unit tax in the amount TA will
F reduce consumer surplus to the area
E cDa and bring in tax revenue in the
D‫׳‬ amount FcaE. Since the area FCKE is
S
greater than the triangle aKA, the gov-
ernment will increase welfare by spend-
O h H Quantity ing the tax proceeds on public goods.

In order to judge the welfare effects of the tax Marshall compared the con-
sumer surplus lost to the tax revenue gained. To be conclusive, this requires an
assumption that the utility created by government expenditure of tax receipts is
equal, dollar-for-dollar, to the utility lost due to higher prices paid by consumers. In
figure 16-7, the critical issue is whether area FcAE exceeds area CcaA. If it does,
then the government could increase welfare by taxation.9

9
As Blaug pointed out in his Economic Theory in Retrospect (p. 388), the argument does not neces-
sarily hold when losses in producer surplus are included.
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 415

Reversing the argument, Marshall concluded that subsidization of an increas-

ing-cost industry would cause a reduction in consumer welfare. This point may also
be demonstrated in figure 16-7, assuming in this case that ss is the original supply
curve and that price and quantity are originally Oc and Oh, respectively. Should the
government subsidize the industry in the amount TA (or aE) per unit, the supply
function would shift rightward toward SS, increasing the equilibrium of output and
price to OH and OC. The total amount of the subsidy required will be the unit
amount TA multiplied by the new equilibrium quantity produced, OH (= CA). The
cost of the subsidy would therefore be represented by the area CRTA. Because the
subsidy results in a lower price, consumer surplus would increase from cDa to CDA,
an increase of CcaA. If this increase in consumer surplus is less than the cost of the
subsidy (which, in this case, it clearly is), then on utility grounds, at least, subsidiz-
ing the industry reduces consumer welfare.

Subsidies and Decreasing Costs

In a second, analogous case, Marshall argued that, on theoretical grounds,
decreasing-cost industries should be subsidized in order to promote maximum wel-
fare. The essentials of the argument are often invoked in contemporary discussions
of electrical utilities and other utilities that are assumed to be characterized by
decreasing costs. Figure 16-8 demonstrates graphically that welfare may be
increased by subsidizing decreasing-cost industries. Assume that the original indus-
try supply and demand functions are DD and ss, establishing price Oc and output
Oh. Now, what if the government decided to subsidize the industry in order to
increase total output to OH? The subsidy required would equal TA (or aE) per unit
of output. The supply curve would, in effect, shift downward to SS, and at the new
equilibrium OH would be produced at price OC. Consumer surplus increases from
cDa (at output Oh) to CDA (at output OH), an increase of CcaA. The total subsidy,

Price

a
c
S
K T
R
E
Figure 16-8 A subsidy in A
C s‫׳‬
the amount of TA per unit of
output will increase con-
sumer surplus from cDa to S‫׳‬
CDA. Since the increase in
consumer surplus exceeds D‫׳‬
the cost of the subsidy, con-
sumer welfare is increased. O h H Quantity
Ekelund-Hebert 6E.book Page 416 Thursday, August 1, 2013 11:03 AM

416 Part IV ■ The Neoclassical Era

as in the increasing-cost example of figure 16-7, is equal to the per-unit amount of

TA multiplied by the number of units sold, OH (= CA), or a total subsidy equal to
area CRTA. For the subsidy to create an increase in welfare, it is necessary that the
increase in consumer surplus CcaA be greater than the government’s subsidy
CRTA. This will be the case, referring to figure 16-8, since area KTA is less than area
RcaK. In this way, Marshall demonstrated that welfare could be improved by subsi-
dizing decreasing-cost industries.10
By extending the same lines of argument to constant-cost industries, of the
kind described in figure 16-1, Marshall showed as well that constant-cost industries
should be neither taxed nor subsidized, because either a tax or a subsidy would
produce smaller changes in consumer surplus than their corresponding changes in
tax receipts.
Some of the theoretical problems associated with Marshall’s use of the demand
curve as a welfare measure have already been discussed. But it is to Marshall’s
credit that he pointed out a particularly important difficulty where taxation and sub-
sidization are involved. In his words, the “doctrine of maximum satisfaction . . .
assumes that all differences in wealth between the different parties concerned may
be neglected, and that the satisfaction which is rated at a shilling by one of them,
may be taken as equal to one that is rated at a shilling by any other” (Principles, p.
471). Any statement imputing utility levels to individuals or groups is, strictly speak-
ing, nonscientific. In the tax-subsidy analysis, there are clearly gainers and losers. Is
the utility lost by the losers (those taxed) greater than, equal to, or less than the util-
ity received by the gainers (consumers of decreasing-cost-industry products)? A
positive or negative answer to the question requires a value judgment, and Marshall
did not flinch from making a few, one of which was that “The happiness which an
additional shilling brings to a poor man is much greater than that which it brings to
a rich one” (Principles, p. 474). When speaking of policies in which there are gain-
ers and losers, some such assumption must be made, and Marshall was, as a first
approximation, ready to make it.
Marshall’s treatment of the doctrine of maximum satisfaction provides us with
more examples of the dichotomy between his theoretical and operational concerns.
The theory and its conclusions are tentative in that they require certain nonscientific
assumptions concerning the summation of utilities of gainers and losers. But Mar-
shall proceeded anyway, issuing warnings all along the way and concluding that his
propositions “do not by themselves afford a valid ground for government interfer-
ence.” In his own view, he simply identified a problem, noting that much remained
to be done, especially in the area of statistical estimates of supply and demand. The
problem of devising policies to maximize welfare did, in fact, engender a great deal
of interest among Marshall’s disciples and others in the Cambridge tradition,
though progress has been piecemeal and incomplete.11 But Marshall was asking
important questions, always with a view to the applications of economic analysis.

Monopoly and Economic Welfare

One other important example of Marshall’s concern for the usefulness of utility
theory can be found in the area of simple monopoly analysis. He went to great
10
By reverse argument he also showed that welfare would be reduced if these industries were taxed.
11
The problem of empirical identification of increasing- and decreasing-cost industries was tackled
by A. C. Pigou, J. H. Clapham, and D. H. Robertson, with small success. The problem of scientific
estimation of welfare or “benefit” transfers has beguiled many economists, who have had even
less success (see notes for further reading at the end of this chapter).
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 417

lengths to point out the implications of the distinction, originally stated by Dupuit
(see chapter 13), between monopoly revenue and consumer surplus. Again, as in
the case of the consumer surplus argument, Marshall enlarged the analytical value
of the tool by probing the implications of the monopolist’s net revenue. Specifically,
Marshall showed that because of various economies of scale and the ability to
finance technological improvement, both associated with monopoly market struc-
ture, “The supply schedule for the commodity, if not monopolized, would show
higher supply price than those of our monopoly supply schedule” (Principles, pp.
484–485). Marshall went further and stated that if the monopolist had unlimited
command over capital, equilibrium quantity under free competition would be less
than that for which demand price is equal to supply price under monopoly.
On some of the most interesting pages of the Principles, Marshall analyzed the
possibility of a short-run “altruistic entrepreneur” who might regard a gain in con-
sumer surplus as coequal with a gain in monopoly revenues. He called the money
sum of consumer surplus and monopoly revenue “total benefit.” In a variation on
this theme, the theory of “compromise benefit,” the monopolist would calculate and
maximize the sum of (1) monopoly revenue to be obtained at any given price and
(2) some percentage (one-half, one-third, etc.) of the corresponding consumer sur-
plus. Marshall thought that such principles could be applied by a government inter-
ested in increasing consumers’ welfare through the supply of public goods (e.g.,
bridges, water, and gas), although he strongly indicated that it should do so only
under the constraint of equating total revenue with total costs. But, ever practical,
Marshall pointed out:
Even a government which considers its own interests coincident with those of the
people has to take account of the fact that, if it abandons one source of revenue, it
must in general fall back on others which have their own disadvantages. For they
will necessarily involve friction and expense in collection, together with some
injury to the public, of the kind which we have described as a loss of consumers’
surplus. (Principles, p. 488)

In the limiting case of government ownership or operation there would be no com-

promise; consumer surplus would be maximized subject only to the provision that
full costs be covered.
Thus, on the issues of governmental policy toward business, Marshall’s utility the-
ory (coupled with his theoretical views on long-run supply functions) led him to some
rather unorthodox and even radical suggestions. Although the type of utility theory on
which his analysis is based has been largely out of favor for many years, the problems
Marshall attacked (determining optimum public policies toward market enterprise)
are still very much with us. It is noteworthy, moreover, that modern attempts to mea-
sure social welfare have not advanced much beyond Marshall’s “welfare triangles.”

The Case of Externalities

One of Marshall’s applications that has loomed large in contemporary eco-
nomic analysis concerns the general area of “externalities,” property rights, and
“market failure.” Marshall’s discovery and elaboration of the concept of external
economies proved to be fertile ground for the development of new theoretical prin-
ciples in the field of public economics. Above we saw that Marshall identified some-
thing called “external economies,” by which the effects of certain types of industry
development and expansion lowered the cost curves of firms within industries—a
positive “externality” to the firm.
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418 Part IV ■ The Neoclassical Era

Apart from Marshall’s very practical identification of an externality, a philo-

sophical tradition of welfare maximization stemming from Benthamite utilitarian-
ism (see chapter 6) continued through J. S. Mill and through one of Marshall’s
Cambridge colleagues, Henry Sidgwick. In this tradition, economists discovered
that providing the greatest good for the greatest number solely through market
means contained a hitch—the market might “fail” to accurately reflect costs and
benefits if externalities existed. An example of negative externalities might be a
steel factory belching smoke and slag into the surrounding area, damaging houses,
lungs, and drinking water downstream. A positive externality might result if one
individual maintains a garden that neighbors enjoy but for which no practical
means of charging the beneficiaries can be devised. Similar problems arise today
whenever we discuss “environmental” issues.
A. C. Pigou, who was Marshall’s protégé and handpicked successor at Cam-
bridge (in 1910), greatly expanded this idea and proposed a “Marshallian” solution.
In 1912, in his Wealth and Welfare and in an expanded “second edition” entitled The
Economics of Welfare (1920), Pigou discussed the possibility of market failure. Con-
sider the problem of water pollution, an example of a negative externality. A nega-
tive externality exists if the marginal social costs of pollution exceed the marginal
private costs of pollution (by an amount equal to the marginal pollution damage).
Figure 16-9 depicts the marginal private cost (MPC), marginal social cost (MSC),
and demand curves for such an activity. If the polluting firm is able to escape the
social costs of pollution, it makes its decision based on the MPC curve. Quantity Q0
is produced, and society is forced to bear marginal pollution costs of AP0. There is
“too much” output of this good from society’s point of view.
Pigou’s solution was to impose a tax on the offending industry so that the MSC
curve would represent the cost of production perceived by the firm. In this case, the
firm would bear the full cost (private + social) of producing this good and output
would be restricted to Q1 (with a higher price than before). Following Marshall,
Pigou chose taxes and subsides as means to address market failures. In this context,
Pigou contemplated an expanded role for government, in the form of legislative or
regulatory action. An extension of this idea from a different perspective emphasiz-

Price MSC
A

P1

MPC Figure 16-9 If the pollut-

ing firm can ignore the
P0 social cost of production,
it will produce output Q0,
forcing society to bear the
Demand
cost AP0. One way to raise
the marginal private cost
to the level of marginal
social cost is by taxing the
polluting firm according
to the difference between
O Q1 Q0 Quantity
MSC and MPC.
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 419

ing private, contractual solutions rather than government intervention, was pio-
neered by another Marshallian, Ronald Coase (see the box, The Force of Ideas: The
Coasian Revolution in Property Rights).

The Force of Ideas: The Coasian Revolution in Property Rights

A twentieth-century economist steeped in the Marshallian tradition made seminal contri-
butions that address the “external effects” problem. In 1960 Ronald Coase drew attention (as
had Bentham and Chadwick before him) to the incentive effects that particular assignments
of property rights have on economic activity. In “The Problem of Social Cost,” a work represen-
tative of the contributions that earned him the Nobel Prize in Economic Science in 1991,
Coase challenged Pigou’s assumption that externalities are unidirectional in nature (see the
discussion surrounding Figure 16-9 in this chapter). Coase emphasized the reciprocal (or bilat-
eral) nature of externalities. A cigarette smoker cannot cause an externality if individuals do
not put themselves in his or her proximity. Water polluters would not have created an exter-
nality if there had been no downstream population settlement.
How does the Coase argument work? Consider an example of air pollution—a factory
belching smoke over a nearby community. While harmful to the community, these “spillover
effects” create benefits to the firm. As the output of the firm rises, however, the firm’s marginal
benefits of pollution decline because the rate of return on additional production generally
declines. On the cost side, the marginal cost of pollution is measured by the harm created by
the smoke, which is an increasing function of production, since more production means more
smoke. In Coase’s conception, the marginal costs of pollution (to the community) must be bal-
anced against its marginal benefits (to the firm).
What often prevents a market solution is the absence of clearly defined property rights.
Who has a right to fresh air? Coase argued that a market solution will result if we simply assign
legal ownership rights over air quality to one of the other parties. If homeowners in the sur-
rounding neighborhood hold the rights to clean air and if free exchange is allowed, the firm
could buy the right to pollute from its neighbors. It would want to do so, so long as its excess
profits from polluting exceed the additional costs it would have to pay the people in the
neighborhood. Marginal benefits to the firm (additional profits from polluting) would decline
as marginal costs (increasing degrees of pollution) rise. At some level of production, the firm
would not be willing to buy pollution rights. The argument is symmetrical in that if firms get
the pollution rights, the same analysis would apply. In this instance the homeowners would
buy pollution reductions from the firm, but only up to the point where the marginal cost to
them was equal to the marginal benefits they receive. That point is exactly the same as the
one where the firm would have been unwilling to buy rights when homeowners had them.
This is the central insight offered by the Coase theorem: In a world in which bargaining costs
nothing, the assignment of legal liability to a particular party does not matter. A certain equi-
librium level of output and its resulting level of pollution will exist regardless of whether firms
or consumers own the air.*
Under the conditions of the Coase theorem, as described above, government interven-
tions (pollution guidelines, tax penalties, etc.) cannot improve on a settlement negotiated by
those parties who are directly involved with the externality problem. The theorem can be
used to analyze a number of real-world externality problems so long as bargaining and trans-
action costs are zero or negligible. Coase argued that if the judicial system makes a proper
assignment of liabilities (to the low-cost participant to the externality), market forces and
incentives may be sufficient to generate efficient solutions to externality problems. Their pres-
ence, in other words, provides no prima facie case for governmental interferences of a legisla-

(continued)
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420 Part IV ■ The Neoclassical Era

tive type (such as the Occupational Safety and Health Administration or the Environmental
Protection Agency in the United States).
What if transaction costs (i.e., the costs of defining and enforcing a system of ownership)
are significant in particular situations? In this event, a number of “solutions” have been tried.
These include taxing or subsidizing externalities (as in the Pigovian solution described in the
text); the government sale of “pollution rights” to offending firms, which could theoretically
get the offenders to reduce pollution to optimal levels; or direct regulation that requires firms
to install certain types of pollution-control equipment and other regulating devices. Because
these “solutions” are generally pursued in the arena of politics, practical outcomes are not
likely to be optimal. Sometimes just leaving the imperfect market solution alone may achieve
the best outcome in a variety of imperfect solutions. At any rate, the Coase theorem provides
a benchmark for analyzing externality problems.
*A whole new (post-1960) field of economics was originated by the Coase theorem. Called “law and eco-
nomics,” it studies the impact of legal rules and institutions on the economy. Many law schools have spe-
cialized fields in law and economics, and two journals (the Journal of Law and Economics and the Journal
of Legal Studies) publish a consistent flow of literature on the subject.

■ MARSHALL ON ELASTICITY, FACTOR DEMAND, AND

OPTIMAL RESOURCE ALLOCATION
Elasticity
One of the most useful tools in the microeconomist’s tool kit is the concept of
elasticity. Like many ideas refined by Marshall, the concept of elasticity can be
found in the works of earlier writers. Jenkin, for example, alluded to it in 1870. But
it was Marshall who gave the concept its mathematical character and its contempo-
rary standing.
Elasticity is a general concept that finds application in many circumstances. It
can be applied to the study of demand, supply, production, and so forth. In its gener-
alized form it simply measures the responsiveness of one variable to changes in
another variable. Armed with an understanding of the concept one can measure
price elasticity of demand, price elasticity of supply, input elasticity, output elastic-
ity, income elasticity, and so forth. We choose to examine Marshall’s use of price
elasticity of demand with the understanding that the concept has widespread appli-
cation in other circumstances as well.
As Marshall put it, “The elasticity (or responsiveness) of demand in a market is
great or small according as the amount demanded increases much or little for a
given fall in price, and diminishes much or little for a given rise in price” (Principles,
p. 102). “Much” or “little” are inexact terms, so Marshall gave the notion more preci-
sion. Price elasticity of demand is defined simply as the percentage change in quan-
tity demanded divided by the percentage change in price. Algebraically, ND = [QD/
QD] ÷ [P/P].12 Demand is considered elastic if ND is greater than 1, inelastic if less
than 1, and of unit elasticity if equal to 1.

12
Marshall also applied the basic concept to supply. Later, a “cross-elasticity” concept was devel-
oped. Cross-elasticity is defined as the responsiveness of the quantity demanded of a commodity
A to a change in price of another commodity B.
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 421

Marshall recognized the circumstances that determine elasticity in each

instance and gave numerous practical examples. Basically, he argued that ceteris
paribus demand is more elastic:
1. The greater the proportion of an individual’s total budget that expenditures on
the commodity represent (salt, for instance, is a necessity and also represents a
small expenditure for both rich and poor people)
2. The longer the price change is in effect (time again)
3. The larger the number of substitutes
4. The larger the number of uses to which the commodity can be put
For good measure, Marshall discussed how elasticity differed between rich, middle-
class, and poor buyers. In a passage clearly revealing his Victorian preoccupation
with classes, he noted the effect of acquired tastes on the demand for meat:
In the ordinary working class districts the inferior and the better joints [of meat]
are sold at nearly the same price: but some well-paid artisans in the north of Eng-
land have developed a liking for the best meat, and will pay for it nearly as high a
price as can be got in the west end of London, where the price is kept artificially
high by the necessity of sending the inferior joints away for sale elsewhere. (Princi-
ples, p. 107)

Always alert to modes of fashion and social standing, Marshall noted, “Part of the
demand for the more expensive kinds of good is really a demand for the means of
obtaining a social distinction, and is almost insatiable” (Principles, p. 106).
The usefulness of price and income elasticity of demand estimates, made possi-
ble by Marshall’s brilliant discussion of the concept, is fairly obvious in budget anal-
ysis and all aspects of consumption theory. But, in a common display of his broad
vision and acute perceptiveness, Marshall extended the notion of elasticity and its
usefulness beyond its realm in the theory of consumer behavior into the theory of
producer behavior—the demand for factor inputs (i.e., labor, capital, land).

Factor Demand13
The study of factor demand (derived demand for productive inputs) and factor-
demand elasticity was presumably initiated by Marshall, and subsequently
advanced further by A. C. Pigou and John R. Hicks. However, at least by the eighth
edition of the Principles, Marshall credited both Böhm-Bawerk and Irving Fisher
with related developments, and it seems fairly clear that Cournot was tinkering with
a similar concept as early as 1838.
Marshall’s discussion of the determinants of derived-factor-demand elasticity is
found chiefly in Book V of his Principles, in chapter 6 entitled “Joint and Composite
Demand, Joint and Composite Supply” (and in his mathematical notes XIV and XV,
pp. 852–854). Characteristically, rather than present an abstract, general theoretical
argument Marshall used homely examples involving plasterers employed in hous-
ing construction and knife handles used in making knives. Also characteristically,
Marshall did not make his underlying assumptions specific. Yet, he did make one
explicit statement that subsequent writers apparently overlooked, a statement that
places Marshall somewhat outside the frame of analysis of writers who followed his
lead. J. R. Hicks, R. G. D. Allen, and others interested in derived demand have

13
This section draws heavily on the treatment of factor demand in S. C. Maurice, “On the Impor-
tance of Being Unimportant” (see references).
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422 Part IV ■ The Neoclassical Era

almost uniformly assumed long-run competitive equilibrium. Marshall, however,

clung to the short run:
The period over which the disturbance extends being short, and the causes of
which we have to account as re-adjusting demand and supply being only such as
are able to operate within that short period . . . we should notice that, referring as
it does to short periods, it is an exception to our general rule of selecting . . . cases
in which there is time enough for the full long-period action of the forces of supply
to be developed. (Principles, p. 382)

In his example involving plasterers’ labor, Marshall seems generally to assume

variable-proportions production, or something very much like it. But like Carl
Menger (see chapter 14), he was undecided in this area. His statement, “A tempo-
rary check to the supply of plasterers’ labour will cause a proportionate check to the
amount of building” suggests fixed proportions, at least as far as plasterers’ labor is
concerned, and his results seem consistent with the assumption of fixed propor-
tions; paradoxically, Marshall implied variable factor proportions throughout his
discussion. Variable proportions enter chiefly through commodity demand, that is,
through a change in the product. Marshall wrote that
an increased difficulty in obtaining one of the factors of a finished commodity can
often be met by modifying the character of the finished product. Some plasterers’
labour may be indispensable; but people are often in doubt about how much plas-
ter work it is worthwhile to have in their houses, and if there is a rise in its price
they will have less of it. (Principles, p. 386)

Whether proportions are fixed or not, Marshall stated the fundamental law of
derived demand in clear terms: “The demand schedule for any factor of production
of a commodity can be derived from that for the commodity by subtracting from the
demand price of each separate amount of the commodity the sum of the supply
prices for corresponding amounts of the other factors” (Principles, p. 383). Blades
and handles are used in fixed proportions to make knives. Knowing the supply of
blades and the demand for knives, the problem Marshall posed was that of deter-
mining the derived demand for handles. He treated the problem both graphically
and mathematically. Marshall’s graphic model is reproduced as figure 16-10, in a
figure that is related to the Mill–Marshall joint-supply model (and constructed in the
same manner as figure 8-1).
Here the demand for knives DD is given, as are the supply functions for knives
and handles SS and ss, respectively. Now the problem is to derive a demand func-
tion for handles, and Marshall uses the following conventions. Take a quantity OM
of knives. MP is the demand price for OM knives. The supply price of OM knives is
MQ, and the supply price of the handles for OM knives is Mq. The difference, Qq, is
the supply price of OM blades. Now in order to obtain the demand price for handle
inputs (to produce quantity OM), Marshall simply subtracted the supply price of
blades (Qq) at OM from the demand price for knives (MP) at OM. A demand price
Mp (MP – Qq) is thus obtained for handles. It can be seen that Qq equals Pp. An
identical procedure is followed for all other quantities of knives, and a demand
function dd for handles may thereby be traced out. The demand price for blades is
simply the difference between the total-knife-demand price and the derived-
demand price for handles. The supply price for blades is given objectively by the
difference between the two supply functions SS and ss.
Equilibrium, in the model described by figure 16-10, takes place when quantity
OB of knives is produced at price BA. The derived demand for handles dd inter-
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 423

Price
(knives) S ‫( ׳‬knives)
D
s‫( ׳‬handles)
P
d

p A

Figure 16-10 At equi-

librium A, the price of S Q
handles, Ba, is determined a
D ‫( ׳‬knives)
by the intersection of ss s q
and dd, and the price of d ‫( ׳‬handles)
blades, aA, is determined
by subtracting Ba from O M B Quantity
the supply of knives. (knives)

sects the handle-supply function at a, and the equilibrium price paid for handles is
Ba; whereas the equilibrium price paid for blades is established at Aa. (Obviously,
Ba + aA = BA.) The demand for any input can be derived, then, if one knows the
supply prices of the other factors and the demand for final output.

Resource Allocation and the Distribution of Product

In his theory of derived demand Marshall allowed fixed input proportions as a
first approximation. His statements are not well organized, but at least in the short
run Marshall adhered to a marginal-productivity theory of distribution. At various
points in the Principles, Marshall asserted that for the most efficient allocation of
resources, all inputs should be hired up to the point where their marginal product
equals their marginal cost. The following passage is a summary statement of Mar-
shall’s famous “principle of substitution.”
Every agent of production, land, machinery, skilled labour, unskilled labour, etc.,
tends to be applied in production as far as it profitably can be. If employers, and
other businessmen, think that they can get a better result by using a little more of
any one agent they will do so. They estimate the net product (that is the net
increase of the money value of their total output after allowing for incidental
expenses) that will be got by a little more outlay in this direction, or a little more
outlay in that; and if they can gain by shifting a little of their outlay from one direc-
tion to another, they will do so.
Thus, then the uses of each agent of production are governed by the general
conditions of demand in relation to supply: that is, on the one hand, by the urgency
of all the uses to which the agent can be put, taken together with the means at the
command of those who need it; and, on the other hand, by the available stocks of
it. And equality is maintained between its values for each use by the constant ten-
dency to shift it from uses in which its services are of less value to others in which
they are of greater value, in accordance with the principle of substitution. (Princi-
ples, pp. 521–522)
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424 Part IV ■ The Neoclassical Era

In a number of chapters (Principles, Book VI, chaps. 1–13), replete with practi-
cal examples, Marshall described the returns to the several factors of production.
Rent is a return to inputs absolutely fixed in supply and without alternative opportu-
nities, but Marshall also introduced the notion of “quasi-rent,” a return to temporar-
ily fixed factors devoted to production in the short run. Quasi-rent, as conceived by
Marshall, is of the nature of “sunk capital.” According to George Stigler, Marshall’s
statement is “merely another way of saying that only prime or variable costs are
price-determining in the short run” (Production and Distribution Theories, p. 95). In
the long run, returns to these fixed investments must be covered by market price, or
capital will exit the industry. In other words, only in the short run is quasi-rent (the
difference between total cost and variable cost) not a necessary payment in order
for output to be produced.
Marshall’s treatment of the returns to labor typifies the new microeconomic
approach to an age-old problem. Under the new paradigm the demand for labor
depends on its marginal productivity, as does the demand for any factor input. But
the conditions governing the supply of labor differ markedly in the two Marshallian
market periods. In the short run, Marshall adopted a theory of labor supply very
much like the one propounded by Jevons (see chapter 15). Jevons had focused on
the intersection of the marginal disutility of labor and the marginal utility of real
income (represented by the marginal utility of the money wage). In Jevons’s model,
laborers stop working when the marginal utility of their wage is equal to the mar-
ginal disutility of work. Although he admitted exceptions, Marshall believed that as
a general rule, the supply of labor was positively related to the reward for labor in
both long-run and short-run situations.
Marshall held that labor supply in the long run was governed chiefly by the cost
of producing labor. Classical economists said as much and argued that long-run
wages would tend toward subsistence. But in view of the fact that wages exceeded
subsistence in England, Marshall was compelled to explain why wages were higher
than the cost of producing labor. His explanation focused on both the physical and
the mental powers of the worker. In anticipation of what was to become known later
as the “human capital” theory, Marshall recognized the cost of acquiring certain
marketable skills. Often, those who pay the cost of acquiring skills do not reap the
rewards, as for example, when parents pay for their children’s education. In such
matters the profit motive may not be a reliable guide. Parents would presumably
educate their children in occupations in which the reward-to-expense ratio is great-
est. But the lag between investment and return is quite long, often fifteen to twenty
years. Prediction over a period of this length is often impossible. Moreover, incomes
of parents differ, which means that expenditures (or investments) in rearing and
educating labor will be significantly different. According to Marshall these and other
rigidities explained the widely differing wage rates observed in England at the time.

■ MARSHALL ON CAPITAL AND ENTREPRENEURSHIP

Marshall explained the returns to capital (interest) and entrepreneurship (prof-
its) in the same manner, thus displaying the sweeping application of marginal anal-
ysis. The demand for capital, which is subject to diminishing returns, is its marginal
productivity, and Marshall clearly indicated that capital would be applied up to the
point where its marginal value product equaled the rate of interest (Principles, p.
520). But in the long run, assuming a perfectly competitive system, the real return to
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 425

capital would be determined, as is the case for all factors of production, by its cost
of production.
Overall, Marshall’s treatment of distribution relied heavily on his Anglo-Saxon
heritage, and it is particularly reminiscent of Smith’s and Ricardo’s handling of the
question. It may well be that he placed too much emphasis on cost of production as
an explanation for factor returns, as did his classical academic forebears. His discus-
sion is also often criticized for general lack of rigor, which is undoubtedly the case.
All this notwithstanding, Marshall was perhaps never so close to practical wisdom
as when he analyzed, through numerous examples, the reasons for wage and profit
differentials or the impact of risk on rate of return. His practical knowledge of busi-
ness behavior and actual markets was phenomenal, all of which makes his discourse
on distribution one of the most enjoyable and profitable parts of the Principles. Also,
his adherence to the popular theories of the day, most particularly the evolutionary
biology of Darwin and Wallace, gave his ruminations on the subject a distinctively
“modern” flavor. The peculiar skill of the entrepreneur, Marshall argued, is shaped
by an economic struggle for survival in the competitive marketplace.
To the extent that they entertained the subject at all, many early neoclassical
writers, with the exception of the Germans, approached entrepreneurship as a cog in
the theory of income distribution. That is to say, they were more interested in explain-
ing the reward to the entrepreneur as a factor return than investigating the role of the
entrepreneur as a motivating force of economic development or as an equilibrating/
disequilibrating force in a market system. Marshall paid more attention than his col-
leagues to the nature and function of entrepreneurship because he was heavily influ-
enced by the German tradition on the one hand and the principles of biological
evolution expounded by Charles Darwin and Alfred Wallace on the other. It would be
misleading to claim a theory of entrepreneurship on Marshall’s behalf, but at the
same time he was more devoted to the subject than many of his contemporaries.
Marshall argued that profit represents a payment for business ability, a slippery
concept, but one that opened a more promising avenue than Mill’s rather limited
idea that profits are “the wages of superintendence.” Marshall accepted Mill’s
explanation up to a point, but followed Mangoldt (chap. 14) in treating entrepre-
neurial profit as a kind of “rent of ability.” The analogy to rent, he claimed, is more
appropriate because entrepreneurial talents tend to be in limited supply (like land)
and unique to individuals who are capable of exercising imagination and shrewd
judgment. How did Marshall reconcile the contrasting views of Mill and Mangoldt?
He thought of entrepreneurs both as individuals and as a class. As a class, Marshall
posited that entrepreneurs’ rewards are commensurate with the levels of human
capital they acquired; but as individuals, he maintained that entrepreneurs receive a
differential return, akin to rent, and hence equal to their marginal productivity.
The class of business undertakers contains a disproportionate number of persons
with high natural ability; since, in addition to the able men born within its ranks it
includes also a large share of the best natural abilities born in the lower ranks of
industry. And thus while profits on capital invested in education is a specially impor-
tant element in the incomes of professional men taken as a class, the rent of rare
natural abilities may be regarded as a specially important element in the income of
businessmen, so long as we consider them as individuals. (Principles, p. 623)

In Industry and Trade, more so than in Principles, Marshall reserved a special

place for the human agent that directs rather than follows economic circumstances.
He described the elements of “business genius” as alertness, sense of proportion,
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426 Part IV ■ The Neoclassical Era

strength of reasoning, coordination, innovation, and willingness to take risks

(Industry and Trade, pp. 356, 358). He argued that this combination of abilities
could be acquired through experience, but not taught by formal education. He
divided entrepreneurs into two classes, active and passive. Active entrepreneurs are
“those who open out new and improved methods of business,” whereas passive
entrepreneurs are “those who follow beaten tracks” (Industry and Trade, p. 597). He
attributed “wages of superintendence” to the latter group of passive entrepreneurs
and “rent of ability” to the former group of active entrepreneurs, whose reward is
subject to risk. The venturesome entrepreneur cannot avoid risk because he directs
capital and labor to an uncertain end. In order to be successful, therefore, he must
be capable of conceiving “wise and far reaching policies, and . . . carry[ing] them
out calmly and resolutely” (Industry and Trade, p. 606).
At bottom, Marshall’s entrepreneur was a business manager, although he used
the term management to mean more than mere superintendence. Following Dar-
win, Marshall argued that professional business managers emerge as a special
group from an evolutionary process that is driven by specialization and division of
labor. This “Darwinism” may explain Marshall’s inability or unwillingness to tie the
entrepreneur to a single function or set of abilities. The concept itself seems to
evolve endlessly in Marshall’s writings, but in the final analysis, he placed more
emphasis on the existence and necessity of business ability than on anything else.14
In his early work, Marshall stressed duty as an important stimulus to human
action. But his faith in the widespread application of this Victorian virtue dwindled
during the 1880s. After 1890, Marshall placed the chief responsibility for the eco-
nomic and moral progress of society on the restless, farsighted, pioneering, but
unsung entrepreneur. By 1907, duty had receded farther into the background, and
Marshall was extolling the entrepreneur for his imagination as well as his leadership:
Men of this class live in constantly shifting visions, fashioned in their own brains,
of various routes to their desired end; of the difficulties which nature will oppose
to them on each route, and of the contrivances by which they hope to get the better
of her opposition. This imagination gains little credit with the people, because it is
not allowed to run riot; its strength is disciplined by a stronger will; and its highest
glory is to have attained great ends by means so simple that no one will know, and
none but experts will even guess, how a dozen other expedients, each suggesting
as much brilliancy to the hasty observer, were set aside in favour of it. (Memorials,
pp. 332–333)

In a purely analytical sense, the most important contribution Marshall made to

the theory of entrepreneurship was to extend Mangoldt’s notion of rent-of-ability,
though he did not, as Schumpeter points out, restrict the idea to the entrepreneur
(History, p. 894). Freeing himself from the analytical impediments of the classical
wages-fund doctrine, Marshall attempted to cut through the amorphous nature of
“labor” to capture the uniqueness of individual ability. Observation and experience
told him that “business genius” was unevenly distributed and that unique skills
received a kind of surplus, or rent.
Despite the fact that Marshall wrote during the high tide of competitive capital-
ism, his theory of entrepreneurship gave little prominence to invention and innova-
tion. Also, despite his lip service to evolution as a vital force in economics, he

14
In a parallel vein, Marshall made the simple declaration, “Knowledge is our most powerful engine
of production”—an insight that is especially resonant in the digital age, which is often referred to
as “the knowledge economy.”
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 427

devoted his intellectual energies mainly to advancing the theory of comparative

statics and partial equilibrium. For the most part, his students and disciples fol-
lowed suit.

■ CONCLUSION
Alfred Marshall’s Principles was, in a significant sense, a benchmark in the
development of economics. But as we have seen, a number of important writers
contributed to the corpus of neoclassical microanalysis before the publication of
Marshall’s classic work. (We return to this theme again in the following chapter.)
Cournot, Dupuit, Jevons, and Walras, to mention only the most seminal contribu-
tors, antedated Marshall’s concerns. On separate points of doctrine (e.g., consumer
surplus, demand, monopoly, joint supply, and marginal productivity), Marshall’s
inventions were upstaged by the aforementioned writers and by John Stuart Mill.
Objectively, on a doctrine-by-doctrine basis, Marshall does not rank extremely high
on originality, although it is true that he developed many ideas independently and
with more intensity and unusual clarity.
On what basis, then, does Marshall’s great (and largely untarnished) reputation
lie? As in the case of Adam Smith, his fame is due principally to the fact that he
wrote a book that caught the academic spirit of the time. He did so, moreover, by
directing his appeal to the intelligent layperson. In modern parlance, he “put it all
together”; Marshall synthesized classical and neoclassical analyses of cost and util-
ity, producing one cogent engine of far-reaching economic analysis.
But, as we have seen, Marshall was much more than a mere synthesizer. His
partial equilibrium method became a kind of glue that bound all the various
branches of economic theory together. The use of conceptual time, which was at the
heart of this method, was a massive and original contribution to modern economic
theory and policy. In addition to numerous original theoretical inventions, Marshall
never touched a “received” concept without extending or improving it.
There is little doubt that Marshall was a great theorist, but we tend to lose sight
of the fact that he was also a very practical man. A probable reason for the subse-
quent emphasis on the theoretical aspects of his work is that Marshall’s students
(whose names almost form a litany of great twentieth-century British theorists)
chose to work on and refine the theoretical concepts of the Principles. In other
words, there appears to be a large and unfortunate gap between Marshall’s interests
in economics and those of the Marshallians, his students and disciples. The Mar-
shallians viewed their task as clarifying and developing the analytical areas of the
Principles, while simultaneously ignoring and dismissing the practical context in
which Marshall encased his ideas. Thus, Marshall has often been accused of mak-
ing ambiguous statements of certain theoretical ideas. But many of these criticisms
are misdirected, for they fail to treat Marshall’s theory as he often treated it him-
self—as a tool for attacking practical social and economic problems. As indicated in
the present chapter, an understanding of the several levels of abstraction he used in
dealing with demand curves might have forestalled the protracted debate over the
nature of the formal specification of demand in the Principles. Marshall’s “ambigui-
ties,” moreover, apparently have not forced other theorists to view all sides of eco-
nomic questions, as he strove to do.
If Marshall were alive today, his quest for an economic analysis that could be
used in practical economic problems might even lead him to characterize the theo-
retical developments that sprang from the Principles as “overelaborate.” The com-
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428 Part IV ■ The Neoclassical Era

plex process of mathematizing economic analysis, which the discipline has been
undergoing for many decades, appears alien to the concept of the nature and pur-
pose of economics. Marshall demanded empirical, or at least imaginable, referents to
all his analytical tools. Many subsequent theorists of high reputation—some claiming
to be disciples of Marshall—have been equally as adamant in demanding none.
Marshall, of course, was always ready to point out the gaps and deficiencies in
his analytical constructs. But his conception of the nature of economics was focused
on suggested applications, making allowance for the analytical deficiencies that
inevitably accompany a social science. He would probably be the first to laud the
development of theoretical improvements, but he would as surely criticize the cleav-
age between theory and actual events that marks a great deal of contemporary eco-
nomics. The kernel of Marshall’s genius lay in his ability to learn from economic
and social problems and, in turn, to contribute toward their solution.

REFERENCES
Blaug, Mark. Economic Theory in Retrospect, 4th ed. London: Cambridge University
Press, 1985.
Coase, Ronald. “The Problem of Social Cost,” Journal of Law and Economics, vol. 3
(October 1960), pp. 1–44.
Friedman, Milton. “The Marshallian Demand Curve,” Journal of Political Economy, vol.
57 (December 1949), pp. 463–495.
Hicks, John R. The Theory of Wages. London: Macmillan, 1932. Revised 1968.
Foxwell, H. S., “The Economic Movement in England,” Quarterly Journal of Economics,
vol. 2 (October 1887), pp. 84–103.
Marshall, Alfred. Principles of Economics, 8th ed. London: Macmillan, 1920.
———. Industry and Trade, 3rd ed. London: Macmillan, 1920.
———. Memorials of Alfred Marshall, A. C. Pigou (ed). London: Macmillan, 1925.
Maurice, S. C. “On the Importance of Being Unimportant: An Analysis of the Paradox in
Marshall’s Third Rule of Derived Demand,” Economica, vol. 42 (November 1975),
pp. 385–393.
Pigou, A. C. Wealth and Welfare. London: Macmillan, 1912.
———. The Economics of Welfare. London: Macmillan, 1920.
Stigler, George J. Production and Distribution Theories. New York: Macmillan, 1941.

NOTES FOR FURTHER READING

The University of Florence (Italy) publishes a Marshall Studies Bulletin, devoted to
studies on Alfred Marshall’s economics and, more generally, to the history of economic
ideas in Britain from the nineteenth to the twentieth century. An electronic version of
this bulletin is available online at http://www.dse.unifi.it/CMpro-v-p-121.html. John Sut-
ton’s Marshall’s Tendencies: What Can Economists Know? (Boston: MIT Press, 2000) is
essential reading for understanding the “standard paradigm” of economics and Mar-
shall’s role in its construction. For some serious fun, especially for mystery buffs, see a
series of books by Marshall Jevons: Murder at the Margin (Princeton: Princeton Univer-
sity Press, 1978); The Fatal Equilibrium (New York: MIT Press, 1985); and A Deadly
Indifference (New York: Carroll and Ampersand Graf Publishers, 1995). These are rivet-
ing “whodunits” in which master-sleuth, Henry Spearman, employs Marshallian analysis
to solve murders. “Marshall Jevons” is the pen name of economists William Breit and
Kenneth G. Elzinga.
The secondary literature on Marshall and his ideas is enormous and growing. On
Marshall himself, the most comprehensive single source is Peter Groenewegen, A Soar-
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 429

ing Eagle: Alfred Marshall, 1842–1924 (Aldershot, UK: Edward Elgar, 1995). See also, J.
M. Keynes, “Alfred Marshall,” Economic Journal, vol. 34 (September 1924), pp. 311–372,
reprinted in Keynes’s Essays in Biography (London: Macmillan, 1933). Keynes’s Essays
also contains a memoir on Marshall’s wife, “Mary Paley Marshall (1850–1944).” R. H.
Coase, “Alfred Marshall’s Mother and Father,” History of Political Economy, vol. 16 (Win-
ter 1984), pp. 519–527, rounds out the family portraits. The Memorials of Alfred Mar-
shall, edited by his student A. C. Pigou (see references), should not be missed. For later
assessments of Marshall’s work by Marshallians, see G. F. Shove, “The Place of Mar-
shall’s Principles in Economic Theory,” and C. W. Guillebaud, “The Evolution of Mar-
shall’s Principles,” both appearing in the Economic Journal, vol. 52 (December 1942), pp.
294–329, 330–349. T. W. Hutchison’s Review of Economic Doctrines 1870–1929, chap. 4
(Oxford: Clarendon Press, 1953), contains a brief interpretive account of Marshall.
For an interesting, though not exhaustive, discussion of Marshall’s method, see R.
H. Coase, “Marshall on Method,” Journal of Law and Economics, vol. 18 (April 1975), pp.
25–31; H. Brems, “Marshall on Mathematics,” Journal of Law and Economics, vol. 18
(October 1975), pp. 583–585; E. F. Beach, “Marshallian Methodology,” International Jour-
nal of Social Economics, vol. 14 (1987), pp. 19–26; Stephen Pratten, “Marshall on Ten-
dencies, Equilibrium, and the Statical Method,” History of Political Economy, vol. 30
(Spring 1998), pp. 121–163; and Andrew Vasquez, “Marshall and the Mathematization of
Economics,” Journal of the History of Economic Thought, vol. 17 (Fall 1995), pp. 247–265.
David Reisman has authored a trilogy on Marshall in which he examines, respec-
tively, the different aspects of Marshall’s thought: economics, politics, and ethics. See, in
order, The Economics of Alfred Marshall (London: Macmillan, 1986); Alfred Marshall:
Progress and Politics (New York: St. Martin’s, 1987); and Alfred Marshall’s Mission (New
York: St. Martin’s, 1990). R. D. C. Black, “Jevons, Marshall and the Utilitarian Tradition,”
Scottish Journal of Political Economy, vol. 37 (February 1990), pp. 5–17, provides addi-
tional insight into Marshall’s tendency to treat economics as applied ethics. Among other
things, Black concludes that although Jevons was a thoroughgoing Benthamite, Marshall
was not. Marshall famously said that he wanted to use economics as a vehicle for social
reform, i.e., doing “good.” For evidence that he really did want to “do good” see Rhead S.
Bowman, “Marshall: Just How Interested in Doing Good Was He?” Journal of the History
of Economic Thought, vol. 26 (December 2004), pp. 493–518.
An excellent and detailed overview of Marshall’s contributions to analysis may be
found in chaps. 9 and 10 of Mark Blaug’s Economic Theory in Retrospect (see refer-
ences). Milton Friedman’s essay entitled “The Marshallian Demand Curve” (see refer-
ences) offers a persuasive case for identifying the Marshallian demand curve with a
constant-purchasing-power-of-money assumption. Other Marshallian writers, such as
Hicks, disagree. See the classic paper by J. R. Hicks and R. G. D. Allen, “A Reconsidera-
tion of the Theory of Value,” Economica, n.s., vol. 1 (February, May 1934), pp. 52–76, 196–
219. See also M. J. Bailey’s comment on Friedman’s paper, “The Marshallian Demand
Curve,” Journal of Political Economy, vol. 62 (June 1954), pp. 255–261. For a sketch of
developments related to the Marshallian demand curve, see R. B. Ekelund, Jr., E. G.
Furubotn, and W. P. Gramm, The Evolution of Modern Demand Theory, chap. 2 (Boston:
Heath, 1972). Also useful is John Aldrich, “The Course of Marshall’s Theorizing About
Demand,” History of Political Economy, vol. 28 (Summer 1996), pp. 171–217. Marshall’s
“Giffen Paradox,” which posits the possibility of a positively sloped demand curve, is ana-
lyzed by G. J. Stigler in “Notes on the History of the Giffen Paradox,” Journal of Political
Economy, vol. 55 (April 1947), pp. 152–156. But for a more recent assessment of Stigler’s
position, see William P. Gramm, “Giffen’s Paradox and the Marshallian Demand Curve,”
The Manchester School of Economic and Social Studies, vol. 38 (March 1970), pp. 65–71.
The firm’s envelope or planning curve, which simplifies Marshall’s long-run analysis,
was developed by Jacob Viner in his classic paper, “Cost Curves and Supply Curves,”
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430 Part IV ■ The Neoclassical Era

Zeitschrift fur Nationalökonomie, vol. 3 (September 1931), pp. 23–46. Marshall’s fiction of
the representative firm is severely criticized in Lionel Robbins, “The Representative Firm,”
Economic Journal, vol. 38 (September 1928), pp. 387–404. The whole area of Marshall’s
theories of production and distribution is brought under skillful and critical review in
chap. 4 of Stigler’s Production and Distribution Theories (see references). On the suffusion
of Marshall’s time period method into his theory of distribution, see H. M. Robertson’s
“Alfred Marshall’s Aims and Methods Illustrated from His Treatment of Distribution,” His-
tory of Political Economy, vol. 2 (Spring 1970), pp. 1–64. Likewise, see G. L. S. Shackle,
“Marshall’s Accommodation of Time,” in Epistemics and Economics (London: Cambridge
University Press, 1972); and P. C. Dooley, “Alfred Marshall: Fitting the Theory to the
Facts,” Cambridge Journal of Economics, vol. 9 (September 1985), pp. 245–255.
Marshall’s fundamental contribution to time-period analysis in market exchange is
also the subject of P. L. Williams, “A Reconstruction of Marshall’s Temporary Equilibrium
Pricing Model,” History of Political Economy, vol. 18 (Winter 1986), pp. 639–653. In the
same broad vein, see J. M. Gee, “Marshall’s Views on ‘Short-Period’ Value Formation,”
History of Political Economy, vol. 15 (Summer 1983), pp. 181–205; O. F. Hamouda, “On
the Notion of Short-Run and Long-Run: Marshall, Ricardo and Equilibrium Theories,”
British Review of Economic Issues, vol. 6 (Spring 1984), pp. 55–82; and Michel De Vroey,
“Marshall on Equilibrium and Time: A Reconstruction,” The European Journal of the His-
tory of Economic Thought, vol. 7 (Summer 2000), pp. 245–269, which tries to sort out the
differences between Marshallian and Walrasian concepts of equilibrium.
R. B. Ekelund, Jr., and R. F. Hébert, “The Dupuit–Marshall Theory of Competitive
Equilibrium,” Economica, vol. 66 (May 1999), pp. 225–240, compare Dupuit’s method
with Marshall’s and conclude that they shared a vision of how economic markets work,
as well as how scientific inquiry on the subject is to be conducted. Marshall’s theory of
exchange has also been reviewed by D. A. Walker, “Marshall’s Theory of Competitive
Exchange,” Canadian Journal of Economics, vol. 2 (November 1969), pp. 590–597. The
following two articles by D. A. Walker on Marshall’s long-run and short-run concepts of
labor supply should be read in tandem: “Marshall on the Long-Run Supply of Labor,”
Zeitschrift für die Gesamte Staatswissenschaft (October 1974), pp. 691–705, and “Mar-
shall on the Short-Run Supply of Labor,” Southern Economic Journal, vol. 41 (January
1975), pp. 429–441. Joseph Persky, “Marshall’s Neo-classical Labor Values,” Journal of
the History of Economic Thought, vol. 21 (September 1999), pp. 257–268, establishes that
Marshall did not entirely forsake key classical concerns.
The related issues of external economies and increasing returns (decreasing costs)
have probably been responsible for more debate than any others discussed in Marshall’s
Principles. As we saw in the text of the present chapter, A. C. Pigou translated the con-
cept of external economies into a divergence between marginal social costs and mar-
ginal private costs. The Pigovian solution was to levy a tax (or a subsidy in the opposite
case) on the industry. In 1924, however, Frank Knight challenged Pigou’s discussion on
several crucial points, demonstrating that competition does not lead to excessive invest-
ment as Pigou (and others) had alleged. See Knight, “Some Fallacies in the Interpreta-
tion of Social Costs,” Quarterly Journal of Economics, vol. 38 (August 1924), pp. 582–606.
The important connection between Pigou’s welfare economics and the earlier work
of Henry Sidgwick is established by Margaret G. O’Donnell in “Pigou: An Extension of
Sidgwickian Thought,” History of Political Economy, vol. 11 (Winter 1979), pp. 588–605.
Roger Backhouse, “Sidgwick, Marshall and Cambridge,” History of Political Economy,
vol. 38 (Spring 2006), pp. 15–44, maintains that Sidgwick’s influence went beyond Pigou
and attempts to overcome the marginalization of Sidgwick’s role in the development of
the broader Cambridge tradition.
The modern Coasian criticism has created an entirely new area of economics—the
economics of property rights. A good place to start in this vast literature is the survey by
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Chapter 16 ■ Alfred Marshall and the Neoclassical Synthesis 431

E. G. Furubotn and S. Pejovich, “Property Rights and Economic Theory: A Survey of

Recent Literature,” Journal of Economic Literature, vol. 10 (December 1972), pp. 1137–
1157. Nahid Aslanbeigui and Steven Medema, “Beyond the Dark Clouds: Pigou and
Coase on Social Cost,” History of Political Economy, vol. 30 (Winter 1998), pp. 601–625,
attempt to narrow the differences between the Pigovian and Coasian approaches.
On the subject of consumer surplus and particularly Marshall’s role in its develop-
ment, see P. C. Dooley, “Consumer’s Surplus: Marshall and His Critics,” Canadian Jour-
nal of Economics, vol. 16 (February 1983), pp. 26–38, and R. B. Ekelund, Jr., and R. F.
Hébert, “Consumer Surplus: The First Hundred Years,” History of Political Economy, vol.
17 (Fall 1985), pp. 419–454.
The question of the existence and, indeed, of the usefulness of the concepts of
industries of constant, increasing, or decreasing returns was raised by J. H. Clapham in a
delightful paper, “Of Empty Economic Boxes,” Economic Journal, vol. 32 (September
1922), pp. 458–465, and D. H. Robertson extended the criticism of the concept in “Those
Empty Boxes,” Economic Journal, vol. 34 (March 1924), pp. 16–31. The incompatibility
of competitive equilibrium and a condition of decreasing costs (increasing returns),
which led partly to the development of the theory of imperfect competition, was brought
out in a brilliant paper by Piero Sraffa, “The Laws of Returns under Competitive Condi-
tions,” Economic Journal, vol. 36 (December 1926), pp. 535–550. The Viner, Knight,
Clapham, Pigou, Robertson, and Sraffa papers mentioned here are reprinted in Readings
in Price Theory, George J. Stigler and Kenneth E. Boulding (eds.) (Homewood, IL: Irwin,
1952). R. Prendergast, “Increasing Returns and Competitive Equilibrium—The Content
and Development of Marshall’s Theory,” Cambridge Journal of Economics, vol. 16
(December 1992), pp. 447–462, deals with this “reconciliation problem,” emphasizing
Marshall’s reliance on biological conceptions. See also N. Hart, “Increasing Returns and
Marshall’s Theory of Value,” Australian Economic Papers, vol. 59 (December 1992), pp.
234–244.
Marshall as “historicist-evolutionist” and the influence of Darwin on his thought are
discussed by the prominent sociologist Talcott Parsons in two classic papers: “Wants and
Activities in Marshall,” Quarterly Journal of Economics, vol. 46 (November 1931), pp.
101–140, and “Economics and Sociology: Marshall in Relation to the Thought of His
Time,” Quarterly Journal of Economics, vol. 46 (February 1932), pp. 316–347. On this
important issue, see Marshall’s own statements in “The Old Generation of Economists
and the New,” Quarterly Journal of Economics, vol. 11 (January 1897), pp. 115–135,
reprinted in Memorials of Alfred Marshall, A. C. Pigou, ed. Several writers have contin-
ued to explore this nebulous idea up to the present time. See, for example, Tiziano Raffa-
elli, Marshall’s Evolutionary Economics (London: Routledge, 2003); same author,
“Whatever Happened to Marshall’s Industrial Economics?” The European Journal of the
History of Economic Thought, vol. 11 (Summer 2004), pp. 209–229; A. A. Awan, “Mar-
shallian and Schumpeterian Theories of Economic Evolution: Gradualism vs. Punctual-
ism,” Atlantic Economic Journal, vol. 14 (December 1986), pp. 37–49; A. L. Levine,
“Marshall’s Principles and the Biological Viewpoint: A Reconsideration,” Manchester
School of Economic and Social Studies, vol. 51 (September 1983), pp. 276–293; and N. B.
Niman, “Biological Analogies in Marshall’s Work,” Journal of the History of Economic
Thought, vol. 13 (Spring 1991), pp. 19–36. Niman examines Marshall’s (not entirely suc-
cessful) attempt to build an economic theory based on the foundations of natural science.
For more evidence of Marshall’s sociology and his tendency to blend it with his eco-
nomics, see T. Levitt, “Alfred Marshall: Victorian Relevance for Modern Economics,”
Quarterly Journal of Economics, vol. 90 (August 1976), pp. 426–444; M. A. Pujol, “Gender
and Class in Marshall’s Principles of Economics,” Cambridge Journal of Economics, vol. 8
(September 1984), pp. 217–234; R. M. Tullberg, “Marshall’s Tendency to Socialism,” His-
tory of Political Economy, vol. 7 (Spring 1975), pp. 75–111; A. Petridis, “Alfred Marshall’s
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432 Part IV ■ The Neoclassical Era

Attitudes to the Economic Analysis of Trade Unions,” History of Political Economy, vol. 5
(Spring 1973), pp. 165–198; and J. D. Chasse, “Marshall, the Human Agent and Economic
Growth: Wants and Activities Revisited,” History of Political Economy, vol. 16 (Fall 1984),
pp. 381–404. The latter explores the relations Marshall developed between income distri-
bution, the standard of living, and economic growth. P. C. Dooley, “Marshall’s Parable of
the Meteoric Stones: Rent, Quasi-Rent and Interest,” American Journal of Economics and
Sociology, vol. 50 (April 1991), pp. 197–206, explores special assumptions required to rec-
oncile the classical theory of distribution with the neoclassical theory. Peter Groenewe-
gen, “Marshall’s Treatment of Technological Change in Industry and Trade,” The
European Journal of the History of Economic Thought, vol. 17 (December 2010), pp. 1253–
1269, examines Marshall’s view of the causes of technological change and its implications
for firm size. Technological change is also an important part of the section of Marshall’s
Industry and Trade (see references) dealing with changes in business organization.
The growing professionalism of economics in his day and particularly Marshall’s
contribution to it are the subjects of J. Maloney, “Marshall, Cunningham and the Emerg-
ing Economics Profession,” Economic History Review, vol. 29 (August 1976), pp. 440–
451; and R. F. Hébert, “Marshall: A Professional Economist Guards the Purity of His Dis-
cipline,” in R. V. Andelson (ed.), Critics of Henry George (London: Associated University
Presses, 1979). Katia Caldari, “Alfred Marshall’s Critical Analysis of Scientific Manage-
ment,” The European Journal of the History of Economic Thought, vol. 14 (March 2007),
pp. 55–78, examines Marshall’s views on scientific management, both critical and affir-
mative. For more on Marshall’s views of entrepreneurship, see Laurence Moss, “Biologi-
cal Theory and Technological Entrepreneurship in Marshall’s Writings,” Eastern
Economic Journal, vol. 8 (January 1982), pp. 3–13.
Finally, some of the best and most interesting recent work on Marshall is that of
John K. Whitaker, especially on the matter of the early development of Marshall’s
thought. See Whitaker’s “Alfred Marshall: The Years 1877 to 1885,” History of Political
Economy, vol. 4 (Spring 1972), pp. 1–61; and same author, “Some Neglected Aspects of
Alfred Marshall’s Economic and Social Thought,” History of Political Economy, vol. 9
(Summer 1977), pp. 161–197. Professor Whitaker has also edited two volumes contain-
ing the early writings of Marshall: The Early Economic Writings of Alfred Marshall,
1867–1890 (New York: Free Press, 1975).
The year 1990 marked the centennial of Marshall’s Principles and spawned a num-
ber of centenary tributes. For two broad retrospectives, see Centenary Essays on Alfred
Marshall, J. K. Whitaker (ed.) (Cambridge: Cambridge University Press, 1990); and
Alfred Marshall in Retrospect, R. M. Tullberg (ed.) (Brookfield, VT: Edward Elgar, 1990).
D. P. O’Brien’s contribution to Centenary Essays should be read in conjunction with G.
Argyrous, “The Growth of Knowledge and Economic Science: Marshall’s Interpretation
of the Classical Economists,” History of Political Economy, vol. 22 (Fall 1990), pp. 529–
537. For more retrospectives, see the Scottish Journal of Political Economy, vol. 37 (Feb-
ruary 1990), an issue devoted mainly to Marshall. Especially noteworthy are the articles
by D. P. O’Brien, “Marshall’s Industrial Analysis,” pp. 61–84, R. D. C. Black (op. cit.), and
J. Creedy, “Marshall and Edgeworth,” pp. 18–39.
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17

The Mantle of Léon Walras

Having seen the brilliance of Cournot and Dupuit in France (see chapter 13), it is
tempting to conclude that Léon Walras (1834–1910) was the heir-apparent to the
French econo-engineering tradition. But the actuality is far more complicated,
involving peculiar institutions and complex human interactions. Although Walras
eventually scaled the heights of economic analysis, his path to the top was long and
bumpy. Unable to secure a university post in his native France, he struggled to gain
a voice from a lonely educational outpost in Switzerland. By contrast, Alfred Mar-
shall reached a position of dominance in a leading English university, Cambridge,
surrounded and supported by able colleagues and disciples. But such differences
aside, it would be difficult to overestimate the collective impact of Walras and Mar-
shall on economics and those that practice it. The framework of contemporary
mainstream developments in microeconomics, as well as key developments in mac-
roeconomics (monetary theory, for instance), is either Walrasian or Marshallian in
character. For these reasons and for many others, Walras and Marshall are right-
fully regarded as two of the most important economic theorists who ever lived.1

■ CONTRASTS BETWEEN MARSHALL’S AND WALRAS’S APPROACHES

Because their joint, though independent, influence on economics was so strong
and vital, it is appropriate to highlight certain fundamental differences between
these two giants of neoclassical economics. Two more dissimilar and diverse con-
tributors to the mainstream of contemporary economic analysis can hardly be imag-
ined. They were contemporaries, but Walras was the elder statesman in terms of
age and priority of publication. Their great works—Walras’s Elements of Pure Eco-
nomics (1874) and Marshall’s Principles of Economics (1890)—published almost
twenty years apart, each had a resounding impact on economics. Yet, each work,
like each man, was different. The most instructive contrasts between them are to be
found in the scope and method of their respective theoretical achievements.

1 This statement is not meant to imply that Walras and Marshall were the only contributors to the
neoclassical paradigm. The small army of writers considered in chaps. 13–15 were of a neoclassi-
cal ilk, and indeed the neoclassical age (c. 1870 to 1920) produced other great economists (e.g.,
Knut Wicksell and a whole Swedish tradition, F. Y. Edgeworth, P. H. Wicksteed, Vilfredo Pareto,
and Irving Fisher), some of whom will be considered subsequently in this book. Nevertheless,
Walras and Marshall are of such significance as to deserve special treatment.

433
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434 Part IV ■ The Neoclassical Era

Partial Equilibrium versus General Equilibrium

Both writers were concerned essentially with the microeconomic foundations
of price formation. That is, they—along with Cournot, Dupuit, and other predeces-
sors—viewed the equilibrating process of prices and quantities as the result of mar-
ket exchange (though, as we shall see, their views of the method of price and
quantity adjustment differed). The essential difference between Walras and Mar-
shall involves the scope of the subject under analysis. Marshall, and virtually all
writers on microeconomics before him, utilized an approach to particular markets
that is now called partial equilibrium analysis. Walras, on the other hand, developed
a broader and more complex method of looking at (interconnected) markets, called
general-equilibrium analysis.
The important distinction between Marshall and Walras on this point is simple,
although it sometimes gets lost in the complexity of analytical twists and turns. Basi-
cally, when a market is analyzed according to Marshall’s partial equilibrium method
it is considered in quasi-isolation. For instance, take the market for any commod-
ity—such as coffee. In both Marshallian and Walrasian views, the equilibrium price
and quantity of coffee are determined by the intersection of the demand function
and the supply function (French economists typically called the latter an “offer
curve”). Where Marshall and Walras differed was in regard to the determinants of
the supply and demand curves and the nature and process of market equilibration.
If he were specifying the individual demand function for coffee, Marshall would
make demand a function not only of the price of coffee but also of the prices of
goods closely related to coffee (substitutes and complements) and of the income
and tastes of consumers. All the other factors influencing the demand for coffee
(the prices of distantly related goods, market interactions vis-à-vis changes in the
price of coffee, etc.) are held constant or ignored altogether. As we saw in the previ-
ous chapter, Marshall used ceteris paribus assumptions in dealing with individual
and market demand and supply curves for any particular good. He was impelled to
ignore or to hold in abeyance seemingly unrelated or distantly related determinants
of the price and quantity of any particular good so that the main features of the indi-
vidual market could be isolated for examination. This partial equilibrium method
had been employed before him by Cournot, Dupuit, and Jenkin, among others.
By contrast, Walras was more interested in the interdependencies between mar-
kets. In his view, all markets are interrelated because the valuation process neces-
sarily occurs in all markets simultaneously. Thus, according to Walras, anyone who
has not maximized his or her satisfactions will have excess demands (to be defined
below) for some goods, including coffee, and excess supplies of others. Utility max-
imization—the object of exchange—means disposing of excess supplies in order to
eliminate excess demands. Therefore, every act of exchange influences the values
of all goods in the economic system. By the same perspective, Walras viewed the
production and input side of economic activity as interrelated. Indeed, the interde-
pendence of the entire system of production and consumption was the focus of Wal-
ras’s Elements.
How, then, would Walras describe the market for coffee? He would argue that
Marshall’s ceteris paribus assumption was inappropriate because other things are
not equal. Because the whole system is interconnected an increase in demand for
coffee necessarily means that there are excess suppliers of other goods in the sys-
tem. Consequently, any price change in coffee will have further effects on other
markets (e.g., haircuts) that react back on the coffee market and produce further
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Chapter 17 ■ The Mantle of Léon Walras 435

changes. These basic interconnections of all markets, which Marshall chose to

ignore, constitute the heart of Walras’s system. Thus, at an abstract, theoretical
level, Walras argued that an analysis of the market for coffee—in isolation from all
variables in the system—was inappropriate.2 In contrast to Marshall’s partial equi-
librium approach, Walras’s method was a general-equilibrium approach.

Doctrinal Antagonism over Method

All this is not to imply that Marshall and Walras were unaware of—or incapable
of using—each other’s system. In fact, in elaborating Mill’s doctrine of reciprocal
demands (see chapter 8), Marshall produced an elegant two-commodity, two-coun-
try general-equilibrium model that explained international values. In his Principles,
however, he consciously chose partial equilibrium analysis as the appropriate
method for dealing with selected markets in a complex world. Even so, he never
denied the correctness of Walras’s system.
For his part, Walras was adamant—even rude—in pointing out what he per-
ceived to be Marshall’s major errors. Although Walras was not opposed to the use of
demand curves for particular goods, he objected to the use of such curves if they
excluded the interdependencies of utilities and demands for all goods. He also vehe-
mently rejected the tacit identification of marginal utility with demand, a practice
that Dupuit had originated. In fact, Walras’s salvos were often directed jointly at
Dupuit and Marshall. In a letter to his Italian contemporary Maffeo Pantaleoni, for
example, Walras pointed out that his analysis of exchange considered demand func-
tions containing many independent variables and that this was the basic difference
between his own concept of demand and those of Dupuit, Marshall, and two promi-
nent Austrian theorists, Rudolph Auspitz and Richard Lieben (Correspondence, let-
ters 379 and 465). Walras identified Marshall’s demand formulation with that of
Dupuit (see chapters 13 and 16), and he held that Dupuit and Marshall illegitimately
attempted to explain demand curves in terms of (marginal) utility curves. As for his
own role in value theory, he considered himself to have been the first to show the
interactions between Cournot’s demand apparatus (without utility accoutrements)
and Jevons’s theory of the final degree of utility (see chapters 13 and 15). Yet, most
of Walras’s objections to the Dupuit–Marshall demand theory were ill-founded, for
in this instance he failed to appreciate the convenience (and usefulness) of the
ceteris paribus convention in partial equilibrium theory.
Curiously, Walras was almost always in a pique when speaking of Marshall. He
seemed always ready to find merit in Continental economists’ work but, with the
exception of Jevons, he launched biting attacks against English writers. For exam-
ple, while exonerating Jevons and Gossen from criticism because they did not
attempt to deduce demand curves from utility curves, he called Marshall the “great
white elephant of political economy” and attacked him and his brilliant colleague F.
Y. Edgeworth for jealously and obstinately attempting to defend Ricardo’s and
Mill’s theory of price (Correspondence, letter 1051).
Part of this divisiveness stems from the fact that Walras and Marshall developed
their analyses and wrote their respective books for two very different audiences.
Marshall’s avowed purpose in writing Principles was to inform the intelligent lay-
person, and particularly the businessperson, of the fundamental tools and uses of
economic analysis. Consequently, most of his formal analysis appears either in foot-

2
This is true irrespective of the fact that Walrasians are forced to utilize partial equilibrium conven-
tions in dealing with practical questions.
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436 Part IV ■ The Neoclassical Era

notes or in appendixes. Walras, however, was clearly writing for his professional
colleagues. It is doubtful whether more than a handful of leading world theorists in
1874 readily digested Walras’s mathematical treatment of exchange (although Mar-
shall was probably one of them), but its formal elegance was sure to impress a few.
These differences of form and substance may help us understand the relative accep-
tance of the two works by the profession. But what is not so easy to understand is
the almost total lack of communication between Marshall and Walras. Cultural and
theoretical differences aside, it is imperative that we understand the ideas of the
men who have come to be appreciated as two of history’s greatest economic theo-
rists. (See the box, Method Squabbles 4: The Hedgehog and the Fox.)

Method Squabbles 4: The Hedgehog and the Fox

Some regard as excessive Schumpeter’s judgment that Walras was, in matters of pure theory,
“the greatest of all economists,”* but most agree that few theorists left a more lasting imprint on
subsequent generations. Walras’s enduring legacy has established a framework for organizing
ideas and for looking at the economic system in a way that avoids mistakes in logic. In assessing
that contribution, we should note, however, that Walras was more of an architect than a builder.
A decade before the appearance of Mill’s Principles of Political Economy, Cournot (1838) wrote:
In reality the economic system is a whole of which all the parts are connected and
react on each other. . . . It seems, therefore, as if, for a complete and rigorous solution
of the problems relative to some parts of the economic system, it were indispensable
to take the entire system into consideration. But this would surpass the powers of
mathematical analysis and of our practical methods of calculation, even if the values
of all the constants could be assigned to them numerically.†
Walras’s lasting achievement was to have constructed a mathematical system displaying in
great detail precisely the interrelationships stressed by Cournot. Despite his boldness, how-
ever, Walras did not provide the “complete and rigorous solution” alluded to by Cournot.
Instead, he provided a solution “in principle,” making no pretense that it could be used directly
in numerical calculations. The difference is important, for it is a matter of form over content.
Emphasis on form is important in economics. On the one hand it helps us to avoid mis-
takes in logic. By translating vague statements into symbolic form and using elementary
mathematics, Walras was able to jettison much irrelevant material, show that some state-
ments are mutually contradictory, and demonstrate the validity of others. On the other hand,
it provides a language, or classificatory scheme for organizing analytical materials—like labels
for the compartments of a filing box. Walras’s general-equilibrium scheme offers us a bird’s-
eye view of the economy as a whole and prods us to be ever mindful of the interconnected-
ness of its constituent parts. But form alone is not sufficient for fruitful economic theory.
Meaningful economic theory requires content as well. Economists need more than the right
kind of language; they also need something to say.
Marshall and Walras each had much to say, even if they set their message in different chan-
nels. The two giants of early neoclassical economics had different conceptions of economic the-
ory. The difference is only palely reflected in the familiar dichotomy between “partial
equilibrium” and “general equilibrium.” Marshall was devoted to economic theory as a means of
solving practical problems. He repeated often the expression that economic theory is “an engine
for the discovery of concrete truth,” and his wryly written “rules” for the use of mathematics in
economic analysis (see chapter 16) belie the same concern. It was Marshall’s contention that:
Facts by themselves are silent. . . . In order to be able with any safety to interpret eco-
nomic facts. . . . We must know what kind of effects to expect from each cause and
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Chapter 17 ■ The Mantle of Léon Walras 437

how these effects are likely to combine with one another. This is the knowledge
which is got by the study of economic science. . . . The economist . . . must stand fast
by the more laborious plan of interrogating facts in order to learn the manner of
action of causes singly and in combination, applying this knowledge to build up the
organon of economic theory, and then making use of the aid of the organon in deal-
ing with the economic side of social problems.‡
According to an ancient Greek poet, “the fox knows many things, but the hedgehog knows
one big thing.” By this analogy, Léon Walras was the hedgehog of economic theory and Alfred
Marshall the fox.
*Joseph Schumpeter, History of Economic Analysis, p. 827.
†Augustin Cournot, Researches, p. 127.
‡
Alfred Marshall, “The Present Position of Economics,” in Pigou’s Memorials, pp. 166, 168, 171.

■ LÉON WALRAS: SKETCH OF HIS LIFE AND WORK

Léon Walras was born in 1834 in Normandy, France. He retained the citizenship
of his birthright even though he spent most of his adult life in neighboring Switzer-
land. Like John Stuart Mill, he was fathered by an economist, though his early edu-
cation was not nearly as rigorous as Mill’s. His father, Auguste, was the only teacher
of economics he knew. Later, when his reputation surpassed that of his parent, Wal-
ras revealed the influence of his father in many matters of economic policy.
Auguste Walras had been a classmate—and probably an admirer—of Cournot at
the École Normale Supérieure in Paris. Other than this we know little of possible fil-
iations between Auguste Walras and Cournot. But we do know that Walras senior
introduced Walras junior to Cournot’s Mathematical Principles of the Theory of
Wealth early on. Eventually, Léon Walras, more than any other writer, called the
world’s attention to the merits of Cournot’s mathematical economics. But despite
his brilliance, Cournot had retreated from the problem of general-equilibrium anal-
ysis, declaring it beyond the powers of mathematical competence. Undaunted, Wal-
ras not only surpassed Cournot in this regard but became the acknowledged
founder of general-equilibrium analysis.
Walras gave little indication in his youth that he would become a great econo-
mist. He received an ordinary education, taking two baccalaureate degrees—one in
letters and one in science. Yet, he flunked the mathematics section of the entrance
exam to the École Polytechnique—France’s elite grande école, and chief prepara-
tory school for civil engineers. Walras might have made a poor engineer, for he
showed little interest in subsequent engineering studies undertaken at the École des
Mines—an engineering school of lesser rank than the École des Ponts et Chaussées,
where Dupuit had excelled. In 1858 he turned to literary pursuits, publishing a
mediocre novel in that year and a hardly more noteworthy short story the following
year. Somewhat chastened by these two disappointing forays into literature, Walras
promised his father that he would make economics his life work. Before he could
obtain an academic position in his chosen field, however, he fathered twin girls out
of wedlock, edited a short-lived monthly review, and worked for a railroad company
and two banks. While he was seeking an academic post he was nevertheless study-
ing economics in his spare time and doing some writing on the subject.
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438 Part IV ■ The Neoclassical Era

Walras’s unpopular ideas—which in his youth were approximately the same as

his father’s (both favored land nationalization, mathematical economics, and a sub-
jective theory of value, in contrast to Ricardo’s cost-of-production theory)—barred
him from securing an academic post in France, but in 1870 he was finally named—
over the objections of almost half of the selection committee—to a professorship in
the faculty of law at what later became the University of Lausanne (Switzerland).3
At Lausanne Walras prospered intellectually, even if not financially. He was never
financially secure until his marriage to a rich widow in 1884, five years after the
death of his first wife. But at Lausanne he began the feverish activity that eventually
led to the publication of all his best-known works in economics.
In 1874 and 1877 he published the two parts of his Élements d’économie politique
pure, a seminal work on the marginal-utility theory of value and on general-equilib-
rium analysis. He followed this in 1881 with the Théorie mathematique de bimétal-
lisme and, in fairly rapid succession, he published Théorie mathematique de la
richesse sociale (1883) and Théorie de la monnaie (1886). He had always planned to
write two systematic treatises on applied economics and social economics to accom-
pany his 1874 work on pure theory, but his strenuous pace at Lausanne sapped much
of his energy. He quit teaching in 1892 and later was content to publish his collected
papers (rather than the systematic works he had earlier envisioned) under the respec-
tive titles Études d’économie sociale (1896) and Études d’économie politique (1898).
In the heyday of his career at Lausanne, Walras corresponded with just about
every economist of any repute throughout the civilized world. In part, he did so out
of frustration, for his law students at the university showed little interest in, or taste
for, economics. Deprived of stimulating colleagues or students (at least in econom-
ics), Walras sent his prepublished manuscripts to other economists abroad for criti-
cal review. This practice eventually blossomed into a vigorous campaign to spread
his ideas globally.
Intellectual frustration was not the only likely cause of Walras’s tireless corre-
spondence. The assembled record of that correspondence reveals his fervent zeal to
persuade, beseech, cajole, or otherwise enlist the aid of other economists in spread-
ing the mathematical method of analysis as it applied to economic theory. Regard-
less of his motives, Walras succeeded on a large scale in advancing the international
dissemination of ideas so essential to rapid progress in any science.
In sum, Walras cast a broad shadow over the entire field of economics. His
strong suit, of course, was pioneering new frontiers in economic analysis. In the
words of William Jaffé, his main biographer:
This was the achievement of Walras, a lonely, cantankerous savant, often in strait-
ened circumstances, plagued with hypochondria and a paranoid temperament,
plodding doggedly through hostile, uncharted territory to discover a fresh vantage
point from which subsequent generations of economists could set out to make
their own discoveries. (“Léon Walras,” p. 452)

He had a keen sense of the importance of building strong foundations on which

other advances could be erected. In a cunning assessment of his own approach to
scientific inquiry, Walras wrote to a friend: “If one wants to harvest quickly, one
must plant carrots and salads; if one has the ambition to plant oaks, he must have
the sense to tell himself: my grandchildren will owe me this shade” (cited in Schum-
peter, History, p. 829).

3
Lausanne followed the practice common in France (the result of a reorganization plan of Napo-
leon) of offering all economics courses in the major universities in the school of law.
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Chapter 17 ■ The Mantle of Léon Walras 439

■ WALRAS AND MARSHALL ON THE MARKET ADJUSTMENT MECHANISM

One of the most instructive contrasts between Walras and Marshall concerns
the so-called law of markets, also referred to as the “adjustment mechanism” in
microeconomic discussions of markets. In discussing this topic, Walras and Mar-
shall emphasized the concepts of excess demand/supply and the stability properties
of equilibrium. Because they are closely related, we treat these issues together,
though the concept of excess demand will be extended further in the following sec-
tion on general equilibrium.

Price Adjustments versus Quantity Adjustments

Insofar as the market adjustment mechanism is concerned the basic difference
between Walras and Marshall is that Walras regarded price as the adjusting variable
when markets are in disequilibrium whereas Marshall focused on quantity as the
adjusting variable. Stated symbolically and somewhat naively, Walras viewed
demand and supply equations (or functions) in the following (mathematical) form:
(a) Qdx = f ( px )
(b) Q sx = f ( p x )

Marshall, on the other hand, viewed functional relations the other way around:

(c) Dpx = f ( qx )

(d) Spx = f ( qx )

Both these formulations require additional explanation. First, the demand and
supply equations are said to be “functions” since, in Walras’s case, quantity
demanded and quantity supplied of some commodity x—the left-hand side of equa-
tions (a) and (b)—are said to be functions (f) of the price of x—the right-hand side
of equations (a) and (b). Marshall, in contrast, related the demand and supply price
of some commodity x to the quantity of x demanded and supplied.
The variable described in parentheses on the right-hand side of all equations is
called the “independent variable” (or price in Walras’s case, and quantity in Mar-
shall’s). Changes in the independent variable cause the dependent variable—the
left-hand side of equations (a)–(d)—to take on different values. Simply stated, Wal-
ras indicated that quantity demanded and supplied depends in some way on prices,
whereas Marshall indicated that demand price and supply price depend in some
way upon the quantity of the good.4
Figure 17-1 on the following page attempts to clarify these matters. Focus first
on figure 17-1b, which assumes that price is the independent variable and depicts
the supply and demand functions for some good.5 Conceptually, one might imagine
4 Obviously, we are neglecting a host of other independent variables in the demand-and-supply rela-
tions, such as income, prices of substitutes and complements (indeed, all other goods in Walras’s
estimation), utility, the production function, and prices of inputs.
5 It is customary (except in economics) to display a two-variable function with the independent variable
always on the horizontal axis. Thus, a literal depiction of Walrasian functions would display price on
the horizontal axis. Through force of habit, and the dominant influence of Marshall, economists gen-
erally portray price on the vertical axis, even when it is assumed to be the independent variable, as in
this case. This modern eccentricity is undoubtedly due to the practice of Marshall, who displayed the
variables as shown in fig. 17-1b. However, Marshall adhered to accepted mathematical practice,
because he considered quantity to be the independent variable, not price (see the discussion below).
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440 Part IV ■ The Neoclassical Era

px px

Supply
p1

p0 p0 E

ED p2

Demand
– O + (Qd – Qs) Q0 Qd , Qs
(a) (b)

Figure 17-1 If market price is too high for equilibrium (for example, p1,), negative
excess demand (i.e., excess supply) will drive price down toward its equilibrium value. If
price is too low for equilibrium (p2), excess demand will drive price upward toward its
equilibrium value.

presenting demanders and suppliers with a list of prices to which they would
declare the quantities they would offer and demand at alternative prices. Point E in
figure 17-1b represents the equilibrium price and quantity that competition will pro-
duce in the market. If, for some reason, price were established below equilibrium,
say at p2, quantity demanded at that price would exceed quantity supplied, and a
shortage would result. This shortage induces competition among buyers, which in
turn bids up price. As price rises, some demanders are excluded from the market,
and some sellers are included. There are market forces, in other words, causing
price and quantity to return to the equilibrium point E. Similarly, should price hap-
pen to be above equilibrium, a surplus of the good would result, and competition
among suppliers would lower price, thereby increasing the number of demanders in
the market and decreasing the number of suppliers. In other words, price is the
adjusting force (the independent variable), so that once equilibrium is displaced by
any cause, price adjustments will cause a return to equilibrium. For this reason, the
system described in figure 17-1 is said to be stable in the Walrasian sense.
Walras’s Excess-Demand Function. Alternatively, stability can be described
in terms of excess demand and its consequences. Excess demand is defined simply
as the difference between quantity demanded and quantity supplied at any given
price, or symbolically as ED = (Qd – Qs). An excess-demand schedule can be drawn
up as in figure 17-1a, which traces out these differences. For example, the excess
demand at price p1 is a negative amount since Qd – Qs at that price is negative. Thus,
a negative excess demand can be regarded as positive excess supply. Excess
demand is zero at the equilibrium price and positive at prices below equilibrium. In
order for a Walrasian system to be stable, the ED function must be negatively
sloped, as drawn in figure 17-1.
Now let us look at the adjustment mechanism and stability properties as repre-
sented by Marshall. Figure 17-2 again reproduces the situation one normally
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Chapter 17 ■ The Mantle of Léon Walras 441

px px
Supply

F H

p0

G J
ED
Demand

– O + (Qd – Qs) O Q1 Q0 Q2 Qd , Qs

(a) (b)

Figure 17-2 If output is below its equilibrium value (for example, Q1), the presence of
economic profits will encourage greater output. If output exceeds its equilibrium value
(Q2), the ensuing economic losses will encourage lower output.

expects to encounter in real markets—a positively sloped supply function and a

negatively sloped demand curve, the same as those shown in figure 17-1. The con-
ceptual difference between Walras and Marshall is that Marshall would draw the
demand and supply curves by presenting a list of alternative quantities to suppliers
and demanders and asking them to list maximum demand and supply prices that
would be assigned to those quantities. The adjustment that takes place in the mar-
ket (when demand and supply are not in equilibrium) is therefore not a price adjust-
ment, as Walras assumed, but a quantity adjustment.
The Marshallian quantity adjustment can be visualized in figure 17-2. Assume
that quantity for some reason is less than the equilibrium quantity Q0. At quantity
Q1, for example, demand price (point F on the demand curve) is greater than supply
price (point G on the supply curve). In Marshallian terms, when Dp > Sp, firms in
the competitive industry are earning economic profits. Output will therefore
increase, bringing the market back into equilibrium at Q0.6 Similarly, if output
should exceed the equilibrium level, as at quantity Q2 in figure 17-2, supply price for
that output (point H) will be greater than demand price (point J), and economic
losses will induce firms to reduce output, and equilibrium will be reestablished at
Q0. Thus, as the arrows in figure 17-2 indicate, the Marshallian equilibrium is sta-
ble. Given disequilibrium, in other words, underlying forces in the system will guar-
antee a return to equilibrium. Likewise, in terms of the excess-demand function
developed by Walras, the Marshallian functions are seen to be stable.7 Given posi-
tively sloped supply curves and negatively sloped demand functions, Marshallian
and Walrasian stability each require a negatively sloped excess-demand function
such as that in figures 17-1 and 17-2.

6
The increase in output occurs for two reasons: (1) existing firms increase output, and (2) there is
entry of new firms in the industry.
7
Actually, to be consistent, some excess-price function should be developed in figure 17-2a. For
convenience, however, we present the inverse of the Marshallian supply and demand functions so
that a Marshallian excess-demand function can be compared with the one generated by Walras.
Marshall never bothered to do this, however.
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442 Part IV ■ The Neoclassical Era

Backward-Bending Supply
Although the respective approaches of Walras and Marshall to market adjust-
ment differ, there is no tension between the two as long as supply curves assume
their traditional upward slope. However, the approach chosen becomes critical in
the case of backward-bending supply curves.8 Such instances are unusual, but two
examples readily come to mind. First, as practically all mercantile writers clearly
perceived, the supply curve of labor might bend backward if workers trade off addi-
tional income from work for more leisure, so that they actually work less at higher
wages. Second, backward-bending supply curves may exist in markets for foreign
exchange, as shown by W. R. Allen (“Stable and Unstable Equilibrium”). So the
issue holds more than mere academic interest. In the presence of a backward-bend-
ing supply curve the analyses of Walras and Marshall diverge rather than converge,
as the following discussion demonstrates.
Assume a market (say, for labor) in which the demand curve intersects only the
backward-bending portion of the supply curve, as depicted in figure 17-3. At demand
price p0 quantity demanded equals quantity supplied. The excess-demand function
shown in panel (a) remains as shown in figures 17-1 and 17-2. It can be shown that
the system is stable in Walrasian terms because a price displacement from equilib-
rium engenders competitive forces that will guarantee a return to equilibrium.
But the system described in figure 17-3 is unstable in Marshallian terms. In
panel (b) assume some quantity Q1 that is less than the equilibrium quantity Q0. At
Q1, supply price G is clearly greater than demand price F. In that event Marshall
envisioned economic losses and a reduction in output supplied. Any reduction in
output from Q1 would magnify the gap between demand and supply. Equilibrium, in
short, would never be reached. Any departure from point E would be followed by

px px
G

p0 F E
p0

Demand
ED
Supply

– O + (Qd – Qs) O Q1 Q0 Qd, Qs

(a) (b)

Figure 17-3 The market described in (b) is stable in a Walrasian sense (i.e., price is the
independent variable), but unstable in a Marshallian sense (i.e., quantity is the indepen-
dent variable).

8
Milton Friedman and Peter Newman offer alternative resolutions of the difference between Wal-
ras and Marshall on the question of stability and backward-bending supply functions (see notes
for further reading at the end of this chapter).
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Chapter 17 ■ The Mantle of Léon Walras 443

explosive market disturbances if Marshallian adjustments take place. In this case,

then, a negatively sloped excess-demand function implies Walrasian stability but
Marshallian instability!
With a little more effort you can grasp the implications of a situation in which
the labeling of the demand and supply curves of figure 17-3 is reversed. In this case
the demand curve would intersect the supply curve from above. The excess-demand
function corresponding to these curves would be positively sloped. The system
would be unstable in the Walrasian sense because quantity demanded would exceed
quantity supplied at all prices above equilibrium price p0. Competition would force
price to ever-higher levels, pushing the system further from equilibrium. However,
Marshallian adjustment in this case would produce stability, because demand price
would exceed supply price at quantities below equilibrium quantity Q0, and thus
produce a return to equilibrium. In sum, the positively sloped excess-demand func-
tion (which accompanies negatively sloped supply and demand schedules)
expresses instability in Walras’s system and stability in Marshall’s. In terms of
excess demand, stability is symmetrical in both systems for normally sloped
demand and supply schedules, but asymmetrical when demand and supply curves
are both negatively sloped.

How Important Is Market Stability?

At first blush the notion of stability might seem esoteric and irrelevant. It could
be argued, for instance, that the issue of instability vanishes in the face of market
experience. If by unstable markets we mean price and quantity “explosions” away
from equilibrium, there is little empirical evidence to support such phenomena.
Nevertheless, the issue is far from being irrelevant. It may be that real-world con-
straints (e.g., futures markets and/or arbitrage in international finance) prevent
markets from exploding. Moreover, even if markets are stable always and every-
where, it is nevertheless important to be able to discern the process by which equi-
librium is displaced and the manner in which it is restored. And even though the
question of market equilibrium is, strictly speaking, a different matter from that of
stability, the adjustment processes of Walras and Marshall force attention to the
problems of stability and instability of market systems.
The practical importance of stability in markets has probably been overshad-
owed by an academic interest in the subject. Following the leads of Walras and Mar-
shall, contemporary economic theorists have demonstrated a persistent interest in
discussing the stability properties of their analytical models. It has not been consid-
ered enough to describe a model; rather, it is important to show that the model has
properties that make it viable and stable. Many of the most important contributions
to modern macroeconomic and monetary theory, for example, deal with displace-
ment of market equilibrium and the process by which equilibrium is restored.
Yet, there is a practical side to the issue as well. Conditions of stability or insta-
bility become paramount when a dynamic element is introduced into the static pro-
cesses of Walras and Marshall. The so-called cobweb theorem, well known to
agricultural economists since it applies principally to goods with long production
processes, is one such model. Lagged-variable models of the cobweb type have
many crucial implications for stability in real-world agricultural markets, and per-
haps in other markets as well.9

9
Evidence indicates that the complexities of cobweb-type models may not have escaped earlier
economists of the nineteenth century. (See R. F. Hébert, “Wage Cobwebs.”)
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444 Part IV ■ The Neoclassical Era

Walras called this rather complex process of dynamic market adjustment

tâtonnement—a groping for equilibrium—and in contemporary analysis his concept
has been of consummate usefulness in numerous models of microeconomic and
macroeconomic behavior. Don Patinkin, a leading macroeconomist of the twentieth
century, and Nobel Prize winners, Sir John R. Hicks and Kenneth Arrow, have
devoted a great deal of time to questions such as: Is a competitive equilibrium possi-
ble, and if there is a displacement, will the system return to equilibrium? Walras’s
contribution to this subject is therefore of a high order. Whereas earlier writers
(Cournot, for example) only hinted at the importance of this issue, Walras and Mar-
shall (particularly the former) made stability a vital part of their analyses.
As an interesting historical footnote, both Walras and Marshall claimed priority
in the development of stability analysis. The issue of priority was raised in corre-
spondence between Marshall and Jevons (Walras, Elements, p. 502, n. 5). Marshall
claimed to have developed the issue of stability in 1873, but as William Jaffé noted,
Marshall’s treatment of the subject was little more than suggestive. In his privately
printed Pure Theory of Foreign Trade (1879) Marshall defined stable equilibrium in
reference to reciprocal-demand curves, but Walras had done so in print as early as
1874 and therefore clearly had priority. Far more important than this issue of prior-
ity (which is a difficult one to settle) is the fact that through the course of the discus-
sion, neither Walras nor Marshall, but particularly Marshall, seemed to have had
any appreciation of the other’s analysis. Simple jealousy might explain a debate on
priority, but Marshall’s failure to understand Walras correctly is something else
again. Nevertheless, an aura of dissonance seemed to envelope the two giants of the
neoclassical era.

■ THE ROLE OF THE ENTREPRENEUR IN WALRASIAN ECONOMICS

Walras’s economics shows us a state of ultimate and timeless adjustment main-
tained by the competitive self-interest of the individual suppliers of productive ser-
vices. In this world each productive service contributes technically and essentially
to the production, transport, and sale of goods, thereby earning each day that
amount by which the withdrawal of one such productive unit would reduce the daily
output of the system as a whole. Furthermore, in his analytic system the total of all
the payments to the suppliers of productive services exactly exhausts their total
product. Theoretically, the entrepreneur takes his place alongside the other suppli-
ers of productive services.
Outwardly Walras considered the entrepreneur an important figure. In his Ele-
ments of Pure Economics (1874), he carefully delineated four classes of productive
factors, thus setting the mode of modern practice. His disquisition is reminiscent of
Cantillon’s three-class presentation of landowners, workers, and entrepreneurs,
with the important difference being that Walras recognized the capitalist apart from
either the landowner or the entrepreneur. He was quite explicit about the separation
and distinction of economic factors of production. After dispensing with the usual
categories of landowner, laborer, and capitalist, Walras wrote:
In addition, let us designate by the term entrepreneur a fourth person, entirely dis-
tinct from those just mentioned, whose role it is to lease land from the landowner,
hire personal faculties from the laborer, and borrow capital from the capitalist, in
order to combine the three productive services in agriculture, industry or trade. It
is undoubtedly true that, in real life, the same person may assume two, three, or
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Chapter 17 ■ The Mantle of Léon Walras 445

even all four of the above-defined roles. In fact, the different ways in which these
roles may be combined give rise to different types of enterprise. However that may
be, the roles themselves, even when performed by the same individual, still remain
distinct. From the scientific point of view, we must keep these roles separate and
avoid both the error of the English economists who identify the entrepreneur with
the capitalist and the error of a certain number of French economists who look
upon the entrepreneur as a worker charged with the special task of managing a
firm. (Elements, p. 222)

Walras’s argument with the English economists concerned a point of scientific

method. He argued that although in practice the functions of capitalist and entre-
preneur may frequently be merged, in theory they must be treated separately in
order to advance clear thinking about the nature and consequences of each. Sur-
prisingly, he reserved his harshest criticism in this regard for his own countrymen.
He accused Say of misunderstanding the nature of the entrepreneurial function,
declaring that “this person [the entrepreneur] is absent from his theory” (Elements,
pp. 425–426). He justified his own position by excluding the activities of coordina-
tion and supervision from the entrepreneur’s functions. Those activities, he argued
repeatedly, are part of routine management and are therefore rewarded by the pay-
ment of the wages of management.10
A study of Walras’s correspondence shows that he maintained his position on
the entrepreneur consistently over a long period of time. In his Elements he charac-
terized the entrepreneur as an intermediary between production and consumption,
an equilibrating agent egged on by profit opportunities in the marketplace that arise
whenever selling price is greater than costs of production. Thus, it would appear
that the entrepreneur operates in an arena of disequilibrium. Walras’s explanation
was evocative of Cantillon:
If the selling price of a product exceeds the cost of the productive services for cer-
tain firms and a profit results, entrepreneurs will flow towards this branch of pro-
duction or expand their output, so that the quantity of the product [on the market]
will increase, its price fall, and the difference between price and cost will be
reduced; and, if [on the contrary], the cost of the productive services exceeds the
selling price for certain firms, so that a loss results, entrepreneurs will leave this
branch of production or curtail their output, so that the quantity of the product [on
the market] will decrease, its price will rise and the difference between price and
cost will again be reduced. (Elements, p. 225)

In 1887, Walras wrote to the American economist Francis Walker that “the defi-
nition of the entrepreneur is, in my opinion, the thing that binds all of economics
together.” He persistently argued against the admixture of economic functions,
declaring the entrepreneur to be “exclusively . . . the person who buys productive
services on the market for services and sells products on the market for products,
thus obtaining either a profit or a loss” (Correspondence, vol. 2, p. 212). He repeated
his position on the entrepreneur several years later, in a letter to his disciple, Vil-
fredo Pareto, explaining how he differed from Alfred Marshall on the subject: “Mar-
shall reasons mainly by assumption that the owner of services is a worker who
takes it upon himself to make goods and sell them,” whereas, “I interpose the entre-

10
In listing his criticisms of past writers Walras’s distinction between the “English” and “French”
was somewhat artificial: Turgot was guilty of the same “error” as the English classical economists
(i.e., not separating capitalist and entrepreneur), and Mill was guilty of the same “error” as Say
(i.e., identifying entrepreneurship with the coordination and supervision of productive factors).
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446 Part IV ■ The Neoclassical Era

preneur as a distinct person whose role is essentially that of demanding services

and selling products” (Correspondence, vol. 2, p. 629).
We may take this evidence as confirmation of the fact that the entrepreneur
held a prominent place in Walras’s view of the world as it actually operates. The
extent to which he integrated the function of the entrepreneur into the core of his
analytical system is another matter, however. At issue is the idealized nature of Wal-
ras’s theoretic model and whether it bears any resemblance to real-world practice.
This issue was debated back and forth in the twentieth-century by prominent econ-
omists, but neither side took a clear victory. Walras obscured matters by introducing
the “zero-profit entrepreneur” into his static, general-equilibrium system, a model
devoid of time or uncertainty. Since the entrepreneur neither gains nor loses in
competitive equilibrium, his raison d’etre disappears in that state. In order to bring
his general-equilibrium system to a determinate mathematical solution, Walras
expunged all of the things from his model that give meaning to the entrepreneur.
Mathematical nicety and practical necessity inevitably clashed, and Walras was not
able to reconcile the two. This explains why there are very few mathematical mod-
els that formally analyze entrepreneurial behavior within a closed economic system.
Enmeshed in this dilemma and seeing no way out, Walras developed a theoretic
construct of an economy that worked like a predictable, impersonal, and friction-
less machine. In G. L. S. Shackle’s phrase, it was an “inhuman model,” incapable of
conveying the full range of economic activity (Uncertainty in Economics, p. 91). On
this account, Schumpeter concluded that Walras’s contribution to the theory of
entrepreneurship was essentially negative (History, p. 893).
Michio Morishima (Walras’ Economics) defended Walras by reasserting the cen-
trality of the entrepreneur in Walras’s theoretic model, but he was roundly criticized
by Jaffé (“Walras’ Economics,” p. 535), who insisted that “in his whole theoretical
construct, Walras deliberately abstracted from uncertainty.” This explains the
absence of the entrepreneur, qua entrepreneur, from the Walrasian model in its “nor-
mal” operation. Jaffé concluded that “as for the role of the entrepreneur in Walras’s
analytical model, the Elements restricted it to that of arbitrageur, and nothing else”
(“Walras’ Economics,” pp. 529–530). But Jaffé’s position was challenged by his former
student, Donald Walker, who asserts that Walras made important and lasting contri-
butions to the theory of the entrepreneur and that Schumpeter built his own novel
concept of the entrepreneur on a Walrasian foundation (“Walras’ Theory,” p. 18).
Because the debate produced no clear consensus, ambiguity and diversity of
opinion continue to beset Walras’s contribution to the theory of entrepreneurship.
On the one hand it appears that Walras had an unambiguous notion of real-world
entrepreneurs and that he assigned them great importance in the practical world of
business. On the other hand his chief scientific achievement, the mathematical gen-
eral-equilibrium model, systematically eliminated—by assumption (and perhaps by
necessity)—the centrality of the entrepreneur. As theory goes, Walras’s general-
equilibrium system was a momentous contribution. But as a suitable showcase for
the essentiality of the entrepreneur it was a total void.

■ PARETO, GENERAL EQUILIBRIUM, AND WELFARE ECONOMICS

Walras’s legacy, perceived at first as insignificant in France, was amply
reflected in the work of his Italian disciple, Vilfredo Pareto (1848–1923). Pareto
adopted Walras’s general-equilibrium framework and used it to improve key areas
of economics, including methodology (see notes for further reading at the end of
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Chapter 17 ■ The Mantle of Léon Walras 447

this chapter). In his Cours d’économie politique (1896–1897) and his Manuel d’écon-
omie politique (1906), Pareto explored the conditions in exchange and production
that comprise the foundations of modern welfare economics. Unlike the English
(Marshall–Pigou) tradition in welfare theory, which was cast in a partial equilibrium
framework, Pareto built his system on Walrasian general-equilibrium precepts.
Although Pareto did not derive all the conditions for a global welfare maximum,
those relating to production and consumption now bear his name.

A Pareto Maximum in Consumption

Borrowing from both British and French traditions, Pareto established the con-
ditions for welfare maximization in exchange. He applied ordinal utility analysis to
Walrasian general equilibrium, engaging F. Y. Edgeworth’s consumer “indifference
curves” (Mathematical Psychics, 1881) to show that in exchange of a fixed supply of
goods, a welfare optimum would occur when no individual could benefit from trade
without injuring someone else. Pareto’s argument can be made more concrete by
identifying a marginal rate of substitution in exchange. For any individual the mar-
ginal rate of substitution between any two commodities—say, x and y—measures
the number of units of y that must be sacrificed per unit of x so that the level of sat-
isfaction remains the same. (The marginal rate of substitution is the slope of the
indifference curve.)
A Pareto optimum in exchange requires that the marginal rate of substitution
between any pair of consumer goods must be the same for any two individuals
(selected at random) who consume both goods. If this is not the case, then one or
both parties could gain from exchange. In other words, exchange is Pareto optimal
as long as at least one of the parties to the trade is made better off without leaving
the other party worse off.11 Once trade reaches a point where one party can benefit
only at the expense of another, any further statements concerning exchange require
additional specification. In fact, a whole area of modern welfare economics centers
on the attempt to specify the conditions under which a value-free answer can be
given when policy changes involve gainers and losers. It is perhaps too early to
decide whether or not the quest for a value-free social welfare function is illusory,
but it is certain that Pareto, at least implicitly, inaugurated the attempt.

Paretian Factor Substitution

In the theory of production, the concept analogous to the consumer’s marginal
rate of substitution between any two goods is the firm’s marginal rate of technical
substitution between any two inputs. The marginal rate of technical substitution
measures the number of units of an input i that can be substituted for another input
j in such a way as to maintain a constant level of output. Thus, as with an indiffer-
ence curve, one might construct a curve (convex to the origin) depicting the manner
in which one input may be substituted for another while output is held constant. In
microeconomic theory, this curve is called an isoquant, and its slope is the marginal
rate of technical substitution.
Although Pareto did not develop isoquants, he did state the conditions neces-
sary for the optimum distribution of resources, given a fixed supply of inputs. The

11
Traditionally, Paretian welfare theory is presented with the aid of an Edgeworth “box diagram,”
which is a useful graphical technique for illustrating the relations between two economic activities
with fixed inputs. See C. E. Ferguson, Microeconomic Theory (in the references) for a lucid expo-
sition of general equilibrium and welfare economics utilizing box diagrams.
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448 Part IV ■ The Neoclassical Era

Pareto condition is that the marginal rate of technical substitution between any pair
of inputs must be the same for all producers (chosen at random) who use both
inputs. If this were not the case, reallocation of inputs could result in larger total
output without a reduction in the output of any single commodity. An optimum fur-
ther implies that each factor receives a wage equal to the value of its marginal prod-
uct, a state of affairs that occurs under perfect competition. Analysis of this issue is
a staple in undergraduate courses in microeconomic theory. Thus, Walras and
Pareto contributed to the principles of optimality in exchange and production.

Welfare and Competition

There are many serious problems connected with Pareto’s development of wel-
fare theory, including the possibility of deriving a nonnormative social-welfare func-
tion. Another severe limitation is the assumption of nonaugmentable supplies of
inputs and outputs. In addition, models focused on static equilibrium disregard the
effects of uncertainty and a host of other factors. Beyond these problems, however,
Pareto’s welfare theory, which rests on the maximizing behavior of individuals, adds
a great deal of support to the assertion (made by Adam Smith) that a freely compet-
itive system leads to optimal social welfare. Consumers, in an attempt to maximize
satisfaction, are led to trade until their marginal rates of substitution between goods
are equal. Producers, in their attempt to maximize profits, are led to hire inputs up
to the point where their marginal rates of technical substitution are equivalent.
Pareto’s demonstration, assuming that “externalities” do not exist (see chapter 16),
places the case for competition on a more objective basis. His emphasis on the
effects of maximizing behavior is in sharp contrast to the somewhat metaphysical
premises that many other proponents of competitive theory relied on. Consequently,
Pareto helped to quicken the acceptance of Walras’s general-equilibrium analysis.

■ WALRAS’S CORRESPONDENCE AND ITS IMPACT ON ECONOMICS

Léon Walras was a passionate believer in the system that he developed, and
with the fervor of a religious zealot, he attempted to proselytize economists and pol-
icy makers all over the globe. Between 1857 and 1909, he communicated with virtu-
ally every major economist in the world. The definitive collection of Walras’s
extraordinary correspondence was published in 1965 under the editorship of Wil-
liam Jaffé. With meticulous care and incredible scholarship, Jaffé selected, edited,
and commented on almost eighteen hundred letters (from a still larger correspon-
dence) in which Walras discussed an enormous array of topics with other econo-
mists and interested parties. A review of this correspondence—which spans fifty
years and five different languages—reveals the many sides of Walras: his petty
debates over the priority of theoretical ideas; his general contempt for English econ-
omists (especially Mill and Marshall); his personal lobbying for a Nobel Peace Prize
in recognition of his scientific discoveries and their alleged application to society
and social problems; his protestations against critics; and his pleadings on behalf of
mathematical economics as the mainspring of social reform.12 Mainly, however, we
find Walras marketing, advertising, and hawking his general-equilibrium system—
here lobbying shamelessly with journal editors for summaries of his system to be
printed, there on the offensive, attacking partial equilibrium analysis.

12
A favorite subject of Walras the socialist was land nationalization. The revenues derived there-
from, he argued, could be used to finance government expenditures.
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Chapter 17 ■ The Mantle of Léon Walras 449

It is clear from his correspondence that Walras was willing to make herculean
efforts to spread his conception of economic science. He was concerned not only
that the errors he perceived in others’ writings be corrected but also that his own
place be established in the profession. In a letter of April 11, 1893, to his student Vil-
fredo Pareto, Walras noted that it would give him
great pleasure (if I am still there to enjoy it) to have others eventually recognize
that only Gossen, Jevons, and I have conceived the degree of utility as the central
element in valuation and that I, alone, have demonstrated the proportionality of the
final degrees of utility to all exchanges, prices, or values to the state of general
equilibrium and production. And as for Dupuit, Menger, Wieser, Böhm-Bawerk,
Auspitz and Lieben, Marshall, Edgeworth, and all the rest, they have confused
price and the final degree of utility through identification of the curve of utility and
the demand curve. (Correspondence, vol. 2, letter 1123)

Walras did not try to mask his Anglophobe sentiments. With the single exception of
William Stanley Jevons, who with Walras’s help added a large appendix on mathe-
matical writings in economics to the 1879 edition of his Theory of Political Economy
(see chapter 15), Walras had very little good to say about traditional British political
economy or economists. He never missed an opportunity to take a swipe at Ricardo,
Edgeworth, or Marshall, the latter being regarded in the “English tradition.” In a let-
ter (May 25, 1877) to his friend Jevons, he even noted that J. S. Mill “is as poor a
logician as he is a mediocre economist”—in spite of the incredible pains, Walras
added, that Mill took to avoid giving proofs.13
In more general terms, Walras’s correspondence is a shimmering mirror of a
most unusual man, his era, and the human spirit that yearns for recognition in light
of accomplishment. Through his correspondence Walras was an international
ambassador for the discipline of economics. Although some of the issues taken up
in the Correspondence seem trifling, they are nevertheless issues that helped shape
the modern profession of economics. Walras’s unflinching attempt to sell econom-
ics as a science was a seminal force in molding the character of the discipline in the
twentieth century. The barriers of national interests and separate languages tended
to fall away with the increasingly mathematical character of the science. More than
any other single economist, Léon Walras established and “sold” an analytical
method whose cultivation transcended national boundaries. How he did so—with
incessant but often rewarding debates and arguments—is not really the main point,
but it certainly flavors the historical record, which has now established Walras
among the giants of the field of economics.

■ CONCLUSION
Walras’s most original contribution to economics was his mathematical specifi-
cation of a general-equilibrium system. Such a system stresses the vast and intricate
web of interrelations in a modern economy. It may be contrasted with partial equi-
librium analysis, which ignores such interrelations in order to focus on specific
firms or individuals. Before Walras, Cournot had pointed out that a complete and
rigorous solution of the problems relative to specific parts of the economic system
requires consideration of the entire system and its interconnections. Even before

13
In fairness, Walras was only agreeing with Jevons’s own assessment of the value of Mill’s writings
on logic (see Correspondence, vol. 1, letter 379). Jevons was ready to identify Richard Cantillon,
and not Adam Smith, as the first great developer of liberal economic doctrine!
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450 Part IV ■ The Neoclassical Era

Cournot, Cantillon and Quesnay had presented a clear vision of the economy con-
sisting of many interconnected parts. But Cournot thought the problem of general
equilibrium was beyond the reach of mathematical analysis, Cantillon applied his
notion of reciprocity to an emergent market system, and Quesnay never got as far
as a mathematical specification of microeconomic relations. Walras’s genius lay in
his grasp of the problem anticipated by Cantillon, Quesnay, and Cournot, and in his
demonstration that the problem was solvable, at least in principle.
It is generally held by most economists that Walras’s contribution was one of
form more than of substance. Clearly there is an architectonic quality to Walras’s
general-equilibrium system. The pattern of the system is precise, but Walras did not
undertake the vast statistical research necessary to provide concrete solutions to
each of the equations in the system. There are, in fact, tremendous problems in
specifying the relevant equations in precise terms and in gathering data on such a
large scale. The recognition of such problems is not meant to diminish the impor-
tance of Walras’s contribution. Himself a mediocre mathematician, Walras never-
theless demonstrated the power of mathematics in solving complex theoretical
problems. He made it possible, moreover, to see that equilibrium of the household
and the markets for final goods was consistent with equilibrium of the firm and fac-
tor markets. The attempts of Jevons and the Austrians to find a simple causal rela-
tion between marginal utility, input prices, and goods prices seem naive and
unsophisticated by comparison.

REFERENCES
Allen, William R. “Stable and Unstable Equilibrium in the Foreign Exchanges,” Kyklos,
vol. 7 (1954), pp. 395–408.
Cournot, A. A. Researches into the Mathematical Principles of the Theory of Wealth, N. T.
Bacon (trans.). New York: A. M. Kelley, 1960 [1838].
Ferguson, C. E. Microeconomic Theory, 3d ed. Homewood, IL: R.D. Irwin, 1972.
Hébert, R. F. “Wage Cobwebs and Cobweb-Type Phenomena: An Early French Formula-
tion,” Western Economic Journal (December 1973), pp. 394–403.
Jaffé, William. “Léon Walras,” in International Encyclopedia of the Social Sciences, vol.
16. New York: Macmillan, 1968, pp. 447–552.
———. “Walras’ Economics as Others See It,” Journal of Economic Literature, vol. 18
(1980), pp. 528–549.
Morishima, Michio. Walras’ Economics: A Pure Theory of Capital and Money. Cam-
bridge: Cambridge University Press, 1977.
Patinkin, Don. Money, Interest and Prices, rev. ed. New York: Harper & Row, 1965.
Pigou, A. C. Memorials of Alfred Marshall. London: Macmillan, 1925.
Schumpeter, J. A. History of Economic Analysis, E. B. Schumpeter (ed.). (New York:
Oxford University Press, 1954).
Shackle, G. L. S. Uncertainty in Economics. Cambridge: Cambridge University Press, 1995.
Walker, Donald A. “Walras’ Theory of the Entrepreneur,” De Economist, vol. 134 (1986),
pp. 1–24.
Walras, Léon. Elements of Pure Economics, William Jaffé (trans.). Homewood, IL: Irwin,
1954 [1874].
———. Correspondence of Léon Walras and Related Papers, William Jaffé (ed.), 3 vols.
Amsterdam: North-Holland, 1965.
Wicksell, Knut. Value, Capital and Rent. New York: A. M. Kelley, 1970.
Ekelund-Hebert 6E.book Page 451 Thursday, August 1, 2013 11:03 AM

Chapter 17 ■ The Mantle of Léon Walras 451

NOTES FOR FURTHER READING

Until his death in 1980, William Jaffé was the leading authority on the life and writ-
ings of Léon Walras. In addition to his translation of Walras’s Elements, Jaffé collected
and edited the voluminous Correspondence (see references), a product that ranks as one
of the great contributions to research in the history of economic thought. Virtually every
major and minor figure of the neoclassical period is presented or discussed in the Corre-
spondence, and Jaffé’s comments and annotations are invaluable and exhaustive. It is a
must, not only for any serious researcher on Walras but also for research on almost any
facet of neoclassical economics. Some idea of the content of the Correspondence may be
obtained from the following review articles: S. C. Kölm, “Léon Walras’ Correspondence
and Related Papers: The Birth of Mathematical Economics,” American Economic Review,
vol. 58 (December 1968), pp. 1330–1341; D. A. Walker, “Léon Walras in the Light of His
Correspondence and Related Papers,” Journal of Political Economy, vol. 78 (July/August
1970), pp. 685–701; and Vincent Tarascio, “Léon Walras: On the Occasion of the Publica-
tion of His Correspondence and Related Papers,” Southern Economic Journal, vol. 34
(July 1967), pp. 133–145.
Before his death, Jaffé was engaged in writing a comprehensive biography of Walras,
a project cut short by his demise. Jaffé’s literary leavings were collected by his student,
Donald Walker, and published posthumously; see William Jaffé, “The Antecedents and
Early Life of Léon Walras,” History of Political Economy, vol. 16 (Spring 1984), pp. 1–57,
which emphasizes the influence of Auguste Walras on his more famous son. In a series of
articles stretching over an academic lifetime, Jaffé explored many aspects of Walras’s eco-
nomics. See, for example, William Jaffé, “A. N. Isnard, Progenitor of the Walrasian General
Equilibrium Model,” History of Political Economy, vol. 1 (Spring 1969), pp. 19–43; “The
Birth of Léon Walras’s Elements,” History of Political Economy, vol. 9 (Summer 1977), pp.
198–214; “Léon Walras’s Role in the ‘Marginal Revolution’ of the 1870’s,” History of Politi-
cal Economy, vol. 4 (Fall 1972), pp. 379–405; “The Walras-Poincaré Correspondence on the
Cardinal Measurability of Utility,” Canadian Journal of Economics, vol. 10 (May 1977), pp.
300–306; “The Normative Bias of the Walrasian Model: Walras versus Gossen,” Quarterly
Journal of Economics, vol. 91 (August 1977), pp. 371–388; and “Léon Walras: An Economic
Adviser Manqué,” Economic Journal, vol. 85 (December 1975), pp. 810–823.
Donald Walker has taken up the mantle left by his mentor Jaffé. In Walras’s Market
Models (Cambridge: Cambridge University Press, 1996) Walker distinguishes three
stages in Walras’s economic thought—juvenile, mature, and decline. In Walrasian Eco-
nomics (Cambridge: Cambridge University Press, 2006) Walker examines the founda-
tions of Walras’s works and the influence he has had on other theorists. Walker has
become virtually a one-man industry on Walras. See, for example, D. A. Walker, “Is Wal-
ras’ Theory of General Equilibrium a Normative Scheme?” History of Political Economy,
vol. 16 (Fall 1984), pp. 445–469, which raises anew a question posed by Jaffé in 1977;
same author, “Walras and His Critics on the Maximum Utility of New Capital Goods,”
History of Political Economy, vol. 16 (Winter 1984), pp. 529–554, which attributes to Wal-
ras an adumbration of the marginal conditions for a Pareto optimum in the market for
capital goods; same author, “The Structure of Walras’s Mature Model of Capital Goods
Markets,” The European Journal of the History of Economic Thought, vol. 3 (Summer
1996), pp. 254–274, which attempts to clarify “Walras’s finest work on the subject of cap-
ital”; same author, “Walras’s Theory of the Entrepreneur,” (see references), which tries to
rescue Walras from “the misunderstandings and decades of neglect” surrounding his
treatment of the entrepreneur in economic theory. For even more Walker on Walras, see
“Walras’s Theories of Tâtonnement,” Journal of Political Economy, vol. 95 (August 1987),
pp. 758–774; “Edgeworth versus Walras on the Theory of Tâtonnement,” Eastern Eco-
nomic Journal, vol. 13 (April/June 1987), pp. 155–165.
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452 Part IV ■ The Neoclassical Era

Outside of the Jaffé–Walker circle, see Milton Friedman, “Léon Walras and His Eco-
nomic System,” American Economic Review, vol. 45 (December 1955), pp. 900–909, for
an evaluation of Walras’s work on the occasion of the first English translation of the Ele-
ments; David Collard, “Léon Walras and the Cambridge Caricature,” Economic Journal,
vol. 83 (June 1973), pp. 465–476, gives an assessment from within the Marshallian tradi-
tion; and R. J. Rotheim, “Equilibrium in Walras’s and Marx’s Theories of Capital Accu-
mulation,” International Journal of Social Economics, vol. 14 (1987), pp. 27–43, presents
the socialist perspective. For a side of Walras not often explored, see Albert Jolink, The
Evolutionist Economics of Léon Walras (New York: Routledge, 1996). Also see Jolink and
Jan van Daal, The Equilibrium Economics of Leon Walras (London: Routledge, 1993),
which traces Walras’ serial development of general-equilibrium models through the five
editions of his Elements, arguing that in a broader context these models should be con-
sidered instrumental in Walras’s design for optimal economic order.
A brief nontechnical discussion of Walras and Marshall on stability is provided by
Axel Leijonhufvud, “Notes on the Theory of Markets,” Intermountain Economic Review,
vol. 1 (Fall 1970), pp. 1–13. Milton Friedman has also proposed a resolution of the Wal-
ras–Marshall stability paradox in his Price Theory: A Provisional Text, rev. ed. (Chicago:
Aldine, 1962), p. 93. Peter Newman, The Theory of Exchange (Englewood Cliffs, NJ:
Prentice-Hall, 1965), pp. 106–108, argues that the Marshall–Walras models are not com-
parable because the Marshallian stability conditions were designed for production the-
ory, while the Walrasian ones were devised for a theory of exchange. Akira Takayama,
Mathematical Economics (Hinsdale, IL: Dryden Press, 1974), pp. 295–301, presents a
nonmathematical summary of Newman’s argument, enlarges on it, and concludes that
both “Marshall and Walras clearly recognized that there are these two types of adjust-
ments and they both used them in the proper context.” Michel De Vroey, “A Marshall-
Walras Divide? A Critical Review of the Prevailing Viewpoints,” History of Political Econ-
omy, vol. 41 (Winter 2009), pp. 709–736, evaluates the viewpoint that Marshall’s theory is
at least partly a proto-general-equilibrium one, and discusses conflicting views about
whether Marshall and Walras are complementary or alternative theorists. Same author,
“Marshall and Walras: Incompatible Bedfellows?” The European Journal of the History of
Economic Thought, vol. 19 (October 2012), pp. 765–783, compares Marshall and Walras
on a number of points where they arguably conflict: the purpose of economic theory, the
use of mathematics in economics, their different methods of handling complexity, their
conceptions of equilibrium, and their presuppositions about trade organization.
A number of nontechnical expositions of Walrasian general equilibrium exist. J. R.
Hicks’s “Léon Walras,” Econometrica, vol. 2 (October 1934), pp. 338–348, may still be read
profitably. A graphical description of general equilibrium and Paretian welfare theory is
contained in C. E. Ferguson, Microeconomic Theory, 3d ed., chaps. 15 & 16 (Homewood,
IL: Irwin, 1972). A more advanced and thorough discussion is presented in Don Patinkin,
Money, Interest and Prices rev. ed. (New York: Harper & Row, 1965). On Walras’s capital
theory as the basis for a theory of economic growth, see W. D. Montgomery, “An Interpre-
tation of Walras’s Theory of Capital as a Model of Economic Growth,” History of Political
Economy, vol. 3 (Fall 1971), pp. 278–297. Jan van Daal, “From Utilitarianism to Hedonism:
Gossen, Jevons and Walras,” Journal of the History of Economic Thought, vol. 18 (Fall
1996), pp. 271–286, compares the Frenchman’s pioneer efforts with his German forebear.
Some comparative questions of method are discussed by A. N. Page, “Marshall’s
Graphs and Walras’s Equations: A Textbook Anomaly,” Economic Inquiry, vol. 18 (Janu-
ary 1980), pp. 138–143; and D. Pokorny, “Smith and Walras: Two Theories of Science,”
Canadian Journal of Economics, vol. 11 (August 1978), pp. 387–403. Andrea von Wittel-
oostuijn and J. A. H. Maks, “Walras on Temporary Equilibrium and Dynamics,” History
of Political Economy, vol. 22 (Summer 1990), pp. 223–237, seek to correct some of the
“textbook” misconceptions of Walras’s economics, especially with regard to uncertainty
and disequilibrium.
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Chapter 17 ■ The Mantle of Léon Walras 453

Michael H. Turk, “The Fault Line of Axiomatization: Walras’ Linkage of Physics with
Economics,” The European Journal of the History of Economic Thought, vol. 13 (June
2006), pp. 195–212, examines the impact of physics on Walras’s attempts to mathematize
economics. Walras’s failure to resolve certain issues in this respect poses serious prob-
lems that have persisted to the present day. Same author, “The Mathematical Turn in
Economics: Walras, The French Mathematicians, and the Road not Taken,” Journal of
the History of Economic Thought, vol. 34 (June 2012), pp 149–167, argues that ideas ger-
minating in nineteenth-century French mathematical literature might have significantly
altered the way in which economics became formalized after Walras.
Walras’s theory of money has not drawn as much attention as other aspects of his
thought, but see S. G. F. Hall, “Money and the Walrasian Utility Function,” Oxford Eco-
nomic Papers, vol. 35 (July 1983), pp. 247–253; and Renato Cirillo, “Léon Walras’ Theory
of Money,” American Journal of Economics & Sociology, vol. 45 (April 1986), pp. 215–
221. See also, same author, “The True Significance of Walras’ General Equilibrium The-
ory,” Revue européenne des sciences sociales, vol. 14 (1976), pp. 5–13.
Maurice Allais and Talcott Parsons give an overview of Pareto and his thought in D.
L. Sills and R. K. Merton (eds.), “Vilfredo Pareto,” International Encyclopedia of the
Social Sciences, vol. 2 (New York: Free Press, 1968). Luigino Bruni, Vilfredo Pareto and
The Birth Of Modern Microeconomics (Cheltenham, UK: Edward Elgar, 2002), reveals
Hicks’s debt to Pareto and concludes that Pareto’s revolution in choice theory is better
understood in the context of his own philosophical framework.
Pareto’s Manuel (the French edition was published in 1906) has been translated, but
the translation has stirred controversy. See William Jaffé, “Pareto Translated: A Review
Article,” Journal of Economic Literature, vol. 10 (December 1972), pp. 1190–1201; and
the exchange between J. F. Schwier, Ann S. Schwier, William Jaffé, and Vincent Tarascio
in the Journal of Economic Literature, vol. 12 (March 1974), pp. 78–96. Vincent Tarascio
has published widely on Pareto’s scientific methodology and welfare theory. See Taras-
cio, Pareto’s Methodological Approach to Economics: A Study in the History of Some Sci-
entific Aspects of Economic Thought (Chapel Hill: The University of North Carolina
Press, 1968); same author, “Vilfredo Pareto and Marginalism,” History of Political Econ-
omy, vol. 4 (Fall 1972), pp. 406–425; same author, “Pareto on Political Economy,” History
of Political Economy, vol. 6 (Winter 1974), pp. 361–380; and again, “Pareto: A View of the
Present through the Past,” Journal of Political Economy, vol. 84 (February 1976), pp. 109–
122. Luigino Bruni and Francesco Guala, “Vilfredo Pareto and the Epistemological Foun-
dations of Choice Theory,” History of Political Economy, vol. 33 (Spring 2001), pp. 21–49,
trace the development of Pareto’s views on the foundations of economic theory and seek
to clarify the curious combination of ordinalism and operationalism that Pareto intro-
duced. See also Christian E. Weber, “Pareto and the 53 Percent Ordinal Theory of Util-
ity,” History of Political Economy, vol. 33 (Fall 2001), pp. 541–576.
Vincent Tarascio, “Paretian Welfare Theory: Some Neglected Aspects,” Journal of
Political Economy, vol. 77 (January–February 1969), pp. 1–20, attempts to clarify some
long-standing issues regarding Pareto’s welfare theory. See also Michael McLure,
“Pareto, Pigou and Third-party Consumption: Divergent Approaches to Welfare Theory
with Implications for the Study of Public Finance,” The European Journal of the History
of Economic Thought, vol. 17 (October 2010), pp. 635–657, argues that the differences
between Pareto’s and Pigou’s ideas on economic and social welfare in the case of third-
party consumption go beyond the difference between ordinal and cardinal representa-
tions of utility and can be traced to fundamentally different characterizations of science.
For a condensed but useful overview of the development of welfare economics and some
of its persistent problems, see R. F. Hébert and R. B. Ekelund, “Welfare Economics,” in
John Creedy and D. P. O’Brien (eds.), Economic Analysis in Historical Perspective (Lon-
don: Butterworth, 1984), pp. 46–83.
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18

Hegemony of
Neoclassical Economics

Most history of economic thought textbooks establish a demarcation in the 1870s

between classical economics and neoclassical economics. Considering the preceding
chapters in this section, the following picture easily emerges. Neoclassical economics
was a tripartite development, launched in England by William Stanley Jevons in 1871;
in Austria by Carl Menger in 1871; and in France by Léon Walras in 1874. Alfred Mar-
shall codified and extended the basic principles of neoclassical theory for modern
economists in his Principles of Economics, first published in 1890. Cournot and Dupuit
paved the way for the transition from classical macroeconomics to neoclassical micro-
economics, but their efforts were largely neglected. This is the conventional wisdom.
The problem is that this potted history grossly simplifies actual developments
in the history of economic thought and ignores many other threads that were woven
into what became the fabric of neoclassical economics. In this chapter we present a
more sophisticated interpretation by elaborating two important and significant
facts. First, the tools of neoclassical analysis were widely available across Europe
well before 1870, making the notion that neoclassical economics experienced a tri-
partite “immaculate conception” around 1870 naive. Second, the popular interpreta-
tion of events undervalues the key contribution of Alfred Marshall, who put an
indelible stamp on neoclassical economics by defining the appropriate method of
economic inquiry. When we refer to neoclassical economics today, we usually mean
the collection of tools of economic knowledge available to (and invented by) Mar-
shall, channeled and directed into uses dictated by his view of economic science.
Admittedly, not all contemporary economists who regard themselves as neoclassi-
cists follow Marshall’s path. Some “high-brow” theorists prefer to adopt Cournot’s
view that economics is rational mechanics. Others maintain that connection to the
real world is unimportant in theoretical research. But the bulk of the profession
accepts Marshall’s method of economic inquiry, and it is his brand of neoclassicism
that forms the core of contemporary neoclassical economics. Of course, like all
giants in a field, Marshall absorbed much from his predecessors.

■ THE PROTO-NEOCLASSICISTS BEFORE 1870

The essence of neoclassical economics is far from settled in the history of eco-
nomic thought. Some writers emphasize the increasingly mathematical character of

454
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Chapter 18 ■ Hegemony of Neoclassical Economics 455

economic thought after 1870. Others point to marginalism as the hallmark of neo-
classical economics. Others plant the roots of neoclassical economics in the subjec-
tivism of utility theory. Still others stress the static analysis of efficient allocation as
the distinguishing feature of neoclassical economics.
There is a grain of truth in all of these claims. But in more ways than are commonly
appreciated, the economist’s tool kit was rapidly filling in the decades before 1870.
Many writers of different nationalities contributed to the assemblage of microeco-
nomic principles. For example, in Great Britain (see table 18-1) William Whewell
applied mathematics to Ricardian economics in 1829 and the ensuing years. He
based his economic studies on the twin beliefs that mathematics could render eco-
nomics simpler, clearer, and more systematic and that it could help avoid the danger
of drawing false conclusions from the assumptions that had to be made. William
Forster Lloyd gave a series of lectures at Oxford University between 1832 and 1837
in which he explained a theory of value based on the principle of marginal utility.
Mountifort Longfield propounded similar ideas at Trinity College in Dublin. His lec-
tures, published in 1834, established a complete demand and supply theory, supple-
mented by utility analysis, and he espoused a marginal productivity theory of
distribution. John Stuart Mill, generally regarded as a classical economist (see
chapter 8), has also been proclaimed an important proto-neoclassical by Nobel lau-
reate, George Stigler (“Nature and Role of Originality”).
One of the most distinctive “neoclassical” contributions of the era was made by
Dionysius Lardner, an astronomer and railway engineer. His book Railway Econ-
omy (1850) brimmed over with suggestions regarding the “neoclassical” theory of

Table 18-1 British Proto-Neoclassical Contributors

Name Profession Writings Contributions
William Scholar Mathematical Exposition of Developed mathematical analysis of
Whewell Some Doctrines of Political Ricardian economics; developed fixed
(1799–1866) Economy (1829–31) capital model and one dealing with
input substitution between labor and
machinery
Mountifort Scholar, Lectures on Political Established complete demand-supply
Longfield Jurist Economy (1834) theory supplemented by elements of
(1802–1884) utility analysis; marginal productivity
theory of distribution
W. F. Lloyd Scholar Lectures on Population, Lectured on marginal-utility theory
(1794–1852) Value, Poor Laws, and Rent of value
(1837)
J. S. Mill Scholar Principles of Political Developed theory of noncompeting
(1806–1873) Economy (1848) groups, joint products, alternative
costs, economics of the firm, supply
and demand
Dionysius Engineer Railway Economy (1850) Analyzed railroad pricing structures;
Lardner developed simple and discriminating
(1793–1859) monopoly analysis; analyzed monopoly
firm in terms of total cost and total reve-
nue, both mathematically and graphi-
cally (with an implicit demand curve)
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456 Part IV ■ The Neoclassical Era

the firm, especially the pricing of transport services, the behavior of simple and dis-
criminating monopolies, the location of firms, and the theory of profit maximiza-
tion. Lardner developed a graphical model that implied a demand curve, but he did
not explicitly sketch one.
These isolated and scattered contributions within Britain do not constitute a
“school of thought” in the usual sense, but they demonstrate that certain building
blocks were being put into place not long after Adam Smith’s death. Outwardly, the
overlap with the classical school was minimal, yet in the first half of the nineteenth
century British writers were already prominently featuring certain elements of eco-
nomic theory—like mathematical models and marginal analysis—that were to
become part of the body of neoclassical economics. The process of inventing and
collecting analytical tools had begun, even though the guiding force that would
direct those tools to greatest effect did not materialize until the next generation.
Our focus on German historical economics in chapter 11 obscures the fact that
a trend toward “neoclassical” economics was established in Germany during the
nineteenth century as well (see table 18-2). In Germany, as in France, engineers
paved the way for soon-to-be economists by raising issues not addressed by classi-
cal economics. A generation before Dupuit, the German engineer Claus Kröncke

Table 18-2 German Proto-Neoclassical Contributors

Name Profession Writings Contribution(s)
Claus Engineer Versuch einer Theorie des Early “cost-benefit” calculations of
Kröncke Fuhrwerks, mit Answendung roads and canals; benefits associated
(1771–1843) ouf den Strassenbau (1802) with cost and price reductions of
improved transport
G. Graf Engineer Die Theorie der National- Used differential calculus to choose
von Buquoy wirthschaft (1815) optimum technique in agriculture;
(1781-1851) grasped decreasing returns and
increasing (marginal) cost, but failed
to understand the “benefits” side of
the calculation
Gottlieb Jurist Neue Grundlegung der staats- Provided early subjective theory of
Hufeland wirthschafskunst, durch value and elements of a productivity
(1783–1850) Prüfung und Berichtigung theory of distribution, based not merely
ihrer Hauptbegriffe von Gut, on physical productivity but on value
Werth, Preis, Geld und Volks- productivity as well, which emerged in
vermögen mit ununterbro- the process of price formation
chener Rücksicht auf die
bisherigen Systeme (1807)
J. H. von Agronomist Der isolierte Staat in Developed theory of rent, location,
Thünen Beziehung aut Landwirt- and resource allocation based on prin-
(1783–1850) schaft und Nationolöko- ciple of marginal productivity, along
nomie (1826–50)* lines of comparative statics
K. H. Rau Scholar Grundsätze der Volkswirth- Developed marginal productivity the-
(1792–1870) schaftlehre (1826; 1841) ory of value simultaneously with von
Thünen; treated all prices in the same
demand-supply framework; saw distri-
bution as part of price theory; drew
supply and demand curves after 1840
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Chapter 18 ■ Hegemony of Neoclassical Economics 457

Table 18-2 German Proto-Neoclassical Contributors (cont’d)

Name Profession Writings Contribution(s)
F. B. W. Scholar, Staatwirthschaftliche Recognized, contra Ricardo, that pro-
Hermann Statistician Untersuchungen (1832) duction costs are demand dependent
(1795–1868) and used “opportunity cost” approach
to demand, but without marginal util-
ity as basis for evaluation; anticipated
later Austrian approach to output and
input valuation.
C. W. C. Schüz Scholar Grundsätze der National- Developed theory of marginal-prod-
(18??–18??) ökonomie (1843) uct pricing of factors (VMP) suggested
by Hermann
H. H. Gossen Law clerk, Entwicklung der Gesetze des Developed utility functions related to
(1810–1858) Businessman menschlichen Verkehrs, und time, not quantity; made optimal alloca-
der daraus fliessenden tion of resources dependent on equal-
Regeln für menschliches ization of marginal utilities; moved
Handeln (1854)* constrained optimization into the cen-
ter of value and allocation theory
W. G. F. Scholar Die Grundlagen der National- Proposed subjective theory of value
Roscher ökonomie: Ein Hand und and theory of noncompetitive pricing;
(1817–1894) Lesebuch für Geschäfts- wrote standard textbook for genera-
manner und Studierende tion of German economists nurtured
(1854)* on Rau
H. K. E. von Scholar Die Lehre vom Unter- Developed partial-equilibrium, mathe-
Mangoldt nehmergewinn (1855)* matical theory of prices that extended
(1824–1868) Grundriss der Volkswirth- beyond Cournot; used comparative stat-
schaftlehre (1863)* ics to analyze multiple equilibria, as well
as joint-supply and demand; derived
demand curves from underlying utilities
in cases of variable quantities
K. G. A. Knies Scholar, “Die nationalökoenomi- Put principle of diminishing marginal
(1821–1864) Statistician sche Lehre vom Werth” utility at core of value theory; rejected
(1855) Marx’s theory of value because it
denied utility
Peter Scholar Grundsätze der National- Menger’s teacher; used utility to mea-
Mischler ökonomie (1857) sure aggregate welfare, prices to mea-
(1824–1864) sure individual utility; anticipated
Gossen on key points
A. E. F. Scholar Das gesellschaftliche System Advanced subjective theory of value;
Schäffle der menschlichen Wirth- emphasized purpose and causal rela-
(1831–1903) schaft (1867) tionship of goods typical of Menger,
but did not recognize von Thünen’s
marginalism; Menger’s predecessor at
University of Vienna
*Translated into English
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458 Part IV ■ The Neoclassical Era

introduced “cost-benefit” calculations of roads and canals. Another German engi-

neer, G. G. von Buquoy, used differential calculus to solve economic problems in
agriculture. The subjectivist tradition in German economics (in which utility consid-
erations were granted a prominent role) began with Gottlieb Hufeland (1807) and
was continued by practically every important writer before Menger. Karl Rau
(1826), a leading textbook writer of the first half of the nineteenth century, insisted
that all prices be treated with the same demand-supply framework, and he drew
demand and supply curves from 1841 on. Friedrich Hermann (1832) did not employ
marginal-utility analysis, but he used an opportunity-cost approach to demand, and
he anticipated the input-valuation procedure later introduced by Menger (see chap-
ter 14). C. W. C. Schüz (1843) extended Hermann’s analysis by developing the the-
ory of factor pricing based on the value of marginal product.
Wilhelm Roscher (1854) (see chapter 11) discussed the theory of noncompeti-
tive pricing and advocated a subjective theory of value in his textbook, which even-
tually supplanted Rau’s popular text. Karl Knies (1855) put the principle of
diminishing marginal utility at the core of his value theory. Hans von Mangoldt (see
chapter 14) elaborated the utility foundations of demand and developed a partial
equilibrium, mathematical theory of prices that surpassed Cournot. Menger’s
teacher, Peter Mischler (1857), defended utility as a measure of economic welfare
and anticipated the equimarginal principle of utility. And Menger’s predecessor at
the University of Vienna, Albert Schäffle (1867), emphasized subjective evaluations
and relationships in much the same manner as Menger.
Two German writers whose writings were “neoclassical” in everything but name
were Johann von Thünen and Hermann Heinrich Gossen (see chapter 14). Von
Thünen practically invented location theory in 1826 and he later established a work-
able microeconomic theory in which economic decisions and economic evaluations
are made at the margin in a constrained optimization model. He borrowed from the
physical sciences, especially in the use of differential calculus, to solve economic
problems. He stands today as the “father” of the comparative statics model. Gossen
did for the theory of consumption what von Thünen did for the theory of production.
He was one of the earliest writers to work out the formal theory of consumer behavior
based on the principle of marginal utility. He also borrowed from the physical sci-
ences in order to introduce more precision and clarity into economic analysis. Gos-
sen’s utility functions relate to time rather than quantity—which technically puts them
outside the strict neoclassical mold—but his originality in using mathematics and dia-
grams to explain the principles of constrained maximization is nevertheless striking
and original. Taken together, the contributions of von Thünen and Gossen provide a
fairly complete neoclassical theory of optimal allocation of economic resources.
Cournot and Dupuit (see chapter 13) brought the econo-engineering tradition
to fruition in France, but French contributions to neoclassical economics can be
traced back to Condillac (1776), who established the subjective theory of value the
same year that The Wealth of Nations appeared (see table 18-3). A. N. Isnard (1781)
anticipated Léon Walras on many essential points and is an important predecessor
of the general-equilibrium approach to neoclassical economics. Demand theory
advanced at the hands of Germain Garnier (1796) and J. B. Say (1828), who devel-
oped an income-stratified notion of demand that Dupuit later incorporated into his
pioneer work. From his classroom at the École Nationale des Ponts et Chaussées in
the early 1830s, Charles Minard (1850) demonstrated the richness of economic
inquiry and its anchor in the concept of utility. Cournot, of course, practically
invented the neoclassical theory of the firm in 1838. In his personal tribute, Alfred
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Chapter 18 ■ Hegemony of Neoclassical Economics 459

Table 18-3 French Proto-Neoclassical Contributors

Name Profession Writings Contributions
E. B. de Philosopher, Le commerce et le gouverne- Established subjective theory of value;
Condillac Cleric ment considérés relative- Roscher’s pet source for notions on
(1714–1780) ment l’un à l’autre (1776)* utility
A. N. Isnard Engineer Traité des richesses (1781) Established mathematics of exchange
(1749–1803) equilibrium, production, capital, inter-
est, and foreign exchange; anticipated
general equilibrium approach of Walras
Germain Aristocrat Abrégé élémentaire des Established income stratification of
Garnier principes de l’économie poli- demand (i.e., the pyramid of wealth)
(1754–1821) tique (1796)
J. B. Say Industrialist, Traité d’économie politique Related utility to demand; Dupuit
(1767–1832) Scholar pratique (1803)* inspired by Say’s confusion to estab-
Cours complet d’économie lish marginal utility theory of demand;
politique pratique (1828) pyramid of wealth; launching pad for
Dupuit’s theory of demand
Charles Engineer “Notions élémentaire Developed cost-benefit analysis based
Minard d’économie politique on discounted value of time; influen-
(1781–1870) appliquée aux travaux tial teacher at École National des Ponts
publics” (1830/1850) et Chaussées
A. A. Cournot Mathemati- Recherches sur les principes Derived mathematical theory of
(1801–1877) cian, mathématiques de la théo- demand and supply; applied marginal
Philosopher rie des richesses (1838)* analysis to the theory of the firm,
under monopoly and competitive
conditions; developed theory of duo-
poly based on quantity conjectures;
based demand curves on “observa-
tion”; adopted a rational and mechani-
cal theory of markets
A. E. J. Engineer “De la mesure de l’utilité Advanced utility-based analysis of
Dupuit des travaux publics” demand; first modern cost-benefit
(1804–1866) (1844)* approach to markets; calculation of
“De l’influence des péages net benefit under alternative market
sur l’utilité des voies com- conditions and pricing structures (e.g.,
munication” (1849)* competition, monopoly, price discrim-
“De l’utilité et de sa ination); identified time period of
mesure: De l’utilité adjustments in market model; estab-
publique” (1853) lished economics as theoretical and
empirical science with a “Marshallian”
methodology; analyzed impact of
property rights assignments and inter-
est groups, public-choice models;
graphical treatment of price-quantity
and price-quality determination
*Translated into English
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460 Part IV ■ The Neoclassical Era

Marshall wrote: “Cournot was a gymnastic master who directed the form of my
thought” (Memorials, p. 360).
In the eighteenth century, Italy produced four major economists who displayed
“neoclassical” tendencies (see table 18-4). The father figure of Italian neoclassicism
was Ferdinando Galiani (1751), who based value theory on utility and scarcity,

Table 18-4 Italian Proto-Neoclassical Contributors

Name Profession Writings Contributions
Ferdinando Scholar, Della Moneta (1751)* Established value theory based on util-
Galiani Statesman ity and scarcity; equilibrium as a result
(1728–1787) of interdependence between price and
quantity; resolved paradox of value
C. B. Beccaria Scholar, Dei delitti e delle pene Embraced utility as principle of eco-
(1712–1769) Administra- (1764)* nomic action; discovered idea that
tor Elementi de economia underlies modern indifference analy-
publica (1771)* sis; established mathematical eco-
nomics; influenced Bentham
Antonio Scholar, Lezioni de Commercio ossia Made a comprehensive presentation
Genovesi Cleric di Economia Civile (1765) of utilitarian welfare economics.
(1712–1794) Derived value from demand, based on
utility; linked quality to value
Pietro Verri Scholar, Degli elementi del commer- Offered a clear conception of eco-
(1728–1797) Administra- cio (1760) nomic equilibrium based on the “cal-
tor Meditazioni sull’economia culus of pleasure and pain”; developed
politica (1771)* a constant outlay demand curve;
argued that supply and demand
determine all prices, including interest
L. M. Scholar Del prezzo delle cose tutte Made astute use of demand and sup-
Valeriani mercantili (1806) ply functions
(1758–1828)
Francesco Scholar Saggi economici (1825–27) Focused on subjective theory of value;
Fuoco idea of “public happiness” as a state of
(1774–1841) equilibrium
Pellegrino Scholar, Cours d’économie politique Applied subjective theory of value;
Rossi Statesman (1840) successor to Say at Collège de France;
(1787–1848) influenced Dupuit
Gerolamo Scholar, Trattato teorico-pratico di Treated value as exchange ratio and
Boccardo Statesman economia politica (1853) market price as outcome of demand
(1829–1904) and supply; argued that reduction in
price uncovers lower levels of demand
(i.e., anticipated elasticity)
Francesco Scholar, “Lezioni di economia polit- Developed a sophisticated theory of
Ferrara Statesman ica” (1856–58) value based on subjective factors, i.e.,
(1810–1900) a psychological cost-benefit analysis
of alternative choices; anticipated the
“marginal revolution”
*Translated into English
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Chapter 18 ■ Hegemony of Neoclassical Economics 461

established economic equilibrium as a result of interdependence between price and

quantity, and resolved the paradox of value before Smith even posed it.
Cesare Beccaria (1764; 1771) also embraced utility as the principle of economic
action, anticipated modern indifference analysis and championed the mathematical
method in economic investigation. Antonio Genovesi (1765) put forth a comprehen-
sive program of utilitarian welfare economics and derived value from demand,
which he based on the concept—if not the name—of marginal utility. Pietro Verri
(1760; 1771) offered a clear conception of economic equilibrium based on the “cal-
culus of pleasure and pain.” He developed a constant-outlay demand curve and
asserted that demand and supply determine all prices, including interest (the price
of loans).
In the nineteenth century, Luigi Valeriani, Francesco Fuoco, Pellegrino Rossi,
Gerolamo Boccardo and Francesco Ferrara continued the Italian tradition. Joseph
Schumpeter said of Valeriani (1806), “he could have taught Senior and Mill how to
handle supply and demand functions” (History, p. 511). Fuoco (1825–1827) advo-
cated a subjective theory of value and advanced the idea that “public happiness” is a
state of equilibrium. Rossi (1840) propounded a subjective theory of value at the
Collège de France, where he succeeded J. B. Say. Dupuit cited Rossi frequently. Boc-
cardo (1853) explained market price as an exchange ratio—the outcome of demand
and supply—and in his arguments about the effect of lower prices on quantity
demanded he anticipated the principle of elasticity that Marshall later popularized.
Ferrara (1856–1858) developed a sophisticated theory of value based on psychologi-
cal cost-benefit considerations.
U.S. economists lagged behind their European cohorts during the nineteenth
century, with one notable exception. Charles Ellet, Jr., studied at the École Natio-
nale des Ponts et Chaussées in Paris—which was then the world’s leading postgrad-
uate institution of engineering studies—and brought that school’s brand of
economic analysis to North America. In the same year that Cournot published his
major economic work, Ellet published his book, An Essay on the Laws of Trade with
Reference to the Works of Internal Improvement in the United States (1839). For
more than a century, economists on both sides of the Atlantic overlooked the merits
of this book, a virtual incubator of “neoclassical” ideas. Its recurrent theme is that
business decisions could and should be based on mathematically derived principles.
Ellet forged a number of new analytical tools, including mathematical models of
monopoly and price discrimination, a theory of optimal input selection, and a duo-
poly model that is, in some respects, superior to Cournot’s.
Regardless of geographic origin, practically all of these proto-neoclassical con-
tributions were based on economic rationality formulated in terms of the “marginal-
ism” inherent in downward-sloping demand curves. Admittedly many of these
contributions were fragmented and isolated. But four writers rose above the rest:
von Thünen, Gossen, Cournot, and Dupuit. In these four writers the fundamental
tools of neoclassical analysis, expressed verbally, graphically, or mathematically,
may be found in clear and original fashion by 1860. Thus, the so-called “marginal-
utility revolution” was not so much a revolution as an evolution.
For example, in the matter of demand theory, Dupuit, Cournot, and Gossen
established downward-sloping demand curves based on the rational behavior of
individual consumers confronting a schedule of costs and benefits. Dupuit went so
far as to invent the principle of consumer surplus as a means of testing the wisdom
of public policy. This group of writers firmly established the importance of maximiz-
ing subject to constraints. Gossen found equilibrium for individuals subject to an
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462 Part IV ■ The Neoclassical Era

expenditure constraint where the marginal benefits were equal. Von Thünen dis-
cussed selection of inputs based on their marginal productivity; Gossen looked at
the choice of labor inputs based on labor’s productivity. Cournot and Dupuit dis-
cussed the concept of price elasticity of demand, although it had not yet been given
that name. Gossen also constructed exchange models based on utility consider-
ations, and Dupuit advanced a model of international exchange that employed Mar-
shallian-like periods of adjustment (i.e., short-run versus long-run).
Cournot, Dupuit, and Gossen established a framework of market equilibrium
based on conceptions of supply and demand. In turn, Cournot and Dupuit showed
how this framework established the underlying profit-maximizing principles for
monopolists and competitors, and Dupuit further discussed the conditions and con-
sequences of price discrimination. Cournot created a theory of oligopoly and duopoly
with mutual interdependence, and Dupuit applied this theory to product differentia-
tion by quality in markets. Von Thünen and Dupuit brought the implications and
effects of time, technology, space, and property rights into economic theory.
If the theoretical tool kit that appears in Marshall’s Principles is taken as a
benchmark for principles that constitute neoclassical microeconomics, there is very
little that cannot be found in the works of Cournot, Dupuit, Gossen, and von
Thünen. Indeed, in a number of areas such as duopoly, price discrimination, and
spatial competition, Marshall’s analysis is less accomplished than his predecessors’.

■ LESSONS TO BE LEARNED
Several overall points emerge from this overview of early developments in neo-
classical economics. First, there is a pronounced Continental dominance in the
development of the “new” themes. In terms of sheer numbers, Germany and Italy
dominated (see tables 18-2 and 18-3); yet, the proto-neoclassical tradition in other
countries also made serious headway. Erich Streissler (“Influence of German Eco-
nomics”) exposed the rich heritage of neoclassical spirit among German writers
who preceded Menger, and Robert Ekelund and Robert Hébert (Secret Origins of
Modern Microeconomics) revealed the obscure origins of French economic theory
before Walras. But the Italian contribution remains largely neglected outside that
country, and in England the proto-neoclassicists have been overshadowed by the
almost exclusive focus on the usual major figures of the classical era.
Second, many new analytical techniques emerged from practitioners like engi-
neers, agronomists, and merchants, not just from academicians. In Great Britain,
Germany, and Italy, the writers who consistently probed “neoclassical” themes came
primarily from within the academy, but in France and the United States it was
chiefly engineers who broke new ground (see tables 18-4 and 18-5). Germany’s most
original economists, von Thünen and Gossen, were outliers. Von Thünen was an
agronomist while Gossen was a law clerk and businessman. Lardner (Great Britain)
was an astronomer and engineer. Whewell (Great Britain) and Cournot (France)
were mathematicians. Condillac (France) and Genovesi (Italy) were clerics.
Third, if history is a proper guide, economic theory is not mathematics, nor is
mathematics the same as economic theory. Gossen, for example, was a mediocre
mathematician but seems to have invented modern diagrammatic economics. New
insights in economic theory are sometimes expressed in mathematical terms, but
they are also often expressed with verbal or graphical tools and only later translated
into mathematics.
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Chapter 18 ■ Hegemony of Neoclassical Economics 463

Table 18-5 American Proto-Neoclassical Contributor

Name Profession Writings Contributions
Charles Engineer An Essay on the Laws of Developed elaborate mathematical
Ellet, Jr. Trade in Reference to the models of monopoly and price dis-
(1810–1862) Works of Internal Improve- criminating firms; invented duopoly
ment in the United States theory in same year as Cournot; devel-
(1839) oped theory of optimal input selection
and joint inputs

The final point is that except for Dupuit, none of the proto-neoclassical writers
who have been discussed so far shared the Marshallian vision of economics as an
engine of scientific discovery—a vision that had a preponderant impact on the way
economists practice economics.

■ WHAT DID MARSHALL KNOW AND WHERE DID HE LEARN IT?

It is difficult to know what sources Alfred Marshall drew from for his Principles
and how he came to know of them. The most thorough attempt to trace the influ-
ences on Marshall’s thought to date can be found in Groenewegen (Soaring Eagle,
ch. 6). By his own testimony, Marshall read Cournot in 1868; von Thünen, Her-
mann, Roscher, Rau, and von Mangoldt around 1869–70; Jenkin in 1870; Jevons in
1871; and Dupuit in 1873 or sometime after. How these influences impinged on his
thinking remains somewhat obscure, but on some points the connections are clear.
For example, Marshall adopted Hermann’s classification of internal and external
wants, acknowledged his anticipation of quasi-rent, and cited his notion of capital
(Principles, pp. 55n, 432n, 788n). It is even plausible, as Streissler (“Influence,” pp.
32–33) contends, that Marshall might have gotten the general structure of the Prin-
ciples from earlier German writers, but we do not believe that he got his ideas on
demand, marginal utility, consumer surplus, and general competitive equilibrium
from them. Marshall told John Bates Clark that von Thünen inspired his distribu-
tion theory (Memorials, pp. 412–413). Furthermore, he said that his opinions
derived more substance from von Thünen than Cournot (p. 360).
It is widely recognized that Marshall drew on earlier sources in assembling the
components of neoclassical microeconomics, and we have long known that Mar-
shall did not regard his contributions as revolutionary. What is new is the claim that
many of the tools in his kit existed before Menger, Jevons, and Walras and that Mar-
shall had some awareness of the earlier proto-neoclassicists. But discussions of
neoclassical economics often underestimate the extent to which it consists of a sci-
entific method, as well as a set of tools, and the extent to which Marshall was instru-
mental in laying the groundwork for that method. Indeed, there are indications that
Marshall considered the lack of a proper scientific basis for economics to be the
most pressing problem confronting the discipline.
Marshall affirmed his belief that economic science is a procedure for scientific
discovery in Book I, chapter 3 of his Principles. He noted similarities between eco-
nomics and all other sciences: “It is the business of economics, as of almost every
other science, to collect facts, to arrange and interpret them, and to draw inferences
from them” (Principles, p. 29). However, economic analysis faces certain limitations
that may not apply in all the other sciences. In sciences like physics or astronomy,
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464 Part IV ■ The Neoclassical Era

the variables used in the theory can include most of the important causes and
effects, so that an empirical test can be matched closely to the theory. Economic the-
ory often fails in this regard because, by necessity, human sciences rely on theories
that do not include all of the variables that are relevant at a specific time and place.
Although Marshall focused on static equilibrium, a concept borrowed from phys-
ics, he denied explicit analogies between the laws of physics, astronomy, or mechan-
ics and those of economics. Instead, Marshall compared economics to meteorology.
The laws of economics are to be compared with the laws of the tides, rather than
the simple and exact law of gravitation. For the actions of men are so various and
uncertain, that the best statement of tendencies, which we can make in a science of
human conduct, must needs be inexact and faulty. . . . And since we must form to
ourselves some notions of the tendencies of human action, our choice is between
forming those notions carelessly and forming them carefully. (Principles, pp. 32–33)

John Sutton explains, “The key to Marshall’s view lies in his claim that eco-
nomic mechanisms work out their influences against a messy background of com-
plicated factors, so that the most we can expect of economic analysis is that it
captures the ‘tendencies’ induced by changes in this or that factor” (“Marshall’s
Tendencies,” p. 4). Thus, Marshall accepted mathematical models and static equilib-
rium theory as helpful organizing principles for understanding the functioning of
actual markets. But he insisted that tendencies produced by self-interested, rational
human behavior yield predictable results only within the limited confines of “dis-
turbing causes,” which must be examined one at a time using the ceteris paribus
assumption. Marshall’s methodology is one in which not all factors are specified
within a theory (nor can they be) and where some of the unspecified factors may
measurably alter predicted results. This latter approach encouraged the develop-
ment of modern methods of econometrics in order to determine, probabilistically,
which factors do and which do not alter results.
In the battle over induction (from theory) versus deduction (from evidence),
Marshall occupied the middle ground. He told Edgeworth that because “theory
alone was empty, while empirical investigations without theory were suspect; hence
only the interweaving of theory and evidence constituted ‘economics proper’” (Sut-
ton, “Marshall’s Tendencies,” p. 13). In his evaluation of Marshall’s impact, Sutton
argues: “What the birth of the standard paradigm brought into economics was a
new insistence on the importance of formulating rival views in the guise of sharply
defined theories that could be evaluated by reference to clear empirical tests. It is
this, rather than any rigid recipe for research, that remains its enduring legacy”
(“Marshall’s Tendencies,” pp. 105–106).
Although Marshall was lavish in his praise of von Thünen and Cournot, he bor-
rowed their theories, not their methods. Von Thünen did not attempt to encase his
theory in a strict methodological framework. In an article written about Gossen,
Jurg Niehans claims that von Thünen made the farm his economic paradigm (New
Palgrave, II, pp. 550–554). Peter Groenewegen asserts that von Thünen’s method
gave Marshall “greater awareness of the importance of gathering facts and experi-
mentation for scientific activity,” which is probably true (Soaring Eagle, p. 152).
However, von Thünen’s method was of a different order than Marshall’s (and
Dupuit’s). Von Thünen collected facts with which to verify theory. This constitutes a
version of the “scientific method” as we know it, but it is a method that belongs to
the realm of arithmetic, whereas the method that Marshall proposed for economics
appears to be “statistical” in the probabilistic sense.
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Chapter 18 ■ Hegemony of Neoclassical Economics 465

Cournot, while widely regarded as the precursor of economic statistics, actually

rejected empiricism when it came to economic science. He took refuge in what
Claude Ménard calls “rational mechanics,” displaying a curiously ambivalent atti-
tude toward statistics (“Three Forms of Resistance to Statistics,” p. 533). This view
of science is verified throughout Cournot’s Researches, where all of the scientific
analogies are to “hard” sciences such as mechanics, physics, astronomy, and
“motion.” Only once did Cournot admit empiricism into his analysis, in the formula-
tion of his demand curve, where he based the inverse relation between price and
quantity on observation. This single insertion is best viewed as a stalking horse for a
mechanical and purely mathematical science of economics. Cournot’s goal was in
fact to fashion economics along the lines of an “abstract science” like hydrostatics.
Ditto for Gossen, who believed: “It is impossible to present the true system of eco-
nomics without the aid of mathematics—a fact that has long been recognised in the
case of pure astronomy, pure physics, mechanics and so forth” (Theocharis, Devel-
opment of Mathematical Economics, p. 198): With proper caveats, virtually the
same mechanical approach was employed by the rest of the proto-neoclassicists.
The single exception was Dupuit.
Dupuit was undaunted by the uncertain or “capricious” nature of utility as a
foundation for the demand curve, and he explained its negative slope on the basis of
diminishing marginal utility, which could be measured in monetary terms.1 He envi-
sioned economic science as a combination of both theory and empiricism. From the
very beginning of his economic investigations, Dupuit combined empiricism—hypo-
thetical or actual observation—with demand, producing actual estimations of
demand curves and consumer surplus (“On the Measure of Utility,” p. 104). In addi-
tion to his empirically based demand curves, Dupuit proffered other examples of
actual or “anecdotal” empirical referents to economic theory, including analysis of
bridges, rock quarries, and canals; population; and water distribution. These discus-
sions show the use of a recognizably modern scientific method involving a priori
theorizing, testing, and reformulating “missing” elements in the original theory.
When Dupuit is compared to Marshall, especially on key points of theory and
method, he stands in the vanguard of the “new” approach. We find Dupuit expound-
ing economic method in 1860 in a fashion exactly analogous to Marshall’s exposi-
tion 30 years later. In discussing the usefulness of mathematical abstraction in the
search for solutions to economic problems, Dupuit cautioned that because of the
complexity of economic events they require empirical verification so as to enrich
and inform “provisional laws.” The following passage makes it clear that Dupuit
regarded economics as a process of discovery. The parallel between his argument
and Marshall’s analogy between economics and tides is striking.
There are times when throngs of curiosity-seekers flock to the seaside to see a
hundred-year tide. Science, which has discovered what causes tides, can tell us
that on a certain day the sun and moon will be so aligned as to cause the water
level to rise far above normal, nevertheless it may happen that the tide does not
behave as predicted. Is this cause to doubt the reigning theory? Does it mean that
the influence of the sun and moon on the tides was suspended for a day? No, of

1
Marshall’s defense of welfare measures in terms of money (Principles, Book I, ch. 2, pp. 15–22 and
following) is identical to that of Dupuit (“On the Measure of Utility,” pp. 102–107). Dupuit always
argued that there is no “utility other than what people will pay for” and that “political economy,
speculating on wealth and on the sacrifices which we are disposed to make in order to obtain it,
must necessarily take into account the energy of the will by its expression in money” (“De l’utilité
et de sa mesure,” p. 14).
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466 Part IV ■ The Neoclassical Era

course not; this great disappointment simply indicates that the height of the tides
depends on regular actions that we know how to calculate and on another action
that still eludes science. On the day when the phenomenon was anticipated, an
action that could not be predicted, such as a shift in wind direction, could have
produced effects contrary to what was calculated. The same is true of economic
events. (La Liberté commerciale, p. 138)

Moreover, Dupuit encased his methodological argument in the context of a “peri-

ods-of-adjustment” (short-run versus long-run) model of competitive equilibrium—a
hallmark of Marshall’s theoretical presentation of competitive markets, and a staple
of every introductory economics text thereafter. Expounding on the effect of a tariff
reduction on the relative prices of English iron and French wine, Dupuit argued:
Economics might predict that free trade would lower the price of iron in France to
170 francs within a few years; but if the price falls to 120 francs instead, due to
improvements in metallurgical processes, or the discovery of more abundant new
minerals; or on the contrary, if the price rises to 300 francs because of the influx of
gold and silver from California or Australia, these events do not refute basic princi-
ples. Of course, doubting Thomases, swayed by mere appearances and overcome
by their great disdain [for abstract theory], can marshal facts in opposition to the
theory, but surely intelligent people will not be convinced by their attacks. (La Lib-
erté commerciale, p. 138)

Likewise, on the usefulness of ceteris paribus Dupuit anticipated Marshall root

and branch, as his writing demonstrates:
When an effect depends on many causes, it can only be calculated exactly if every
condition is taken into account simultaneously. Nevertheless, it is defensible for
science to isolate each of these causes and to calculate their effects separately;
indeed it is the only way for it to investigate and to discover knowledge. (La Lib-
erté commerciale, p. 138)

These passages, which Dupuit amplified considerably in their original context,

present clear and unequivocal evidence that the primary method by which econo-
mists study economic phenomena today was explicitly outlined a generation before
Marshall. Marshallian neoclassical economics parallels Dupuit’s method and not
Cournot’s, or von Thünen’s, or any of the other proto-neoclassical writers.
Whether this remarkable parallel constitutes evidence of a genuine connection
between Marshall and Dupuit or a mere instance of historical serendipity is not
really the issue. Marshall could have formed his views on scientific method—as well
as his theoretical insights on utility, demand, and consumer surplus—independently
of Dupuit, or through other intellectual connections. For example, Marshall knew
the work of Jevons, who also mentioned tides in his discourse on economic method,
although Jevons ultimately adopted a “harder” view of economic science.2 The issue

2 Marshall was also quite familiar with the work of John Stuart Mill, who elaborated a view of eco-
nomic method that anticipated Dupuit and Marshall in several key respects. Mill admitted the com-
plexity of economics, recognized the uncertainty introduced to it by disturbing causes,
distinguished between social sciences and physical sciences, and outlined the necessity of ceteris
paribus. Later, however, Mill appeared to argue that ceteris paribus is only a logical convention in
reasoning, not a method of discovery to the extent that each causal element is brought in one at a
time empirically to explain effects within a theory and possibly to change its nature (A System of
Logic, Book VI, ch. 2, parts 1 and 2). For his part, Dupuit asserted that empirical methods are useful
for discovering general principles as well as verifying their existence, whereas Mill rejected the role
of a posteriori methods as a discovery mechanism (“On the Definition of Political Economy,” p. 331).
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Chapter 18 ■ Hegemony of Neoclassical Economics 467

instead is that both Marshall and Dupuit espoused the same method—the method
practiced today—which has progressively stimulated improved econometric and
statistical techniques. Hence, Marshall transmitted many of Dupuit’s ideas, either
wittingly or unwittingly. This means that his central importance to economics con-
sists not so much in the originality of his ideas but in his ability to persuade the bulk
of the profession of the efficacy of the new paradigm.

The Force of Ideas: Fame and Notoriety in Economics

Reflecting on fate, the Roman emperor, Marcus Aurelius (AD 121–180), noted that all is
ephemeral, including fame. Life is short; nothing lasts forever. But no matter how transitory, it
is interesting to reflect on how fame is achieved in the first place. In many fields of endeavor,
true creativity is not easily recognized, and fame often eludes those who later prove to be
masters of a subject. The Augustinian monk, Gregor Mendel (1822–1884), discovered the
basic principles of genetics with his pea-growing experiments only to bury his results in an
obscure agricultural journal, where they were ignored until rediscovered a century later. It
took thirty-four years for the rest of the scientific community to catch up to it. Johann Sebas-
tian Bach—now recognized as one of the greatest musical composers of all time—lapsed into
virtual obscurity after his death only to be elevated to his rightful place many decades later.
Many great creative minds are never recognized. So it was with the economists who antici-
pated neoclassical economics. Many wrote piecemeal contributions “above their time,” out of
their time, before their time, and generally before microeconomics and its mathematical
emphasis came to be recognized as a central paradigm.
This chapter has focused on a large number of “anticipators” of neoclassical economic the-
ory—figures from many disciplines and from many countries, who, by virtue of their writings,
may be deserving of a certain amount of fame or recognition. There may well be others who
have escaped recognition altogether. Despite these piecemeal contributions of economic cre-
ativity, we have argued that two French writers (Cournot and Dupuit) and two German writers
(von Thünen and Gossen) were, taken together, the authors of the whole paradigm of neo-
classical theoretical thinking. None were trained as “economists” but each contributed greatly
to traditional modern price theory.
Of these four pioneers, only Dupuit and Cournot attempted to “market” their ideas. An
engineer, Dupuit met with only limited success in selling his “neoclassical” theory and method
to economists committed to traditional modes of thought. Cournot attempted three times (in
1838, 1863, and 1877) to persuade the economics profession of the superiority of his “scien-
tific” conception of economics as rational mechanics. Was he ignored? Shunned is a better
word. His second effort of 1863 received reviews of mixed praise and constructive criticism.
But Cournot stubbornly persisted in believing that his brilliant theoretical system supported a
nascent socialist system of economic organization—a belief rejected by the reigning French
liberals of his day.*
Luck seems to play a large role in determining whether one receives lasting fame. Over the
long haul, as Aurelius suggested, fame is fleeting. But, in the short run, ideas must be aggres-
sively marketed and reviews written. Indeed, over the short run, it may well be true that the
only bad review is an obituary. Or, as saucy screen actress Mae West said: “It’s better to be
looked over, than overlooked.”
*See Robert B. Ekelund, Jr., and Robert F. Hébert, “Cournot and His Contemporaries” (in the reference section).
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468 Part IV ■ The Neoclassical Era

■ CONCLUSION
A genuine, functioning tool kit for neoclassical microeconomics existed long
before Marshall’s Principles in 1890 and well before the legendary triumvirate of
Menger, Jevons, and Walras came on the scene around 1870. The argument could be
made that neoclassical/marginalist ideas that floated about prior to 1870 were merely
scattered pieces in a great intellectual puzzle. In some individual cases, that may
have been true. It is also true that neoclassical microeconomics does not appear to
have evolved in a neat or linear way, or in an intellectual battle between “systems” or
“schools.” But the quantity and quality of the achievement of the proto-neoclassicists
is too great for their work to be set aside as isolated, fragmentary, or incomplete.
Jules Dupuit, in particular, managed to assemble a complete paradigm with
demand/utility specifications, marginalism with respect to inputs, cost conceptions
based on time periods of production, welfare calculations under alternative market
structures, graphical and mathematical analysis and illustrations, and a well-stated
and well-formed method for establishing microeconomic science. Dupuit antici-
pated Marshall in most of the key ingredients that came together to form neoclassi-
cal microeconomics.
Alfred Marshall was an accomplished theorist, but more importantly, he was at
the center of a “synthesizing community.” He shaped his theoretical tools with a sin-
gle purpose in mind: to make economics an engine of scientific discovery. Further-
more, by specifying its methodological framework, he channeled the new tools of
economic theory into what has become the traditional neoclassical paradigm. The
Marshallian method, which combined inductive theory and deductive empiricism,
ultimately shaped the modern practice of economics and spurred the twentieth-cen-
tury development of econometrics.

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Whewell, William. Mathematical Exposition of Certain Doctrines of Political Economy.
New York: A. M. Kelley, 1971.

NOTES FOR FURTHER READING

The idea that marginalism constitutes the essence of neoclassical economics has
been defended by T. W. Hutchison, A Review of Economic Doctrines, 1870–1929 (Oxford:
Ekelund-Hebert 6E.book Page 471 Thursday, August 1, 2013 11:03 AM

Chapter 18 ■ Hegemony of Neoclassical Economics 471

Clarendon Press, 1953), p. 16, and by a host of contributors to “Papers on the Marginal
Revolution in Economics,” History of Political Economy, vol. 4 (Fall 1972). Emilia di Patti,
“Francesco Ferrara and Subjective Value Theory,” History of Political Economy, vol. 33
(Summer 2001), pp. 315–344, finds the roots of neoclassical economics in the subjectiv-
ism of utility theory; whereas Klaus Hennings, “The Transition from Classical to Neo-
classical Economic Theory: Hans von Mangoldt,” Kyklos, vol. 33 (1980), pp. 658–681,
insists on the static analysis of efficient allocation as the distinguishing feature of neo-
classical economics. Lawrence Birken, “From Macroeconomics to Microeconomics: The
Marginalist Revolution in Sociocultural Perspective” History of Political Economy, vol. 20
(Summer 1988), pp. 251–264, concludes that “the emergence of marginalism was part of
a larger cultural redefinition that occurred during (and may have been shaped by) the
transition from a proto-industrial to an industrial culture.”
The standard reference on Whewell and his mathematical school is James P. Hen-
derson, Early Mathematical Economics: William Whewell and the British Case (Lanham,
MD: Rowman & Littlefield, 1996). See also, Jinbang Kim, “The Technique of Compara-
tive-Static Analysis in Whewell’s ‘Mathematical Exposition,’” History of Political Econ-
omy, vol. 33 (Winter 2001), pp. 843–854. Menachem Fisch and Simon Schaffer (eds.),
William Whewell: A Composite Portrait (Oxford: Oxford University Press, 1991), have
assembled a collection of papers on this famous British polymath. See especially the arti-
cle by Gerd Buchdahl, “Deductivist versus Inductivist Approaches in the Philosophy of
Science as Illustrated by Some Controversies Between Whewell and Mill,” pp. 311–344.
Along the same lines, see E. W. Strong, “William Whewell and John Stuart Mill: Their
Controversy over Scientific Knowledge,” Journal of the History of Ideas, vol. 16 (1955),
pp. 209–231. E. R. A. Seligman, “On Some Neglected British Economists,” Economic
Journal, vol. 13 (September–December, 1903), first called attention to the British “mar-
ginal-utility” school. Richard M. Romano, “William Forster Lloyd—A Non-Ricardian,”
History of Political Economy, vol. 9 (Fall 1977), pp. 412–441; and Laurence S. Moss,
“Mountifort Longfield’s Supply and Demand Theory of Price and Its Place in the Devel-
opment of British Economic Theory,” History of Political Economy, vol. 6 (Winter 1974),
pp. 405–434, provide further embellishments on Lloyd and Longfield. Lardner’s contri-
butions to microeconomic theory have been explored by Donald M. Hooks, “Monopoly
Price Discrimination in 1850: Dionysius Lardner,” History of Political Economy, vol. 3
(Spring 1971), pp. 208–223; see also the extensive discussion of Lardner in R. B. Eke-
lund, Jr., and R. F. Hébert, Secret Origins of Modern Microeconomics (Chicago: Univer-
sity of Chicago Press, 1999).
Aside from von Thünen, secondary literature on the German writers reviewed in
this chapter is scarce. On the prominence of von Thünen in economic theory, see Mark
Blaug, “The German Hegemony of Location Theory: A Puzzle in the History of Economic
Thought,” History of Political Economy, vol. 11, no. 1 (1979), pp. 21–29; and Heinz D.
Kurz, “Thünen’s Contribution to Location Economics and Marginal Productivity Theory,”
in Industry, Space and Competition: The Contributions of Economists of the Past, Michel
Bellet and Corine L’Harmet (eds.) (Aldershot, UK: Edward Elgar, 1998), pp. 25–48. Erich
W. Streissler, “Rau, Hermann and Roscher: Contributions of German Economics Around
the Middle of the Nineteenth Century,” The European Journal of the History of Economic
Thought, vol. 8 (Autumn 2001), pp. 311–331, focuses on three prominent German econo-
mists. For more on Hermann, see Heinz D. Kurz, “Friedrich Benedikt Wilhelm Hermann
on Capital and Profits,” European Journal of the History of Economic Thought, vol. 5
(Spring 1998), pp. 85–119. On von Mangoldt, see Hennings’ article in Kyklos cited above.
Kosmas Papadopoulos and Bradley W. Bateman, “Karl Knies and the Prehistory of Neo-
classical Economics: Understanding the Importance of Die Nationaloekonomische Lehre
vom Werth” (1855),” Journal of the History of Economic Thought, vol. 33 (March 2011),
pp 19–35, evaluate Knies’s role in anticipating marginal value theory.
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472 Part IV ■ The Neoclassical Era

Gossen’s preeminence is justifiably proclaimed by William Baumol and Stephen M.

Goldfeld, Precursors in Mathematical Economics: An Anthology (London: London School
of Economics and Political Science, 1968); by Nicholas Georgescu-Roegen, “Hermann
Heinrich Gossen: His Life and Work in Historical Perspective,” in H. H. Gossen, The Laws
of Human Relations and the Rules of Human Action Derived Therefrom, R. C. Blitz
(trans.) (Cambridge, MA: MIT Press, 1983); and by R. D. Theocharis, The Development of
Mathematical Economics from Cournot to Jevons (London: Macmillan, 1993). Georgescu-
Roegen and Theocharis agree that Gossen invented graphical analysis in economics.
Shelagh Eltis has translated Condillac’s key economic contribution as Commerce
and Government Considered in their Mutual Relationship (Cheltenham, UK: Edward
Elgar, 1997). The introduction to this translation, written by Shelagh and Walter Eltis,
lends support to the claim that Condillac was an important proto-neoclassical in France.
See also Walter Eltis, “France’s Free Market Reforms in 1774–6 and Russia’s in 1991–3:
The Immediate Relevance of l’Abbé de Condillac’s Analysis,” The European Journal of
the History of Economic Thought, vol. 1 (Autumn 1993), pp. 5–19; and Arnaud Orain,
“‘Preferring that which You Desire Less’: A Condillacian Approach to Choice Under
Uncertainty,” The European Journal of the History of Economic Thought, vol. 18, (Fall
2011), pp. 321–352, examines Condillac’s probabilistic theory of choice.
In the twentieth century French economics came to be dominated by Walras and his
disciples, but as William Jaffé, “A. N. Isnard, Progenitor of the Walrasian General Equi-
librium Model,” History of Political Economy, vol. 1, no. 1 (1969), pp. 19–43, has shown,
Isnard was an important precursor. Almost nothing has been written on Germain Gar-
nier, despite his indirect influence on Say and Dupuit. But see Yves Breton, “Germain
Garnier, L’économiste et l’homme politique,” in Gilbert Faccarello and Philippe Steiner
(eds.), La Pensée Économique pendant la Révolution Française. (Grenoble: Presses Uni-
versitaires de Grenoble, 1990). Cournot, Dupuit, and, to a lesser extent, Say, are treated
in detail by Ekelund and Hébert in Secret Origins (cited above). See also notes for fur-
ther reading following chapter 13 in this text. Stephen Stigler, The History of Statistics:
The Measurement of Uncertainty Before 1900 (Cambridge, MA: Harvard University
Press, 1986), contains an excellent treatment of Cournot and his tenuous relationship
with statistics.
Outside of Italy there is very little secondary literature on the writers presented in
this chapter. Rossi’s influence within France is discussed by Martin S. Staum, “French
Lecturers in Political Economy, 1815–1848: Varieties of Liberalism,” History of Political
Economy, vol. 30 (Spring 1998), pp. 95–120. For those who read French, see László
Ledermann, Pellegrino Rossi, L’Homme et l’économiste, 1787–1848 (Paris: Sirey, 1929).
On Ferrara, see di Patti (cited above); and Antonio Guccione, “Ferrara’s Theory of Value
and the Cost of Reproduction Principle,” History of Political Economy, vol. 25 (Winter
1993), pp. 677–696. Some sense of Galiani’s economic reforms is conveyed by Gilbert
Faccarello, “Galiani and Necker on Economic Reforms,” The European Journal of the
History of Economic Thought, vol. 1 (Autumn 1994), pp. 519–550. Pierre Luigi Porta and
Roberto Scazzieri explore Verri’s ideas in “Pietro Verri’s Political Economy: Commercial
Society, Civil Society, and the Science of the Legislator,” History of Political Economy,
vol. 34, (2002), pp. 83–110.
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Part V
TWENTIETH-CENTURY
PARADIGMS

The heyday of early neoclassical economics ran from about 1870 to about 1920.
However, Marxism was gaining ground, especially among underdeveloped nations
anticipating a leap into the industrial age, even while the new science was being
assembled by Jevons, Menger, Walras, and Marshall. Other challenges to the exist-
ing orthodoxy mounted as well. In America—a country that tolerated dissent even
as it embraced capitalism and individual freedom—a new, heterodox school of
thought arose called institutionalism, which harbored a distinctly antitheoretical
bias. Moreover, as orthodox economic theory fended off the challenge of institution-
alism, it was redirecting itself back toward macroeconomics, especially after the
onslaught of the Great Depression. Periods of economic upheaval inevitably
encourage reexamination of fundamental economic premises, and the Great
Depression was no exception. Modern macroeconomics was born in the midst of
this global economic catastrophe, mainly through the efforts of John Maynard
Keynes. The early part of the twentieth century may therefore be characterized as a
period of considerable upheaval. This section brings together multiple strands of
thought, from the stridency of American institutionalism against neoclassical eco-
nomics (chapter 19), to the reaffirmation of neoclassical economics expressed in
the new political economy of the postwar era (chapter 24).
Leadership in economic theory shifted to America after World War II, aided in
large part by the emigration of many European scholars to the United States. Resto-
ration of world peace and the relocation of much of the world’s intelligentsia
unleashed extensive creative activity. Economists on both sides of the Atlantic
began to rethink the respective roles of competition and monopoly, as well as hybrid
forms, in economic theory (chapter 20). In the post–World War II period Keynesian
macroeconomics (chapter 21) rose to a position of dominance but confronted chal-
lenges from new classical theorists (chapter 22) that led to many modifications and
refinements. Austrian economics (chapter 23), which was repressed in the
onslaught of Keynesian theory, began to reassert itself after disaffection mounted
with the Keynesian legacy. And “political economy”—that sphere of human activity
where the economic and the political intersect—enjoyed a resurgence as the second
half of the century got underway (chapter 24), driven in part by the study of how
economic policy can be perverted by democratic institutions.

473
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19

British Historicism,
Thorstein Veblen, and
American Institutional Economics

We saw in chapters 11 and 12 that the nineteenth-century intellectual landscape was

strewn with vociferous and sometimes shrill critics of classical theoretical econom-
ics. Criticism from certain quarters did not abate with the advent of neoclassical
economics. Like theory, criticism possesses a tradition of its own—a tradition that is
alive and well in contemporary assessments of capitalism and the capitalist process.
The present chapter features the “institutional economics” of Thorstein Veblen
(1857–1929), a twentieth-century critic of received theoretical economics. Although
influenced to some extent by British Historicists, Veblen created the only uniquely
American school of economics. In very much the same spirit as their German coun-
terparts, British historicists at the turn of the century touted a method of economic
study that emphasized the search for broad laws of historical development, use of
inductive empirical generalizations rather than deductive logic, and the general irrel-
evance of accepted economic science. Veblen’s work also projected a mood of large-
scale dissatisfaction with British neoclassical economics, and like some British histor-
icists, he adopted a “Darwinian” view of the capitalist process. However, Veblen went
far beyond the British historicists in terms of methodology and cohesiveness. Indeed,
it is essentially Veblen’s methodology that made its permanent mark on economics.
We begin, therefore, with a statement of the leading British historicists’ “case against
economic method” as a springboard to our investigation of Veblen’s contributions.

■ NINETEENTH-CENTURY BRITISH HISTORICISM

As late as the 1840s, intellectual conditions in England had decidedly solidified
around Ricardian economics, a situation that strongly contrasted to the intellectual
“anarchy” on the Continent. Eric Roll noted that “The legacy of Ricardo was consid-
ered sacrosanct; and even as late as 1848 John Stuart Mill regarded himself in mat-
ters of theory as little more than a proponent of pure Ricardianism” (History, p.
299). J. R. McCulloch, James Mill, and Harriet Martineau (who penned moralistic
fairy tales replete with “lessons” from classical economics) turned out to be effec-
tive popularizers of what they thought to be the Ricardian legend. The charisma
surrounding Ricardian abstraction grew to formidable proportions.

475
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476 Part V ■ Twentieth-Century Paradigms

Ironically, however, a cohesive historicist revolt originated on British soil. In

1831 the Reverend Richard Jones, sometimes regarded in economics as the first
institutionalist, published An Essay on the Distribution of Wealth and on the Sources
of Taxation. In it he complained that the matrix of the Ricardian analysis was far too
narrow to be of practical use. He felt that economic assumptions should be histori-
cally determined and empirically justifiable. In his words, the Ricardians “confined
the observations on which they founded their reasonings to the small portion of the
earth’s surface by which they were immediately surrounded” (p. xxiii). But his
lonely voice was drowned in a sea of Ricardian dogma. Still, methodological criti-
cism of classical economics resurfaced in England from time to time.

Bagehot, Spencer, and Darwin

Walter Bagehot (1826–1877), banker, author of Lombard Street, and editor of
the conservative periodical, The Economist (which was founded by his father-in-law,
James Wilson), espoused the heretical cause in 1876 in the Fortnightly Review, a
journal that became the unofficial mouthpiece of the British historicists. The claim
by Lord Bryce that Bagehot was “the most original mind of his generation,” is diffi-
cult to sustain based on his scattered economic writings, but his intellectual versatil-
ity was never in doubt (Buchan, Spare Chancellor, p. 260). He saw connections
between economics, politics, psychology, anthropology, and the natural sciences,
and therefore refused to draw natural boundaries between most of these subjects
and “literary studies.” Initially a follower of Ricardo, Bagehot later pressed the
necessity of integrating institutional structures with economic theory. By ignoring
institutions, Bagehot claimed, economic theory was guilty of the pretentious and
fallacious claim of overgeneralization. He maintained that the Smith–Ricardo Brit-
ish tradition in political economy suffered from three major defects. First, it was too
culture-bound; it took things for granted that did not apply to other countries.
Hence, orthodox classical economics was practically useless in understanding eco-
nomic development outside Great Britain, since the institutional backdrop was sel-
dom the same in other countries. Second, British economics dealt with “imaginary”
people, not “real” ones. By ignoring the aforesaid connections between economics,
politics, psychology, anthropology, and the natural sciences, economics dealt with a
mere narrow facet of human behavior. Third, considered as a body of knowledge,
British political economy claimed a certainty that did not accord with the facts of
human experience.
Despite his interest in methodology, Bagehot did not push his criticism very far.
He failed to draw out the implications of his behaviorist and institutionalist
approach to economics. He left no school of disciples, nor did he provide an agenda
for future political economists. But in certain circles his style of argument was
extremely persuasive and he inspired others to carry the same torch.
Awakening intellectual despair over the alleged uselessness of classical eco-
nomic postulates was due in large measure to philosophical ferment. Herbert Spen-
cer, himself subeditor of The Economist from 1848 to 1853, was partly responsible for
this agitation, although he in no way condoned it. Spencer’s first love was biology,
but his writings clearly spelled out the relation between biological and social evolu-
tion, even before Darwin. He sketched this relationship in clear and vibrant prose:
A social organism is like an individual organism in these essential traits: that it
grows; that while growing it becomes more complex; that while becoming more
complex, its parts acquire increasing mutual dependence; that its life is immense
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Chapter 19 ■ British Historicism, Veblen, and American Institutional Economics 477

in length compared with the lives of its component units . . . that in both cases
there is increasing integration accompanied by increasing heterogeneity. (Autobi-
ography, vol. 2, pp. 55–56)

Along with other social sciences, economics was being interpreted in the light of
this type of analysis. In England, increasing economic interdependence manifested
itself in the growing division of labor and burgeoning British trade. Spencer’s con-
cept of integration provided one explanation for the rapidly declining atomism of
firms and their drift toward monopoly and oligopoly.
This philosophical stew of ideas was stirred immensely by the appearance of
Darwin’s Origin of Species in 1859. To the orthodox economist, and of course to the
extremely individualistic Spencer, Darwin’s work merely reiterated what had been
known all along about the “inevitable” forces of laissez-faire. But the British histori-
cists, eclectic in their appraisal of Spencer and Darwin, added biological evolution
to their theories of institutional and social development. Bagehot even applied Dar-
winian principles of natural selection to the political struggles of nation-states. And,
importantly, one of the strongest and most vigorous foundations of Veblen’s institu-
tional economics—his theory of change—finds its origin in the Spencer–Darwin
conceptions of “process” and “evolutionary and quasi-random change.” However,
the British historicists did not apply Spencerian–Darwinian evolutionist principles
to economic institutions in any significant and cohesive manner, either individually
or as a group. Rather, they looked to other “deterministic” theories of change in
forming their concepts of economics.

Comte, Ingram, and Cliffe-Leslie

One of the leading philosophers of the nineteenth century was the French posi-
tivist, Auguste Comte, whose ideas were very much in vogue among certain British
intellectuals. One British historicist in particular, John Kells Ingram (1823–1907),
reflected Comte’s views. Ingram’s whole professional career was spent at Trinity
College in Dublin. A man of ubiquitous interests, he accepted much more than his
mentor’s views on social and economic progress; he became the leading British
expositor of Comtian thought, going to the extremes of writing sonnets on the “reli-
gion of humanity.” Comte’s “social dynamics” infused Ingram’s History of Political
Economy—British historicism’s only full-length critique of economic theory. But
Comte’s use of this phrase clashes with the modern economic meaning of the term
and even more so with the Darwinian conception of evolution. Comte’s “social
dynamics” imply a necessary and continuous movement of humanity toward a tele-
ological and predictable end. Relating as it does to the development of society,
Comte’s concept derives its basic data from history and is, therefore, the science of
history. Ingram eagerly co-opted this notion in setting forth what he conceived to be
the proper method of economic inquiry. In 1888 he maintained:
These [Comte’s] general principles affect the economic no less than other
branches of social speculation; and with respect to that department of inquiry, they
lead to important results. They show that the idea of forming a true theory of the
economic frame and working of society apart from its other sides is illusory. (His-
tory, pp. 193–194)

Ingram was not being entirely original, because John Stuart Mill’s work also
reflects the influence of Comte, especially in Book IV (on social reform) of his Prin-
cipals of Political Economy (1848). But Ingram was not impressed by Mill’s treat-
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478 Part V ■ Twentieth-Century Paradigms

ment. Speaking for the historicists, he declared that this part of Mill’s Principles
“appears to us one of the least satisfactory portions of his work” (History, p. 194).
Moreover, Mill did not represent the dominant view. Mill’s contemporary, John
Elliot Cairnes (1823–1875), believed that infiltration of Comtian ideas offered little
promise for political economy, even though he acknowledged that the subject “has
no panacea to offer for the cure of social evils” and that “practical application of sci-
entific principles are . . . not the proper fruit, but the accidental consequence of sci-
entific knowledge” (“M. Comte and Political Economy,” p. 602). Cairnes thought
that Mill’s pet idea, the subordination of political economy to the more general field
of sociology, would be a barren endeavor, at least until cognate social sciences were
brought up to a like stage of advancement.
Minority view or not, the historicists used Comte’s and other deterministic phi-
losophies of change as a starting point for their assault on the “vicious abstraction”
and attachment to the deductive method of the British classical economists. Ingram
was influenced partly by his contemporary, T. E. Cliffe-Leslie (1826–1882), who
joined the chorus of wages-fund criticisms and categorically attacked wanton
deduction. Cliffe-Leslie presented a case for “positive economics” regarding statisti-
cal verification of all laws and assumptions as crucial to social theory. The British
historicists argued that the formal incorporation of empiricism with economic sci-
ence had the great advantage of forcing the economist to use much neglected and
ever-changing facts. The alternative was metaphysics. They attacked unverified
abstraction as alien to the very conception of a social science.
Some historicists simply felt that the existing body of theory was untenable.
Cliffe-Leslie proposed a purge of all heuristic postulates from the science, hoping to
clear the air for new “theory.” Arnold Toynbee, uncle of the famous historian by the
same name, more circumspect in his appraisal of existing abstraction, proposed a
symbiotic relationship between history and theory and felt that “Ricardo becomes
painfully interesting when we read the history of his time” (Lectures, p. 28). Toyn-
bee abandoned the attempt to discover a universal body of economic truths, how-
ever, feeling that economics is necessarily relativistic. Historicists generally
believed that theories would be derived by placing political economy on a broader
base, such as making it a branch of sociology. Ingram underlined this point in an
analogy comparing society to the human body, and the economist to the physician:
The physician who had studied only one organ and its function would be very
untrustworthy even in the therapeutics of that organ. He who treats every disease
as purely local, without regard to the general constitution, is a quack; and he who
ignores the mutual action of the physique and the moral in disease, is not properly
a physician, but a veterinary. These considerations are just as applicable, mutatis
mutandis to the study of society, which is in so many respects kindred to biology.
(“Present Position,” p. 50)

In the historicist paradigm, economics was regarded as a science, but one that
assigned a minor role to logical deduction and rejected a priori abstractions. His-
toricists maintained that theory should be derived by induction and by historical
processes. Subjects worthy of study could be found by comparing the successive
states of society in order to discover the laws of social affiliation—a process similar
in principle to the comparison of organisms at different stages of biological devel-
opment. Society and social facts could not be studied apart from their history. His-
tory was therefore seen as the mainspring from which the science of economics
would emerge.
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Chapter 19 ■ British Historicism, Veblen, and American Institutional Economics 479

The Impact of British Historicism

All of this had noteworthy practical effects. Although the attempts to make eco-
nomics a branch of sociology and to derive a body of theory via historical processes
failed, the writings of Bagehot, Cliffe-Leslie, Ingram, and Toynbee left their mark on
major British theorists of the day. Influenced by Cliffe-Leslie, William Stanley Jevons
(see chapter 15) judged the historicists’ orientation to be “indispensable,” and quali-
fiedly repudiated the laissez-faire principle. However, he continued to defend the
deductive method. Indeed, Jevons considered deduction to be a necessary element
in the process of induction. He grew to believe that statistical verification was
required to rescue economics from public hostility as well as from the more basic
status of idle speculation. Although he agreed with the general methodological pre-
scriptions of Cliffe-Leslie and Ingram, and although he thought that their criticism
could “hardly fail to overcome in the end the prestige of the false old doctrines,”
(Theory of Political Economy, p. xxi) Jevons nevertheless remained suspicious of the
attempt to supplant orthodox theory with the historical approach. To do so, he
thought, would be to make of political economy a barren and occult science.
At the pinnacle of nineteenth-century neoclassicism Alfred Marshall (see chapter
16) praised the work of the historicists, finding it “one of the great achievements of our
age; and an important addition to our real wealth” (Principles, p. 70). Somewhat later he
affirmed his alliance to the “new generation” of economists, those propounding a less
didactic and modified orthodoxy. In many respects, Marshall’s Principles reflect econo-
mists’ growing concern for social reform, and his plea for an “evolutionary” approach to
economics may have been a direct result of his brush with historicism. Marshall’s con-
temporary, John Neville Keynes, father of John Maynard and the foremost methodolo-
gist of his day, said that the “study of economic history plays a distinct and characteristic
part in the building up and perfecting of political economy” (Scope and Method, p. 314),
but he, along with Jevons and Marshall, thought that the study of history and the “induc-
tive” method should supplement, not replace, economic theory. With the passage of
time, even though ideas on appropriate methodology continued to clash, neoclassical
theoretical economics ultimately provided the accepted training ground for economists
in England, and economic history (with the emphasis on the noun) largely became, in
England and the United States, a subfield of general economics.

■ THORSTEIN VEBLEN AND AMERICAN INSTITUTIONALISM

Conditions within the economics profession in late-nineteenth-century America
were markedly different from those in Britain and Europe. Eclecticism had always
been the hallmark of American economists. From Thomas Jefferson and Alexander
Hamilton to Henry Carey and Henry George, English and Continental ideas were
filtered through the uniquely American experiences and institutions. Pragmatism
permeated both philosophy and economics well into the twentieth century. Classical
and neoclassical theoretical analysis consequently never had the hold on American
economists that it did on English economists.1 Some classical theoretical ideas were

1
American Nobel laureate Kenneth Arrow reports that, as late as his graduate student days at
Columbia University (1940–1942), no required course in price theory was offered, though Veble-
nian economics was prominently featured. Further, Arrow notes, “The corrosive skepticism of
Veblen towards ‘received’ theory had, belatedly and even posthumously, undermined the never-
very-secure hold of neoclassical thought on the teaching of American economics” (“Thorstein
Veblen as an Economic Theorist,” p. 5).
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480 Part V ■ Twentieth-Century Paradigms

turned on their heads in order to fit them to the American situation by economists
such as Henry Carey and Francis A. Walker. The ideas of historicists were able to
take root in such a freewheeling intellectual environment. Richard T. Ely and E. R.
A. Seligman, along with the more orthodox F. A. Walker, all founders of the Ameri-
can Economic Association (AEA) in 1886, were sympathetic to the historicist cause.
(Ely was educated in Germany under the aegis of historicists.) In many respects,
these writers represented a left wing of the AEA and its professional economists. In
the preface to Ely’s Introduction to Political Economy, J. K. Ingram heralded the
growing acceptance of historicist views, declaring, “A more humane and genial
spirit has taken the place of the old dryness and hardness which once repelled so
many of the best minds from the study of economics” (pp. 5–6). Into this very recep-
tive milieu stepped a formidable American critic and iconoclast, Thorstein Veblen.
Although he was influenced by philosophical and intellectual forces (including
those of the historicists) from abroad, Veblen’s ideas on economics may neverthe-
less be clearly stamped “Made in U.S.A.”

The Critic’s Life and Preconceptions

Thorstein Bunde Veblen was born in Wisconsin and was of Norwegian ancestry
(his first name means “son of Thor,” the Norse god of thunder). At the age of eight
he moved to a large farm in Minnesota. In 1874 he entered Carleton College, a reli-
gious training school, where he quickly demonstrated his brilliance along with a
calculatingly critical attitude toward everything, including religion. Veblen also
studied at Johns Hopkins University, where he was greatly influenced by J. B. Clark,
and at Yale University, where he received a PhD in philosophy in 1884. Unable to
secure an academic position, he returned to his father’s farm. For seven years he
was a voracious and eclectic reader of social science literature, including econom-
ics. In 1890 Veblen entered Cornell University as a graduate student, but soon there-
after he joined the faculty of the University of Chicago, where he became editor of
the Journal of Political Economy.
During his twelve-year tenure at Chicago and afterward, Veblen became the
most visible and highly regarded social and economic critic of his time. In numerous
journal contributions and books, including the iconic Theory of the Leisure Class
(1899), he assessed problems in then-existing social institutions and scathingly crit-
icized classical and neoclassical economic analysis. Veblen’s prestige as a thinker
and academician (by all accounts he was an awful teacher) was not sufficient to
overcome his flagrant and frequent violations of social mores and his biting attacks
on businesspeople supporting the university—and he was asked to leave in 1904.
After leaving Chicago, he took positions at Stanford University, at the Univer-
sity of Missouri, and at the New School for Social Research, never rising above the
rank of assistant professor. In 1927 he returned to California, where he died on
August 3, 1929, a few months before the great stock market crash (which in a sense
he had predicted, and probably would have enjoyed a great deal). His brilliant stu-
dent, Wesley C. Mitchell, penned the following epitaph:
A heretic needs a high heart, though sustained by faith that he is everlastingly
right and sure of his reward hereafter. The heretic who views his own ideas as but
tomorrow’s fashion in thought needs still firmer courage. Such courage Veblen
had. All his uneasy life, he faced outer hostility and inner doubt with a quizzical
smile. Uncertain what the future had in store, he did the day’s work as best he
might, getting a philosopher’s pleasures from playing with ideas and exercising
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Chapter 19 ■ British Historicism, Veblen, and American Institutional Economics 481

“his swift wit and his slow irony” upon his fellows. However matters went with
him, and often they went ill, he made no intellectual compromises. (What Veblen
Taught, p. xlix)

Despite the relatively simple facts of his life, Veblen was a complex intellectual.
Throughout his very productive life he was uncannily able to view the real world
and the world of ideas (circa turn-of-the-century America) from the outside. He
once attributed the intellectual and scientific predominance of European Jews to
their lack of contemporary preconceptions and to their initial immersion in a cul-
ture stamped “B.C.” Like them, and perhaps because of the essentially Nordic cul-
tural background of his youth, Veblen was able to view society in much the way a
pathologist approaches an autopsy. He was insatiably curious about what makes
social and economic processes “tick” and especially about the mode and method of
how societies—as the totality of cultural and technological institutions—change.
The formative forces that shaped Veblen’s preconceptions were manifold. His
views on human nature were shaped by behaviorism and, specifically, by theories of
instincts and habits, which stood in strong contrast to the rationalistic and utilitar-
ian conceptions of the classical and neoclassical writers. The Spencer–Darwin view
of social and biological evolutionary change had a major impact on Veblen’s “world-
view,” as did the instrumentalist philosophy of William James. Veblen also much
distrusted mathematics and statistics as tools of science, sarcastically labeling those
who resorted to such calculations as “animated slide-rules.” (Were he alive today he
might call them “computer jockeys.”)
Veblen’s thoughts on particular subjects are often hard to decipher because
they appear in statements that are piecemeal, scattered, and often contradictory. An
appreciation of his “system” is not rendered easier by the fact that his writings are
peppered with polemical speculation, personal prejudices, gratuitously normative
statements, cynicism, and wry humor. His brilliant command of the English lan-
guage has sent more than a few readers running to the dictionary. The study of
Veblen is akin to a ride on a Ferris wheel. Categorically, it matters not where one
gets on, for the rider always returns to the same spot. The essentials of Veblen’s the-
ory were formed early and remained virtually unchanged throughout his life.
Indeed, one might say that his later works were merely extensions and elaborations
of a central thesis set forth earlier. We begin our analysis with Veblen’s views on
human nature and his ideas on the method of economics.

Human Nature and Economic Method

In part II of this book we saw how the classical economists regarded people as
rational calculators of pleasures and pains. Natural law, or its extension, the “invisi-
ble hand,” kept people on course and in general promoted the greatest social good
for the greatest number. Veblen denounced this belief as superficial nonsense. He
argued that humans are significantly more complex creatures, led by particular
instincts and characterized by instinctive behavior and habits.2 People aren’t “light-
ning fast calculators” of pleasures and pains but rather are curious beings who, by
nature, hit on new ways of doing things. In sum, people are creatively curious and
are creatures of acquired propensities and habits.

2
Veblen’s instinct-habit psychology and its interactions with human propensities of thought have
been criticized as one of the less satisfactory parts of his work. We do not take a position on this
issue, but interested readers may wish to consult notes for further reading at the end of the chap-
ter for more information.
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482 Part V ■ Twentieth-Century Paradigms

In an anthropological study of human culture, Veblen concluded that certain

instincts, such as the “instinct of workmanship” (the title of one of his most interest-
ing books) applied to all humans in all societies. Veblen concluded that the most sig-
nificant factor in determining human propensities and preconceptions is the
material circumstances in which people find themselves. Material circumstances
(including technology) shape a person’s or a society’s worldview, which, in turn,
give rise to relations between humans and property, humans and the legal-political
system, humans and philosophy, humans and religion, and so on. A worldview is
thus premised on the material conditions of any particular age. Institutions—ways
of doing things, thinking about things, and distributing the rewards for work, and
so forth—arise to support a set of material circumstances. Most beings are indelibly
stamped with a set of preconceptions unique to their particular time and place, pre-
conceptions that are bestowed by a given technological system. Veblen posited that
interactions between technological institutions, on the one hand, and ceremonial
institutions, on the other, constitute the mainsprings of change in his system.
All this should sound somewhat familiar to anyone versed in the ideas of Marx
(see chapter 12). Marx’s views of human nature and the impact of technology on
culture were partially analogous to Veblen’s, but without the Darwinian influence.
Veblen’s theory of cultural and institutional change follows the Darwinian theory of
biological evolution in which “ends” are not exactly predictable. The application of
evolutionary principles to human culture was, in Veblen’s view, even more critical
since human biological evolution and mental capacity had been essentially fixed for
thousands of years, while cultural evolution has progressed at a much more rapid
pace. In other words, the imprint of evolution is almost exclusively cultural. Thus,
the basic difference between Marx and Veblen concerns the theory of change each
advanced. This is also an essential difference between Veblen and practically all
other economic writers, including the classical economists. A fuller appreciation of
this important concept of economic and cultural change resides in what Veblen con-
sidered the “proper” method of economic study.

“Matter of Fact” versus Animistic Preconceptions

Veblen attacked the philosophical foundations of economic orthodoxy in a long
and brilliant critical essay entitled “The Preconceptions of Economic Science” (first
published in the Quarterly Journal of Economics in 1899–1900). He argued that
Adam Smith was, in part, possessed of a matter-of-fact, empirical preconception,
though he was guilty of fostering an “animistic” view of the world in economic sci-
ence. In an animistic preconception, perceptions of reality are guided by deistic
notions (i.e., God or Nature), so that life has a teleological, or natural, outcome.
Thus, we find Smith (and other classical economists) discussing a natural or equi-
librium price, which, when disturbed, would return through an assumed natural
order (see chapter 5). According to Veblen:
The animistic preconception enforces the apprehension of phenomena in terms
generically identical with the terms of personality or individuality. As a certain
modern group of psychologists would say, it imputes to objects and sequences an
element of habit and attention similar in kind, though not necessarily in degree, to
the like spiritual attitude present in the activities of a personal agent. The matter-
of-fact preconception, on the other hand, enforces a handling of facts without
imputation of personal force or attention, but with an imputation of mechanical
continuity, substantially the preconception which has reached a formulation at the
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Chapter 19 ■ British Historicism, Veblen, and American Institutional Economics 483

hands of scientists under the name of conservation of energy or persistence of

quantity. Some appreciable resort to the latter method of knowledge is unavoid-
able at any cultural stage, for it is indispensable to all industrial efficiency. All tech-
nological processes and all mechanical contrivances rest, psychologically
speaking, on this ground. This habit of thought is a selectively necessary conse-
quence of industrial life, and, indeed, of all human experience in making use of the
material means of life. It should therefore follow that, in a general way, the higher
the culture, the greater the share of the mechanical preconception in shaping
human thought and knowledge, since, in a general way, the stage of culture
attained depends on the efficiency of industry. (“Preconceptions,” p. 141)

Veblen said that the utilitarianism of Bentham and Mill simply substituted hedo-
nism (“self-interest”) for achievement of purpose as a ground for legitimacy. The
result was that utilitarian philosophy made economics a science of wealth, in which
the individual is inert, because human will and institutions are basic assumptions,
and values are therefore eliminated. Economics became (and remained, in Veblen’s
view) a deterministic and categorical discipline that attributed all good things to a
beneficent, but functionless and static, competitive system (i.e., good = normal =
right). Based on an incessant quest for monetary gain, the competitive system yields
predictable outcomes when interfered with, or when interferences are removed.3
One of Veblen’s persistent themes was that the instincts and habits emerging from
pecuniary hedonism characterized American society both on the supply and on the
demand sides. Absentee ownership and conspicuous consumption and leisure were
the expected responses to a pervasive utilitarian preconception that created a “con-
sumption economy.” (We shall return to this matter below.)
Veblen’s methodological critique may be summarized as follows. First, he
argued that the orthodox neoclassical view of the economic system, and the theoret-
ical superstructure it supported, was sterile and essentially useless. But he did not
argue, as is sometimes supposed, that neoclassical analysis was invalid, given its
assumptions. One difficulty was its simplistic view of human nature—Bentham’s
concept of “pecuniary rationality”—rather than an instinct-habit conception, and
another was its outmoded concept of change. Second, in a positive vein, Veblen
based his own theory on (1) an implicit hypothesis that historical events (social,
economic, and political) are determined and best described by group characteristics
formed by the sum of instinct-habitual human behavior, and (2) a Darwinian (evolu-
tionary), not a deterministic, view of change is the appropriate tool for dealing with
social and economic phenomena.
Even today many dissident writers share Veblen’s assumption regarding group
behavior. His Darwinian view of change, an insight of genuine originality, is moti-
vated by a causal sequence or process. Consider a movement from situation A to sit-
uation B. The determinist would argue that if A represents a competitive
equilibrium, its displacement would either cause equilibrium to be restored once
the disturbing factor was removed or cause equilibrium to change in some predict-
able way if the disturbing factor was allowed to persist for a long period of time.
That is, assuming that fundamental economic data (utility functions, costs, institu-
tions, etc.) do not change from A to B, the effects of a single disturbing change may
be analyzed with considerable precision. (See the Marshallian method of ceteris
paribus discussed at length in chapter 16.)
3
This type of competitive system was described by numerous neoclassical writers, including the
Austrians and Alfred Marshall. But it must be remembered that Wieser and Marshall exhibited
strong undercurrents of dissent from this method.
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484 Part V ■ Twentieth-Century Paradigms

In Veblen’s concept of causal sequence, the mere cessation of interference with

the system, or the introduction of a single, permanent change at state A, will not
leave the outcome the same as if no interference had taken place. The effects of sin-
gle changes at A are not predictable; nor are states A and B comparable in any
meaningful way as long as tastes, technology, and institutions are constantly chang-
ing. By employing a deterministic method orthodox economic analysis requires that
the underlying data of the system remain the same over the period of analysis. How-
ever, Veblen proposed a system of constant and ineluctable change. To him, eco-
nomics was most accurately described as a process, or as a “proliferation.”

The Interaction of Ceremony and Technology

Veblen put these methodological concepts and his instinct-habit psychology at
the core of a positive theory of economic change. His analysis may be applied to
specific institutions, as we shall soon see, but the overall design of his theory incor-
porates a grand view of economy-wide institutional change. Figure 19-1 represents
a schematic attempt to portray Veblen’s concept of economic change.
Veblen identified two groups of institutions, “technological” and “ceremonial,”
each of which is in a constant state of flux. The existence and characteristics of these
two sets of institutions are determined by the unchangeable characteristics of
human nature on the one hand, and the anthropological and historical processes
they engender, on the other. Institutions are shaped over time by human instincts—
Veblen specifically emphasized the instincts of workmanship and the innate “idle
curiosity” of human beings—which manifest themselves in a certain technology. The
technology of the modern age is characterized by a “machine process,” which is
instrumental in establishing ceremonial institutions: a characteristic set of property
rights, social and economic structures, habits of thought, and so on. The technologi-
cal institutions (i.e., machine process) is the dynamic force in Veblen’s society,
whereas ceremonial institutions tend to be static. Thus, the social and economic
institutions characteristic of a “long primitive stage” of society are inextricably

Continuous process

Dynamic Static
Technological Institutions Ceremonial Institutions
The “machine process,” A set of property rights,
inventions, production methods, social and economic structures,
technology, etc. financial institutions, etc.

Continuous process

Figure 19-1 The interrelation of technological and ceremonial institutions is based

on unchangeable characteristics of human nature and the anthropological and histori-
cal processes.
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Chapter 19 ■ British Historicism, Veblen, and American Institutional Economics 485

bound to the nature (and growth) of technology over that period. Feudal social and
economic institutions were as essentially characteristic of the technology extant
over the Middle Ages as contemporary “ceremonial” institutions were characteristic
of the more advanced production methods of the nineteenth and twentieth centuries.
Two aspects of the institutional process described in figure 19-1 must be
expanded because: (1) the relations between the two types of institutions are not
quite as simple as described above, and (2) certain forms of social and economic
behavior, as well as associated mental preconceptions that characterize humans
throughout their development, have been amplified under a given “machine process.”
In the first place, ceremonial institutions, including property rights, not only are
the product of the machine process of any given period but also impinge on technol-
ogy, thwarting or encouraging it as the case may be. This interrelation could last
only over a “short” period of time (perhaps several hundred years), however, since
in the long run a technology based on idle curiosity and the human ability to invent
must be dynamic. Stated differently, ceremonial institutions can constrain the
machine process, but only temporarily. In the long run, according to Veblen, techno-
logical institutions will shape social and economic relations.
In the second place, certain preconceptions or behavioral characteristics may
be common to humans throughout their entire development but may be emphasized
by a particular state of technology. Thus, as we shall see, conspicuous consumption
and leisure, while very much in evidence over a certain stage in development, rest
on certain general behavioral characteristics of humans typical to them since the
beginning of time. Humans are born with certain instincts and with a set of precon-
ceptions about the way in which the world works. For example, emulation is a
behavioral characteristic of humans, especially in societies that embrace a pecuni-
ary culture. Likewise, a pecuniary culture is the product of a technology that per-
mits and even fosters the divorce between ownership and management; between
proprietary accumulation and the actual productive process; between “business”
and enterprise.
Early in the twentieth century Veblen viewed the capitalist process as one that
generates an indigenous business cycle, but the institutional framework that super-
sedes it is always the product of past and present interactions of ceremonial and
technological institutions. Ceremonial institutions regarding private property, like
economic science itself, are increasingly characterized by a love of money. Advanc-
ing technology permits a separation of production from finance. “Making goods”
becomes very different from “making money.” In this well-known distinction Veblen
noted that, after the Industrial Revolution, the functions of owner-producers and
managers became increasingly separated. Businesspeople and captains of finance
attempted to subvert the progress of technology, reducing output and increasing
pecuniary returns through monopoly measures. Making money, not goods, became
the object of the game. (Note the augmentation of certain Marxian themes.) Accord-
ing to Veblen, acquisition of money through subversion and “warlike traits” are
characteristic of businesspeople. (Veblen’s infamous attacks on the role of business-
people in commerce were pitiless.) At the same time workers and engineers—those
close to the machine process—tend to reject old technology and develop new (and
presumably cheaper) means of production.

Economics Meets Sociology: Conspicuous Consumption

Veblen’s envisioned outcome of the dynamic process of technological change
and the cyclical forces that it produces are near at hand. But first we must digress to
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486 Part V ■ Twentieth-Century Paradigms

examine an important aspect of the social process—conspicuous consumption.

Veblen’s most subtle and famous idea juxtaposed psychology, economics, and soci-
ology.4 In The Theory of the Leisure Class he launched a detailed study of the forma-
tion of tastes and the act of consumption. Neoclassical economists had assigned
utility functions to individuals on the assumption that utility derived from any given
expenditure was independent of the utility from any other expenditure, either by the
same consumer or by any other. (In more formal jargon, utility functions are said to
be additive.) Veblen claimed that this was defective theory because it neglected an
essential part of the economic process—study of the formation of tastes and con-
sumption patterns. In other words, the neoclassical economists took as given one of
the most fundamental parts of the analysis.5 Veblen’s critique was vivid:
The hedonistic conception of man is that of a lightning calculator of pleasures and
pains, who oscillates like a homogeneous globule of desire of happiness under the
impulse of stimuli that shift him about the area, but leave him intact. (“Why,” p. 389)
As a practical matter Veblen recognized the prime importance of higher con-
sumption to the maintenance of aggregate demand in a pecuniary economy. But he
insisted that consumption be treated as an inextricable part of the ceremonial insti-
tutions of capitalism. Moreover, his view was rooted in a theory of pecuniary emula-
tion rather than in that of simple utility maximization.
In Veblen’s conception, the instinct to emulate others was second in strength
only to the instinct of self-preservation. In his lengthy anthropological study of the
“emulatory instinct” (Theory, pp. 22–34), Veblen argued that property acquisition
became the conventional basis for social esteem early in the history of humankind.
Most property was initially acquired through plunder, but over the long path of his-
tory, it became “more honorable” to acquire wealth passively rather than through
predation. In addition to the “honor” of passively acquired wealth, a person’s status
is determined by how well one’s holdings compare with those of his or her immedi-
ate peer group and with the group immediately above. In a sense, therefore, acquis-
itiveness drives economic activity:
In any community where goods are held in severalty it is necessary, in order to his
own peace of mind, that an individual should possess as large a portion of goods as
others with whom he is accustomed to class himself; and it is extremely gratifying
to possess something more than others. But as fast as a person makes new acquisi-
tions, and becomes accustomed to the resulting new standard of wealth, the new
standard forthwith ceases to afford appreciably greater satisfaction than the ear-
lier standard did. The tendency in any case is constantly to make the present pecu-
niary standard the point of departure for a fresh increase of wealth; and this in
turn gives rise to a new standard of sufficiency and a new pecuniary classification
of one’s self as compared with one’s neighbours. (Theory, p. 31)
Veblen’s theory of pecuniary emulation recognizes the nonsatiability of human
wants as much as neoclassical economics does. “More is better than less” in both
paradigms. But in emphasizing the basic human “instinct of workmanship” as the
motor of pecuniary achievement, Veblen asserts that ironically, in the acquisitive
society productive work becomes a mark of infirmity and leisure becomes evidence

4
The idea of “conspicuous consumption” may be judged to have originated during mercantile times
by Bernard de Mandeville and revisited later in the classical period by John Rae. However, Veblen
raised the concept to its highest expression.
5
In a wry twist, critics of academic economists have often accused them of enjoying “the leisure of
the theory class.”
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Chapter 19 ■ British Historicism, Veblen, and American Institutional Economics 487

of pecuniary strength. Leisure itself becomes a consumption good, and conspicuous

consumption and conspicuous leisure are thus two sides of the same coin. Although
there is a distinguishable, elite “leisure class,” every class in society is subject to the
same strivings.6
The bulk of Veblen’s book is composed of wide-ranging (and largely sociologi-
cal) applications of this bold generalization. With disregard for common disciplin-
ary boundaries, he extended his theory into the realm of sociology to investigate the
consumption of “immaterial goods by leisure-class gentlemen: quasi-academic,
quasi-scholarly pursuits, awards, and trophies” that stand in evidence of unproduc-
tive leisure. Veblen also brought within the fold of his analysis such matters as gift
giving, fashion, the leisure activities of middle-class wives, the social status of ath-
letics, manners, and higher learning.7 He concluded that conspicuous consumption
is a waste of goods and conspicuous leisure is a waste of time. Just what Veblen
would do about these matters is not clear, but the avoidance of productive work and
the enjoyment of conspicuous waste were part and parcel of contemporary society
as he saw it.
While Veblen’s brilliant analysis of consumption brings a certain delight to icon-
oclasts, his ideas did not permeate twentieth-century orthodox analysis. Neverthe-
less, some features have been incorporated by degrees into both macroeconomic
and microeconomic studies. Harvey Leibenstein attempted to reconcile Veblen’s
analysis with neoclassical theory in his 1950 article “Bandwagon, Snob, and Veblen
Effects in the Theory of Consumers’ Demand.” Leibenstein identified a “Veblen
good” as one whose utility derived not only from the direct use of the good but also
from the price paid for it. Thus, a conspicuous price is the price that a consumer
believes other people think he or she paid for a commodity. It is this price that deter-
mines a good’s “conspicuous consumption utility.” Quantity demanded may then be
regarded as a function of a good’s money price, P, and its expected conspicuous
price, P. This kind of behavior may be illustrated by figure 19-2 (on the following
page), which is adapted from Leibenstein. In the diagram, alternative demand
curves for consumers are derived by changing the money price on the assumption
that some expected conspicuous price is constant. Thus, demand curve D1 is
derived varying the money price and assuming that expected conspicuous price P1
is constant. In a perfect market with perfect information, equilibrium occurs when
expected conspicuous price and actual real price are equal, where P1 = P1 , P2 = P2 ,
and so forth. If the expected conspicuous price increases, the demand curve shifts
to the right for every money price. Alternative possible equilibriums may then be
traced out as points A, E, F, yielding an upward-sloping Veblenian demand curve
(not to be confused with the Giffen good of orthodox neoclassical theory).
A Veblen effect may be isolated, moreover, by supposing a decline in price from
equilibrium at P2 to P1. In the absence of any changes in expected conspicuous price,

6 Veblen relates two anthropological episodes to galvanize his point. The first involves Polynesian
chiefs who, “under the stress of good form, prefer to starve rather than carry their food to their
mouths with their own hands.” The second involved a French king who died through an excess of
moral stamina in the observance of good form: “In absence of the functionary whose office it was
to shift his master’s seat, the king sat uncomplaining before the fire and suffered his royal person
to be toasted beyond recovery. But in so doing he saved his Most Christian Majesty from menial
contamination” (Theory, pp. 42–43).
7
Among other Veblenian gems is his treatment of children as conspicuous waste, i.e., as a con-
sumer good. Says Veblen: “The conspicuous consumption, and the consequent increased expense,
required in the reputable maintenance of a child is very considerable and acts as a powerful deter-
rent. It is probably the most effectual of the Malthusian prudential checks” (Theory, p. 113).
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488 Part V ■ Twentieth-Century Paradigms

Actual price,
DVeblen
expected
conspicuous
price
F
P3, P 3‫׳‬

E
P2, P 2‫׳‬

A
P1, P 1‫׳‬ B C D3

D2

D1
O Q1 Q0 Q2 Quantity

Figure 19-2 As the expected conspicuous price rises from P1 to P2 to P3 , the
demand curve shifts to the right, from D1 to D2 to D3. Tracing out the alternative equi-
libriums, A, E, F yields an upward-sloping Veblenian demand curve.

quantity demanded would expand along demand curve D2 from Q0 to Q2. But when
expected conspicuous price falls to P1 , output thereby declines by an amount Q2Q1.
Thus, the pure price effect is positive, Q0Q2, and the Veblen effect is negative, Q2Q1,
producing a net negative effect on quantity of Q0Q1. Price reduction of a Veblen good
may produce a reduction in quantity if the Veblen effect outweighs or overbalances
the price effect. The point of this discussion is that although the consumption con-
cepts propounded by Veblen are complex and subtle, they may have relevance for,
and be integrated within, the neoclassical framework of microeconomics.

Economic Change and the Future of Capitalism

In a number of studies, including the Theory of Business Enterprise (1904) and a
set of essays entitled The Engineers and the Price System (1921), Veblen expanded
his theory of institutional change under capitalism. In the process, he spelled out a
theory of the business cycle and a prognosis for the capitalist system.
Veblen saw economic and social change as the result of interaction between
technological and ceremonial institutions. This interaction is made more concrete by
identifying the two institutions with certain groups in the process of change.
Whereas Veblen identified “captains of industry,” corporate financiers, investment
bankers, absentee owners, and businesspeople as part of the ceremonial process, he
lumped technicians, engineers, and certain workers into his definition of technologi-
cal institutions. Originally, the functions of directly overseeing the “machine process”
and the management of the firm were one and the same. This melding of functions
created the preconditions for maximum production, which was Veblen’s goal. As the
pecuniary aspects of culture began to dominate, however, and as specialized knowl-
edge grew apace, the two functions were divorced. Veblen described this split:
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Chapter 19 ■ British Historicism, Veblen, and American Institutional Economics 489

A new move in the organization of business enterprise has come in sight, whereby
the discretionary control of industrial production is shifting still farther over to the
side of finance and still farther out of touch with the requirements of maximum
production. The new move is of a twofold character: (a) the financial captains of
industry have been proving their industrial incompetence in a progressively con-
vincing fashion, and (b) their own proper work of financial management has pro-
gressively taken on a character of standardized routine such as no longer calls for
or admits any large measure of discretion or initiative. They have been losing
touch with the management of industrial process. (Engineers, p. 41)

In their pursuit of profits, businesspeople face two alternative courses of action:

lower production costs or restrict output (in monopoly fashion). According to
Veblen, businesspeople had in the main followed the latter practice because, among
other reasons, it required less familiarity with the workings of the machine process.
But this is shortsighted, he argued, because by choosing to “make money” rather
than “make goods” businesspeople mismanage resources and even sabotage the
technological-productive process, all the while catering to the vested interests of
investment bankers, stockholders, and so forth.
Technicians, engineers, and workers close to “the machine process” generally
have a different mind-set. Their goal is to encourage and devise means and
machines for maximizing real output. Though they work for the businesspeople–
corporate financiers, Veblen argued that they were becoming increasingly aware of
the utter wastes of business enterprise. Thus, it was the industrial experts, not the
businesspeople, who finally began to criticize this “unbusinesslike” mismanage-
ment and neglect of the ways and means of industry:
Two things have been happening which have deranged the regime of the corpora-
tion financier: industrial experts, engineers, chemists, mineralogists, technicians
of all kinds, have been drifting into more responsible positions in the industrial
system and have been growing up and multiplying within the system, because the
system will no longer work at all without them; and on the other hand, the large
financial interests on whose support the corporation financiers have been leaning
have gradually come to realize that corporation finance can best be managed as a
comprehensive bureaucratic routine. (Engineers, pp. 44–45)

Veblen therefore looked to the engineers and other industrial experts to reorder the
system of production, a role that fit more conveniently into his theory of the busi-
ness cycle.
Like Marx (see chapter 12), Veblen believed that business cycles were endoge-
nous to capitalism, and for many of the same reasons. While he did not ground his
theory of business cycles on a labor theory of value, Veblen explained recession and
prolonged depressions along Marxian lines. He maintained that there were two
basic factors leading to recession: (1) banker uncertainty after a period of new capi-
talization and expansion of industry and (2) technological displacement by new and
more efficient inventions and productive processes.
In the first instance businesses accumulate debt as a result of increased business
capitalization during a boom. The banker-lender becomes uncertain as to repayment
and begins to call in loans (or not renew them). Possibly due to its maturity structure,
the holders of existing debt are unable to meet banker demands, and as more and more
uncertainty develops, the entire system becomes vulnerable and foments a recession.
In the second instance the technological displacement of old firms by new firms
induces recession. Cost-reducing inventions are typically adopted by new competi-
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490 Part V ■ Twentieth-Century Paradigms

tors. Rates of return are thereby driven down on the older assets of existing firms,
causing lower-than-anticipated profits or, at the limit, bankruptcies. Investment
falls, and the psychology of recession leads to a downturn of business activity.8
Thus, depression results both from instabilities in the financial system and from
technological displacement caused by new inventions. After a depression phase, the
cycle “bottoms out” as the overhead burden is “worked off.” Financial expansion
takes place along with increases in employment and new capital investment. Rising
prices and overexpansion occur, once more precipitating a new cycle.
A number of aspects of the Veblenian cycle are of interest. Veblen characterized
the expansion phase of the cycle as one of overproduction and overcapitalization.
Overproduction is the consequence of underconsumption in Veblen’s theory of the
cycle. Joining such underconsumptionists as Malthus before him (see chapter 7)
and J. M. Keynes after him (see chapter 21), Veblen believed that the business cycle
was exacerbated by the saving and investment motives of financiers and owners of
business enterprises. Though the instinct to emulate and to consume conspicuously
was operative in all classes, Veblen apparently thought it insufficient to maintain
aggregate demand. Consequently, underconsumption and the psychological effect
of falling prices and redundant capital were factors leading to prolonged recession.
Whereas Marx attributed business cycles to the inner contradictions of capital-
ism, Veblen emphasized the failings of human nature. He believed that the busi-
nessperson’s attempt to avert crises caused by declining profit rates led to business
concentration and to other forms of (inadvertent) “sabotage.” Consolidations of
industry took place in order to avoid reductions in total business capitalization.
Thus, after progressive cycles, capitalist industry became more and more consoli-
dated in the same manner as premised in Marx’s laws of “increasing concentration”
and the “falling rate of profit” (see chapter 12).
But the sabotage might be pervasive. In an argument that clearly anticipates an
important contemporary idea, Veblen charged that businesspeople would attempt to
“capture” the government’s regulatory apparatus and use it for orderly and orga-
nized sabotage against the public. One example of the incestuous relationship
between government and business that is encouraged by capitalism is the matter of
tariffs and external trade restrictions. Veblen wrote:
Where the national government is charged with the general care of the country’s
business interests, as is invariably the case among the civilized nations, it follows
from the nature of the case that the nation’s lawgivers and administration will have
some share in administering that necessary modicum of sabotage that must always
go into the day’s work of carrying on industry by business methods and for busi-
ness purposes. The government is in a position to penalize excessive or unwhole-
some traffic. So, it is always considered necessary, or at least expedient, by all
sound mercantilists, as by a tariff or by subsidies, to impose and maintain a certain
balance or proportion among the several branches of industry and trade that go to
make up the nation’s industrial system. (Engineers, pp. 18–19)

In a brilliantly incisive passage Veblen turned his “capture theory” loose on internal
regulation and restrictions:
Of a similar character, in so far that in effect they are in the nature of sabotage—
conscientious withdrawal of efficiency—are all manner of excise and revenue-

8
Contemporary writers have amplified Veblen’s point and argued that initial investment problems
caused by anticipated technological innovations lead to government regulation or to “adminis-
tered controls” (see notes for further reading).
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Chapter 19 ■ British Historicism, Veblen, and American Institutional Economics 491

stamp regulations; although they are not always designed for that purpose. Such
would be, for instance, the partial or complete prohibition of alcoholic beverages,
the regulation of the trade in tobacco, opium, and other deleterious narcotics,
drugs, poisons, and high explosives. Of the same nature, in effect if not in inten-
tion, are such regulations as the oleomargarine law; as also the unnecessarily
costly and vexatious routine of inspection imposed on the production of industrial
(denatured) alcohol, which has inured to the benefit of certain business concerns
that are interested in other fuels for use in internal-combustion engines; so also the
singularly vexatious and elaborately imbecile specifications that limit and discour-
age the use of the parcel post, for the benefit of the express companies and other
carriers which have vested interest in traffic of that kind. (Engineers, pp. 20–21)

As these passages reveal, Veblen saw, correctly, that the aim of much regulation,
especially that which endorses legalized cartels and legitimizes monopolies, was
the protection of vested interests at the expense of the public interest.9
These examples of “sabotage” comprise what Veblen called a conscientious
withdrawal of efficiency by business. All such withdrawals attempt to subvert the
productive process—to reduce output to the most profitable levels. This subversion
of the productive process brings on business cycles of increasing severity. Veblen
tells us that the representatives of technological institutions could be expected to
resist the imbecile activities of businesspeople, but from where would the resistance
come, and what sort of institutions would eventually triumph?
Marx had argued that propertyless workers would coalesce in common cause
to challenge and overthrow the propertied bourgeoisie, but Veblen believed that
organized labor exercised its own conscientious withdrawal of efficiency in order to
keep its returns above the “competitive level” earned by the “common man.” He
therefore opposed the American Federation of Labor (AFL), a frequent target of his
criticism. American labor organizations, he asserted, were vested interests in their
own right, always ready to do battle for their own privilege and profit. Union lead-
ers dominated the politics of the AFL, but the benefits to its rank-and-file workers
were dubious at best.
The rank and file assuredly are not of the kept classes, nor do they visibly come in
for a free income. Yet they stand on the defensive in maintaining a vested interest
in the prerogatives and perquisites of their organization. They are apparently
moved by a feeling that so long as the established arrangements are maintained
they will come in for a little something over and above what goes to the common
man. (Vested Interests, p. 165)

Far from placing trust in the labor movement, Veblen lumped business and
organized labor together in their efforts to subvert the productive process. There-
fore, if capitalism was to be saved, it would have to be by the efforts of engineers
and industrial managers. Although this class of people represented less than 1 per-
cent of the population, Veblen nevertheless believed it could alter the industrial

9 Veblen also recognized that government perversions of the system extend to the financial sector
as well. At a time when the Federal Reserve System was a new creature of government, Veblen
objected: the “process of pooling and syndication that is remaking the world of credit and corpo-
ration finance has been greatly helped on in America by the establishment of the Federal Reserve
System. . . . That system . . . has very conveniently left the substantial control in the hands of those
larger financial interests into whose hands the lines of control in credit and industrial business
were already being gathered. . . .” (Engineers, pp. 50–51). How many times since Veblen penned
these words has the Fed been accused of favoring big business interests at a high cost to workers,
small-business owners, and investors?
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492 Part V ■ Twentieth-Century Paradigms

order of finance capitalism. Engineers and other industrial-production personnel

were trained largely at public expense, and they alone would be competent to run
the system. Veblen often hinted that nonaligned workers, the “common man” (and
even the rank and file), were becoming more aware of the profitable abuse of tech-
nology perpetrated by business and organized labor. Eventually, therefore, a strug-
gle must ensue, but Veblen was never clear about the nature of the struggle or its
outcome. Presumably some type of socialism was the likely result, but whereas
Marx could issue precise predictions within his system, Veblen could not. The fact
that he consistently maintained an evolutionist’s outlook on the prospects of capi-
talism meant that he could never be certain of the outcome, and in the end he could
only speculate. His intriguing speculation was that capitalism, particularly Ameri-
can capitalism, was at a turning point:
In effect, the progressive advance of this industrial system towards an all-inclusive
mechanical balance of interlocking processes appears to be approaching a critical
pass, beyond which it will no longer be practicable to leave its control in the hands
of businesspeople working at cross purposes for private gain, or to entrust its con-
tinued administration to others than suitably trained technological experts, pro-
duction engineers without a commercial interest. What these men may then do
with it all is not so plain; the best they can do may not be good enough; but the
negative proposition is becoming sufficiently plain, that this mechanical state of
the industrial arts will not long tolerate the continued control of production by the
vested interests under the current businesslike rule of incapacity by advisement.
(Engineers, p. 58)

A Brief Assessment of Veblen’s Economics

Veblen’s prognostication of social upheaval certainly appeared to be vindicated
when the stock market crashed in 1929. Although the causes of the onset and the
severity of the Great Depression are still being debated, there is no argument about
the extent of the financial collapse and the human and resource unemployment that
followed in its wake. Was this the “critical pass” Veblen spoke of in referring to the
probable collapse of the capitalist system? The question is problematic, but the
answer may be informed by considering Veblen’s analysis of the capitalist system
from both the theoretical and the practical side.
First, consider Veblen’s theoretical scenario. The Great Depression did not
bring on an “age of engineers” or an end to the price system of resource allocation
and distribution. Veblen failed to perceive that self-interested behavior would have
extended to any group of individuals in control of the productive process. Engineers
and the “common man” were not “philosopher kings” any more than businesspeo-
ple, financiers, and organized labor were. The ascendance of the engineers would
simply have created new “vested interests” in money making. To be sure, institu-
tional changes occurred in American capitalism after the Depression but they did
not result from the development of a new elite class of technological superiority.
Second, Veblen’s analysis suggested that engineers, or some technical elite,
would maximize production without regard to prices in a hazily conceived type of
socialism or quasi-socialistic system. But, empirically, no communistic or socialistic
state has survived in the modern era without some recourse to a price system. Some
form of prices (either explicit prices or shadow prices) are necessary in socialist
systems in order to obtain efficient allocations of resources. As F. A. Hayek so force-
fully argued, prices convey necessary information in a market system (see chapter
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Chapter 19 ■ British Historicism, Veblen, and American Institutional Economics 493

23). If you eliminate the market system, you eliminate the informational data neces-
sary to achieve efficiency. Both Veblen and Marx were naive in their understanding
of markets. To date nothing has proved superior to prices as providers of economic
information in the marketplace.
Third, from a more practical point of view, Veblen underestimated the ability of
the system to adjust. His strong disdain of businesspeople led him to the erroneous
belief that virtually all output markets were characterized by monopoly or oligopoly.
Veblen never appreciated the fact that real competition constrains the attempted
“withdrawal of efficiency” by businesspeople in most instances. Fourth, he underes-
timated the role of government and the legal system in addressing problems of
social costs and externalities. For good or evil, the government instituted numerous
interventions to alter income distribution in the post-1930s era. At least some of
these interventions have sometimes acted as a political filter between “vested inter-
ests” and the “common man.”
We have observed before that economists typically don’t make good prophets.
Veblen is no exception. But although his speculations may be easily criticized or dis-
missed, his economics commands serious attention. Deficiencies aside, Veblen tried
to construct a theory of human behavior outside the utilitarian mold. However ques-
tionable his success may be, he probed issues that refuse to go away, especially
those that pertain to economic development and to the nature and consequences of
property rights.
While the Veblenian paradigm has never substituted for the usefulness of neo-
classical economic analysis (as perhaps Veblen thought it should), it is not neces-
sary to choose one or the other. His long-run institutional studies may be used to
supplement short-run price theoretical analysis. Surely there is room for discussion
within the economics profession along the lines of Veblen’s “grand vision.” If for no
other reason, Veblen may be read for the gainful reminder that economics is a social
science, not a mere branch of mathematical inquiry. (On the possible intersections
between institutional economics and neoclassical economics, see the box, The
Force of Ideas: Evolutionary Economics, Then and Now.)

The Force of Ideas: Evolutionary Economics, Then and Now

Economics has always been used to analyze and explain past institutions and, hopefully, to
predict the directions of quantities that matter to humans (e.g., wages, prices, GDP, employment,
and so on). That quest is the object of all economists, Veblenian and neoclassical, those who use
statics or dynamics. Economists, in other words, have always been interested in how institutions
and economies modify and change. That was, as noted in this chapter, certainly Veblen’s objec-
tive, and it is a fair question to ask how far his views have come in achieving this end.
The key to understanding economic growth involves understanding the “motor” that propels
institutional change. The essential propellants for Veblen were “habits” or “instincts.” He believed
that each society and each stage of society can be identified by its own set of habits and institu-
tions—the latter evolving to meet “instinctual” human ends. However, although he recognized a
specific sociological-anthropological variant of “economizing,” Veblen did not identify how a
cost-benefit mechanism applied to utility-maximizing behavior could explain change.*
Neoinstitutional economics is the result of applying modern microeconomic analysis to
institutions and institutional change.† It makes the good old-fashioned neoclassical theory of
economizing through behavioral calculation of costs and benefits the motor of institutional

(continued)
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494 Part V ■ Twentieth-Century Paradigms

change. It stems from the proposition that rational choice (under particular constraints) cre-
ates and alters institutions such as property rights structures, law, contracts, government
structures, and regulation. These institutions and the organizations they help create provide
incentives or establish costs and benefits that, for a time, govern economic activity and eco-
nomic growth. But through time institutions are themselves altered by economic activity due
to either “feedback” mechanisms or because particular institutions create economic incen-
tives for change. Within such a model, any change in an “exogenous” variable (i.e., external
shock) could alter the configuration of property rights or costs and benefits, creating institu-
tional change. Laws surrounding marriage, administrative regulation, or the form of religious
or fiscal institutions may (and have been) analyzed using neoinstitutional economics.
Thus, neoinstitutional economics has strayed from the original intent of Veblen, whose
antagonism toward businesspeople led him to disdain market economics. Even so, Veblen’s
emphasis on institutional change had a poignant effect. Neoinstitutionalists have profitably
employed cost-benefit analysis in producing an evolutionary approach to society and culture.
This has served to disrupt the almost exclusive emphasis by neoclassical economists on a
static and (sometimes) institutionless world. There is more than a touch of irony in the fact
that a blend of neoclassical and institutional traditions is producing an entirely new and
enriched area of contemporary economics.
*See R. W. Ault and R. B. Ekelund, “Habits in Economic Analysis,” pp. 431–445. The fact that Veblen argued
that pecuniary behavior was responsible for creating institutions such as the corporation, the stock mar-
ket, and corporate finance generally does not mean that he produced an economizing theory of endoge-
nous habit formation (see the Raines and Leathers paper in “Notes for Further Reading,” this chapter).
†
Neoinstitutional economics has been advanced most vigorously by 1993 Nobel Prize winner Douglass North.

■ SECOND-GENERATION VEBLENIANS
Veblen’s ideas, unlike those of Adam Smith or Alfred Marshall, were not so eas-
ily cultivated by his successors. Although it may be said that Veblen had a theory of
economic and social development, there was far less specificity and cohesiveness
about his work than that exhibited in the neoclassical paradigms of Alfred Marshall
or Léon Walras. Moreover, whereas Marx was orderly in arranging his (often
obscure) ideas, Veblen was not. A research program for future scholars is difficult to
flesh out of his turgid, rambling prose.10 In addition, as noted at the beginning of
this chapter, Veblen wore different hats, sometimes that of the economic scientist,
sometimes that of the iconoclastic polemicist and social critic. Some of the theoreti-
cally inclined followers of Veblen have imitated him by studying the role of specific
institutions and processes, while others have pursued more practical studies. In
order to impart the eclectic flavor of Veblen’s legacy, in this section we briefly review
the ideas of three Veblenians (a much looser term than “Marshallians”)—J. R. Com-
mons, W. C. Mitchell, and C. E. Ayres—prior to a more detailed discussion of a third-
generation Veblenian, John Kenneth Galbraith, in a separate section. Although each
is recognized as an American institutionalist, one could hardly imagine a more dis-
parate group of individuals.

10
That sardonic wit and acerbic pundit H. L. Mencken was so exasperated by Veblen’s writings that
he remarked in response to one of Veblen’s essays: “What is the sweating professor trying to say?”
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Chapter 19 ■ British Historicism, Veblen, and American Institutional Economics 495

John Rogers Commons (1862–1945)

Commons was born in Ohio, did graduate work at Johns Hopkins University,
and was probably the foremost scholar at the University of Wisconsin for almost
three decades (1904–1932). He was less of a theoretician than an adamant cham-
pion of social and economic reform, pursued through legislation. Along with Wis-
consin’s liberal governor Robert M. LaFollette, Commons wrote and sponsored
labor, antitrust, and public-utility regulations for the state. Wisconsin’s enactments
of his legislative proposals established a model from which federal regulations of
similar activities were later drawn. Commons’s numerous publications are a pot-
pourri of criticism; demand for social reform; historical-empirical information; and
classical, socialist, and marginalist ideas. He was not a pure institutionalist of the
Veblenian stripe, choosing instead to focus on the operation of man-made institu-
tions (such as regulatory or antitrust agencies) and how they are affected by private
property, legislation, and court decisions.
In the Legal Foundations of Capitalism (1924) Commons emphasized law and the
courts as constraining elements in the economic system, an idea that is very much
alive today in the economics of government regulation (see notes for further reading
at the end of the chapter). But in his multivolume (and practically incomprehensible)
Institutional Economics (1934) Commons took the definition of institutionalism
beyond Veblen’s original vision. To Commons, markets and their effects could be
judged good or bad through (admittedly normative) criteria of efficiency and justice.
A just and efficient system therefore could be devised and implemented through opti-
mal legislative regulations and judicial action. He clearly did not share Veblen’s skep-
ticism about government’s ability to raise the general welfare through institutional
change. Although Commons was unable to effect any fundamental reorientation of
economics, he did have a profound impact on a number of his students at Wisconsin.

Wesley Clair Mitchell (1874–1948)

Wesley Clair Mitchell was a student of Veblen, professor at the University of
Chicago from 1922 to 1940, and one of the two or three most famous American
economists of his generation. Mitchell gave economics in general, and institutional
economics in particular, a statistical foundation. He established the National Bureau
of Economic Research in 1920, an institution thriving to this day. It is difficult to
overestimate the importance of Mitchell’s pioneering attempts to quantify simple
economic concepts such as “money,” “prices,” and “income,” but it is fair to say that
Jevons’s earlier pathbreaking analyses of index-number construction and statistical
studies of price series (see chapter 15) came to life under Mitchell’s able supervi-
sion. In his monumental book, Business Cycles (1913), Mitchell analyzed booms
and depressions from the nineteenth century through the monetary panic of 1907,
utilizing masterfully reconstructed data on bond prices and yields, wages, commod-
ity prices, the money stock (a central variable in Mitchell’s interpretation), and
monetary velocity. His approach to economic analysis—theory interrelated with
empirical explanation—had a profound impact on the direction taken by economic
studies in twentieth-century America. Due in large measure to his efforts, studies in
GNP accounting, business-cycle analysis, growth, antitrust, and industrial organiza-
tion can now be accompanied by empirical referents. In sum, Mitchell established a
program for the collection and use of empirical data that, together with subsequent
mathematical and statistical analysis, has given much of modern economics its par-
ticular character.
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496 Part V ■ Twentieth-Century Paradigms

But how did Mitchell’s great contribution relate to his mentor’s institutionalism,
especially since Veblen vigorously denounced as unproductive mathematical and
statistical complements to economic theory? Whereas Veblen sought to establish
the cultural and psychological bases for certain types of institutions and for institu-
tional change, Mitchell aimed to objectify pecuniary institutions and business fluc-
tuations. As such, Mitchell’s work was an extension of Veblen’s, but one that Veblen
himself did not pursue or find extremely useful. As in the case of Commons, Mitch-
ell’s “institutional economics” took a direction that was somewhat askant from
Veblen’s original conception.

Clarence Edwin Ayres (1892–1972)

Of all the American institutionalists Clarence Edwin Ayres remained closest to
Veblen’s original theoretical conceptions. Educated at Brown University and at the
University of Chicago, Ayres spent practically his entire academic career (1930–
1968) at the University of Texas. Indeed, owing to the influence of Ayres, the Uni-
versity of Texas became the locus of the institutionalist school in America over
these years. In a number of important publications, including The Theory of Eco-
nomic Progress (1944) and Toward a Reasonable Society: The Value of Industrial
Civilization (1961), Ayres reworked the theoretical concerns of Thorstein Veblen.
Like Veblen, Ayres was steeped in philosophy, being particularly oriented to John
Dewey’s pragmatist-instrumentalist approach. In terms of economic policy, Ayres
advocated pragmatic, liberal modifications of capitalism, akin to those championed
by Commons. But he rejected socialism and fascism. An underconsumptionist like
Veblen and J. M. Keynes, Ayres supported modified economic planning and eco-
nomic regulation as a palliative for what he judged the excesses of capitalism.
In terms of theory, however, Ayres was a technological determinist. He believed
that technology is an absolute value toward which society should be gravitating. He
spoke of a life process to which institutions either did or did not contribute. The
goal of Ayres’s system was “full production,” which included maximization of
human creativity, artistic pursuits, and so forth, in addition to material well-being.
Ayres contrasted institutional values with technological values, indicating that
“true” and “false” institutional values could be judged on the basis of their “contri-
bution to the life process.”11 In his view technology was an ultimate value since it
alone was independent of cultural considerations. In effect, Ayres made institu-
tional economics a study of technology and of technological change. Unlike Veblen,
he did not totally repudiate the value of markets and the price system, but he did
argue that prices and markets were less important than technology and institutions
in determining the direction of “full production.” Like Veblen, however, Ayres was
unable to provide a consistent and cohesive framework within which to analyze the
momentum and life history of economic societies. In spite of Ayres’s very creative
work, there are numerous gaps and contradictions in the institutionalist theoretical
paradigm that remain to be filled and resolved by others.

■ JOHN KENNETH GALBRAITH: THE INSTITUTIONALISTS’ POPULARIZER

Even a cursory review demonstrates that institutional economics took several
divergent paths after Veblen. Mitchell added an inductive-statistical component; Com-

11
During the 1960s the authors of this book attended a lecture by Ayres in which he attacked Coca-
Cola as a “false” value, i.e., one detracting from the “life process.”
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Chapter 19 ■ British Historicism, Veblen, and American Institutional Economics 497

mons translated institutional economics into a program for social (chiefly legislative)
reform; and Ayres extended Veblen’s conception into a theory of technological values.
The concerns of modern institutionalists reflect all these diverse interests and many
others. But, perhaps more than any other writer of institutionalist leanings, John Ken-
neth Galbraith cornered the interest of social scientists and the reading public.
Galbraith (1908–2006) is one of the best-known social critics of twentieth-cen-
tury America. His long and active life took him down many avenues: Harvard fac-
ulty member, economic adviser to the president, novelist, and U.S. ambassador to
India, among others. He has also written numerous influential and heretical books
on the social and economic system. In part, Galbraith’s work is a modern repository
of heterodox thought. His thought reveals many traces from varied sources, but his
ideas invariably align with those of Veblen. We choose here to focus on two ideas
that are distinctly Galbraithian: (1) the process of countervailing power and (2) the
identification of a social imbalance within the context of an affluent society.
As early as 1952, in his book American Capitalism, Galbraith was concerned
with the traditional (i.e., orthodox Marshallian) explanation of “how things work”
in the American economic system. He was already arguing that affluence (which he
called “unseemly opulence”) was a mixed blessing. Most particularly, he charged
that orthodox economic theory was unrealistic, since any acquaintance at all with
the facts of the real world would negate the relevance of the competitive model—the
stock-in-trade of Marshallian economics. Galbraith was not afraid to issue certain
value judgments that, when placed in a dynamic theory of social behavior, provided
a springboard for his criticism of static, orthodox political economy. Thus, he
argued that income inequality “distorts the use of resources,” since “it diverts them
from the wants of the many to the esoteric desires of the few—if not from bread to
cake at least from Chevrolets to Cadillacs” (American Capitalism, pp. 104–105). He
maintained as well that unnecessary inequality of income—unnecessary in the
sense that it does not reward differences in intelligence, application, or willingness
to take risks—may also impair economic stability.

Countervailing Power
Galbraith baldly declared that the competitive model of neoclassical economics
was academic hokum. Modern markets do not operate smoothly and continuously
to establish and maintain competitive equilibria. Competition had broken down, he
said, creating concentration and monopoly power and destroying the self-regulating
tendencies of many markets. Yet, this one-sided development did not dissolve all
restraints. What the economic orthodoxy overlooked, according to Galbraith, was
the existence of countervailing power and its effect on market outcomes.12 In other
words, new restraints on private power arise in monopolistic markets to replace
competition, constraints that
were nurtured by the same process of concentration which impaired or destroyed
competition. But they appeared not on the same side of the market but on the
opposite side, not with competitors but with customers and suppliers. It will be
convenient to have a name for this counterpart of competition and I shall call it
countervailing power. (American Capitalism, p. 111)

At first blush, “countervailing power” appears to be a manifestation of the stan-

dard, neoclassical theory of bilateral monopoly. But Galbraith rejects this idea; he

12
This concept can be traced back to Wieser’s Social Economics (see chapter 14).
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498 Part V ■ Twentieth-Century Paradigms

argues that the presence of bilateral monopoly is a mere “adventitious occurrence,”

whereas countervailing power is a process that develops in response to private eco-
nomic power that emerges from the original breakdown of competition. In other
words, Galbraith envisions countervailing power as a process in the Veblenian
sense. Moreover, Galbraith advanced the concept as an important explanation for
many developments, including trade unionism, retail cooperatives, chain stores,
and the like. His concepts of market and product go beyond the narrow confines of
traditional theory, approaching E. H. Chamberlin’s treatment of differentiated prod-
ucts in monopolistic competition (see chapter 20).
Galbraith maintained that the existence or nonexistence of countervailing
power has great relevance for public policy. Specifically, the failure of countervail-
ing power to restrain monopoly forces is a raison d’être for government interven-
tion in a private economy. As he wrote in 1952:
Without the phenomenon itself being fully recognized, the provision of state assis-
tance to the development of countervailing power has become a major function of
government—perhaps the major domestic function of government. Much of the
domestic legislation of the last twenty years, that of the New Deal episode in par-
ticular, only becomes fully comprehensible when it is viewed in this light. (Ameri-
can Capitalism, p. 128)

To further punctuate his argument, Galbraith wrote:

The groups that sought the assistance of government in building countervailing
power sought that power in order to use it against market authority to which they
had previously been subordinate. (American Capitalism, p. 136)

Galbraith also argued that antitrust policy should be modified to permit the imple-
mentation of those policies that encourage the development of countervailing
power so as to check monopoly power wherever possible. Moreover, he asserted
that where government intervention has occurred, it has been the result not of com-
petition but of a breakdown in countervailing power.
There are, however, gaps of a serious nature in Galbraith’s theory of counter-
vailing power. If it is to be used as a tool of public policy, one must be able to deter-
mine original as opposed to generated countervailing power. In American
Capitalism, Galbraith identified two categories of monopoly: (1) original monopoly
that emerges as a result of the breakdown of competition and (2) countervailing
monopoly that develops in response to existing market power. He might well have
added a third category (which, in fact Veblen anticipated), namely that which arises
because of industry demands for regulation—in the form of assistance, subsidies,
and contracts, not to mention control over entry.
In a more fundamental sense, Galbraith’s theory lacks a cogent explanation of
how power emerges in the first place and how it affects market processes and the
political system, all of which are interesting and legitimate concerns of the econo-
mist as social scientist. One wonders how countervailing power is supposed to
affect prices and the distribution of income, a subject that should be of high interest
in Galbraith’s socialist state. When does the government step in to socialize or con-
trol areas of the economy (e.g., low-cost housing)? How long do we wait for market
processes to develop in “defenseless” areas of the economy before the government
steps in? Unfortunately, Galbraith’s theory does not give us the answers to these
queries. Nevertheless, his discussion may provide a starting point for an eventual
neoinstitutionalist synthesis.
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Chapter 19 ■ British Historicism, Veblen, and American Institutional Economics 499

Social Imbalance
In The Affluent Society (1958), a book that has sold more copies than Adam
Smith’s The Wealth of Nations, Galbraith seemed to object to American society
because it is rich and because its values are misdirected. This time Galbraith took
on the orthodoxy through the theory of consumer demand. He maintained that (1)
to its detriment the received theory has disallowed “any notion of necessary versus
unnecessary or important as against unimportant goods” (Affluent Society, p. 147);
and (2) having neglected certain implications of diminishing marginal utility, econo-
mists have been unable to see that more of certain goods—through time—is not bet-
ter than less. This is, of course, normative stuff. In his critique of positive
economics, Galbraith wrote:
Any notion of necessary versus unnecessary or important as against unimportant
goods was rigorously excluded from the subject. . . . Nothing in economics so
quickly marks an individual as incompetently trained as a disposition to remark on
the legitimacy of the desire for more food and the frivolity of the desire for a more
elaborate automobile. (Affluent Society, p. 147)

With scholarly impertinence, Galbraith asserted that consumer sovereignty is a

myth and that in modern times the chain of cause and effect runs from production
to consumption, not the other way around. In order to maintain an affluent society,
one in which production and income are growing, new wants must be manufac-
tured. Thus, Galbraith focused on the crucial role of advertising in creating and
manipulating wants for new consumer goods, which are provided at the expense of
social goods. He denounced the social imbalance that results.
In the tradition of another American maverick, Henry George, Galbraith main-
tained that economic problems lead to social ills. “The more goods people procure,
the more packages they discard and the more trash that must be carried away. If the
appropriate sanitation services are not provided, the counterpart of increasing opu-
lence will be deepening filth. The greater the wealth, the thicker will be the dirt”
(Affluent Society, p. 256). Here’s another example of Galbraith at full throttle. Com-
menting on the rebellion of youth, he said: “Schools do not compete with television
and the movies. The dubious heroes of the latter, not Miss Jones, become the idols
of the young” (Affluent Society, p. 257).
Galbraith details a whole litany of social ills that result from a breakdown of the
economic forces of competition and a value system that encourages wasteful private
consumption at the expense of public goods. At the heart of this “inappropriate”
value system is the fact that advertising and emulation work primarily on the cre-
ation of private wants. In fact, a large part of Galbraith’s theory rests on Veblen’s
concept of conspicuous consumption, as described earlier in this chapter. In order
to redress social imbalance, Galbraith proposes increased government taxation at
all levels and redirection of government expenditures (away from national defense,
to be sure). In The New Industrial State he asserted: “In the absence of social inter-
vention, private production will monopolize all resources” (p. 310). Hence he
argued vigorously that government must take a more active role to assure that
social balance is engendered and preserved in the process.

Some Comments on Galbraith’s System

Though a Canadian by birth, John Kenneth Galbraith is a lineal intellectual
descendant of former American heterodox thinkers, especially Henry George and
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500 Part V ■ Twentieth-Century Paradigms

Thorstein Veblen. There is a commonality among these writers insofar as they make
group behavior the focal point of analysis. Moreover, like Veblen, Galbraith takes an
institutional approach in his attempt to provide a theory of the unfolding process of
modern capitalism. But Galbraith’s ideas—like those of his distinguished predeces-
sors—lack specificity. There are many gaps, moreover, in his theory of the evolu-
tionary process of capitalism. A case in point relates to the government’s redress of
social imbalance. Galbraith argues that “affirmative action” on the part of the gov-
ernment is required, but he does not spell out how social needs and their magni-
tudes are to be assessed. One wonders whether it is to be on the basis of conjecture,
special pleading, or value judgments. Principles of modern public finance (which
developed within the orthodoxy) such as benefit-cost analysis are admittedly imper-
fect, but they appear to be incomparably more useful as a guide to policy than those
suggested by Galbraith and his camp.
Galbraith’s disregard of the individual, and especially of the individual’s intel-
lectual independence and preferences, predisposed him to conclude that individuals
cannot discern what is in their own best interests. He is unimpressed by the useful-
ness of the price system in allowing individuals to register their choices between
economic and social alternatives (for example, to choose less costly gasoline and
more pollution rather than more costly gasoline and less pollution). His frustration
with the distribution of income and the level of social-goods provision determined
by free will and market led him to champion the extension of government as a palli-
ative. There is no question that social goods must be provided. Modern economists
who defend the neoclassical theory of markets are at least as interested as Galbraith
in the problem of the provision of public goods. The debatable issue, of course, is
the method of provision and the theory and philosophy behind it.

■ CONCLUSION
The fate of a pure institutionalist paradigm remains uncertain. No one, not even
a self-proclaimed institutionalist, pretends to have established a single, cohesive,
and consistent body of thought. Should we identify the “system” of Veblen, or some
combination of the writings of Veblen, Commons, Mitchell, Ayres, and Galbraith, as
the foundation for a school of neoinstitutionalism? “Institutional economics”
appears to be an open-ended inquiry.
There is a strong and growing recognition within the traditional body of con-
temporary American economics that institutions, and specifically property-rights
institutions, must be integrated into economics in a meaningful way. In other words,
a property-rights literature is developing that highlights the interactions of legal
institutions, economic behavior, and economic outcomes. Major beneficiaries of this
broader approach have been theories of economic growth and development, law
and economics, comparative economic organization, and economic regulation. At a
time when a large segment of American economists have retreated from policy mat-
ters and forced economic theory into tighter mathematical straitjackets, others have
been expanding economic theory and policy in very interesting and fruitful ways
(see, for example, chapter 26). Institutional economics may yet have much to con-
tribute to this expansive development.
In short, we might regard institutional economics as an umbrella under which
many significant and productive ideas may be sheltered. As a separate inquiry, the
“school” has largely consisted of an organon for strident criticism of neoclassical
economics. Progress may well require compromise with more traditional strains of
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Chapter 19 ■ British Historicism, Veblen, and American Institutional Economics 501

American economic thought. Compromise and eclecticism are, after all, distinctly
American characteristics.

REFERENCES
Ault, R. W., and R. B. Ekelund, Jr. “Habits in Economic Analysis: Veblen and the Neoclas-
sicals,” History of Political Economy, vol. 20 (Fall 1988), pp. 431–445.
Arrow, Kenneth. “Thorstein Veblen as an Economic Theorist,” American Economist, vol.
19 (Spring 1975), pp. 5–9.
Buchan, A. The Spare Chancellor: The Life of Walter Bagehot. London: Chatto & Win-
dus, 1959.
Cairnes, J. E. “M. Comte and Political Economy,” Fortnightly Review, vol. 7 (1870), pp.
579–602.
———. “Political Economy and Laissez-Faire,” Fortnightly Review, vol. 10 (1871), pp. 80–97.
Ely, Richard T. Introduction to Political Economy. New York: Hunt and Eaton, 1891.
Galbraith, J. K. American Capitalism: The Concept of Countervailing Power. Boston:
Houghton Mifflin, 1952.
———. The Affluent Society. Boston: Houghton Mifflin, 1958.
———. The New Industrial State. Boston: Houghton Mifflin, 1967.
Ingram, John K. History of Political Economy. London: A. & C. Black, 1915 [1888].
———. “The Present Position and Prospects of Political Economy,” in R. L. Smyth (ed.),
Essays in Economic Method. New York: McGraw-Hill, 1963 [1898].
Jevons, W. S. The Theory of Political Economy, 5th ed. New York: A. M. Kelley, 1965 [1879].
Jones, Richard. Essay on the Distribution of Wealth and on the Sources of Taxation. Lon-
don: John Murray, 1831.
Keynes, J. N. The Scope and Method of Political Economy. New York: A. M. Kelley, 1963
[1890].
Leibenstein, Harvey. “Bandwagon, Snob, and Veblen Effects in the Theory of Consum-
ers’ Demand,” The Quarterly Journal of Economics, vol. 62 (May 1950), pp. 183–207.
Marshall, Alfred. Principles of Economics, 4th ed. London: Macmillan, 1899.
Mitchell, W. C. (ed.). What Veblen Taught: Selected Writings of Thorstein Veblen. New
York: A. M. Kelley, 1964.
Roll, Eric. A History of Economic Thought, 4th ed. Homewood, IL: Richard D. Irwin, 1974.
Smyth, R. L. (ed.). Essays in Economic Method. New York: McGraw-Hill, 1963.
Spencer, Herbert. Autobiography, 2 vols. New York: Appleton, 1904.
Toynbee, Arnold. Lectures on the Industrial Revolution of the Eighteenth Century in Eng-
land. London: Longmans, Green, 1890.
Veblen, Thorstein. “Why Economics Is Not an Evolutionary Science,” Quarterly Journal
of Economics, vol. 12 (July 1898), pp. 373–426; vol. 14 (February 1900), pp. 240–269.
———. “The Preconceptions of Economic Science,” Quarterly Journal of Economics, vol.
13 (January 1899), pp. 121–150, (July 1899), pp. 396–426; vol. 14 (February 1900),
pp. 240–269.
———. The Theory of the Leisure Class. New York: Modern Library, 1934 [1899].
———. The Vested Interests and the Common Man. New York: Capricorn Books, 1969
[1919].
———. The Engineers and the Price System. New York: Viking, 1921.

NOTES FOR FURTHER READING

Two excellent summaries of the historical movement are T. W. Hutchison, A Review
of Economic Doctrines, 1870–1929, chaps. 8, 12 (Oxford: Clarendon Press, 1953); and Ben
B. Seligman, Main Currents in Modern Economics, chap. 1 (New York: Free Press, 1962).
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502 Part V ■ Twentieth-Century Paradigms

Social Darwinism was an important influence on the philosophical and social

thought of the time. In this regard, see William Graham Sumner, Social Darwinism:
Selected Essays (Englewood Cliffs, NJ: Prentice-Hall, 1963); and the brilliant overview
by Richard Hofstadter, Social Darwinism in American Thought, rev. ed. (Boston: Beacon
Press, 1955).
On British historicism and its development, see R. B. Ekelund, Jr., “A British Rejec-
tion of Economic Orthodoxy,” Southwestern Social Science Quarterly, vol. 47 (September
1966), pp. 172–180; and A. W. Coats, “The Historicist Reaction in English Political Econ-
omy, 1870–1890,” Economica, vol. 21 (May 1954), pp. 143–153. John Neville Keynes’s
Scope and Method of Political Economy (see references) is still one of the most penetrat-
ing contributions to economic methodology in the literature. With incredible skill and
thoroughness Keynes sorted out the issues and the supposed conflicts between the
orthodox methods of Mill and Cairnes and those defended by the German and British
historicists. In the process, the elder Keynes produced a work of lasting significance.
An interesting and growing literature exists on specific members of the British his-
torical school demonstrating their eclecticism vis-à-vis orthodox political economy and
their great diversity of interests. Cliffe-Leslie’s interest in Irish and English social reform
and his role in the origins of the historical movement are the subject of G. M. Koot’s “T.
E. Cliffe-Leslie, Irish Social Reform and the Origins of the English School of Economics,”
History of Political Economy, vol. 7 (Fall 1975), pp. 312–316. See also, R. D. C. Black,
“The Political Economy of T. E. Cliffe-Leslie (1826–82): A Reassessment,” The European
Journal of the History of Economic Thought, vol. 9 (Spring 2002), pp. 17–41. Ingram’s
affinity to Comte is explored by Gregory C. Moore, “John Kells Ingram, the Comtean
Movement, and the English Methodenstreit,” History of Political Economy, vol. 31
(Spring 1999), pp. 53–78. A leading doctrinal opponent of orthodox laissez-faire princi-
ples regarding labor and union policy in the mid-Victorian period is considered in P.
Adelman, “Frederic Harrison and the Positivist Attack on Orthodox Political Economy,”
American Journal of Economics & Sociology, vol. 31 (July 1972), pp. 307–317. The most
extensive study of the methodological and philosophical underpinnings of the British
historical movement is contained in Craig Bolton, The British Historical School in Politi-
cal Economy: Its Meaning and Significance (unpublished PhD dissertation, Texas A & M
University, 1976). The Reverend Richard Jones’s actual use of induction is the subject of
W. L. Miller’s “Richard Jones: A Case Study in Methodology,” History of Political Econ-
omy, vol. 3 (Spring 1971), pp. 198–207. Miller’s careful studies of the evolutionist and
economist-social scientist Herbert Spencer may be consulted with profit. See, for exam-
ple, his treatment of Spencer’s conception of public policy in the “static” state of society:
“Herbert Spencer’s Theory of Welfare and Public Policy,” History of Political Economy,
vol. 4 (Spring 1972), pp. 207–231.
The joy and pleasure of reading Veblen in the original should not be missed by any
student of economic and social thought. In addition to the works listed in the references
of this chapter, all of Veblen’s major works have been reprinted by A. M. Kelley and are
generally accessible. The secondary literature on Veblen is vast and kaleidoscopic. For
someone unfamiliar with Veblen a good place to start is Stephen Edgell, Veblen in Per-
spective: His Life and Thought (Armonk, NY: M. E. Sharpe, 2001). Arguably, the best bio-
graphical study of Veblen and his times remains Joseph Dorfman’s Thorstein Veblen and
His America (New York: A. M. Kelley, 1961 [1934]). John Patrick Diggins, Thorstein
Veblen: Theorist of the Leisure Class (Princeton University Press, 1999), originally pub-
lished as The Bard of Savagery, is a critical biography that attempts to unravel the riddles
that surround Veblen’s reputation and to assess his varied and important contributions to
modern social theory. See also the brief but incisive paper by Kenneth J. Arrow, “Thor-
stein Veblen as an Economic Theorist” (see references). Excellent overviews of Veblen’s
economic system and his economic critique of capitalism are contained in two essays:
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Chapter 19 ■ British Historicism, Veblen, and American Institutional Economics 503

Thomas Sowell, “The Evolutionary Economics of Thorstein Veblen,” Oxford Economic

Papers, n.s., vol. 1 (July 1967), pp. 177–198; and, especially, Donald A. Walker, “Thorstein
Veblen’s Economic System,” Economic Inquiry, vol. 15 (April 1977), pp. 213–237. Phillip
A. O’Hara, “Veblen’s Critique of Marx’s Philosophical Preconceptions of Political Econ-
omy,” The European Journal of the History of Economic Thought, vol. 4 (Spring 1997), pp.
65–91, judges the correctness of Veblen’s criticisms of Marx and Marxism. On the con-
nections between American and British institutionalists, see Malcolm Rutherford, “Amer-
ican Institutionalism and its British Connections,” The European Journal of the History of
Economic Thought, vol. 14 (2007), pp. 291–323. Rutherford argues that the connections
between the two camps are far more extensive than is commonly thought, and he pon-
ders why the British institutionalists never formed a unified school of thought.
Veblen’s concept of conspicuous consumption is echoed in some twentieth-century
economic analysis, as Leibenstein’s microeconomic formulation suggests. In a macro-
economic context, see James S. Duesenberry’s Income, Saving and the Theory of Con-
sumer Behavior (Cambridge, MA: Harvard University Press, 1949). A modern
reaffirmation of the “given tastes” assumption of neoclassical microanalysis—one that
Veblen challenged—is found in G. J. Stigler and G. S. Becker, “De Gustibus Non Est Dis-
putandum,” American Economic Review, vol. 67 (March 1977), pp. 76–90.
That there is a genetic component or predisposition in habit formation is indisput-
able, and Veblen may have very well appreciated the fact. Beyond a possible awareness of
the role of evolution and genetics, however, Veblen focused on the inexact forces of
“expedience, adaptation and concessive adjustments” in his explanation of the role of
habits in economic change. Richard W. Ault and Robert B. Ekelund, Jr., (see references)
argue that a blending of Veblen’s anthropological view of habits with a neoclassical cost-
choice framework, wherein habits are considered endogenous to the choice process,
yields a more cogent and satisfactory analysis of economic and institutional change than
either produces individually. Ault and Ekelund also believe that Veblen’s analysis suffered
from his refusal to view economizing and habit formation in the manner of neoclassical
economics (i.e., as largely endogenous to economic processes). On the mischief caused
by making institutional change an endogenous factor, see Olivier Brette, “Thorstein
Veblen’s Theory of Institutional Change: Beyond Technological Determinism,” The Euro-
pean Journal of the History of Economic Thought, vol. 10 (Autumn 2003), pp. 455–477.
The combination of Veblen’s views on habits and habit formation and neoclassical
cost-choice theory yields something very much like the new institutionalist analysis of eco-
nomic history and change; see D. C. North and R. P. Thomas, The Rise of the Western
World (London: Cambridge University Press, 1973). This view has been rejected by Mal-
colm Rutherford in Institutions in Economics: The Old and the New Institutionalism (Cam-
bridge: Cambridge University Press, 1994), although he compares W. C. Mitchell’s work
favorably with North and Thomas in a later paper; see Rutherford, “An Introduction to
‘Money Economy and Modern Civilization,’” History of Political Economy, vol. 28 (Fall
1996), pp. 317–328, where he argues that Veblen was only “inexact,” that his “theory” of
habit formation was in fact endogenous, and that his ideas were “formative” in producing
a theory of institutional change. But it is Veblen’s “theory” that is constantly outdistanced
by the neoclassical theory and evidence of economizing behavior. Further, as noted in this
chapter, pecuniary values were not associated with material progress. For example, J. P.
Raines and C. G. Leathers, “Evolving Financial Institutions in Veblen’s Business Enterprise
System,” Journal of the History of Economic Thought, vol. 15 (1993), pp. 249–264, showed
that Veblen argued “pecuniary behavior” was primarily responsible for creating institu-
tions such as the corporation, common and preferred stock, and corporate finance gener-
ally. This is not, however, as Raines and Leathers themselves pointed out, a general theory
of endogenous habit formation, and Veblen did not or was incapable of describing a utility-
maximizing view of institutional change outside of an ill-understood “pecuniary context.”
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504 Part V ■ Twentieth-Century Paradigms

Veblen’s prediction of a technical revolution led by engineers is a matter of some

controversy. Malcolm Rutherford, “Thorstein Veblen and the Problem of the Engineers,”
International Review of Sociology, vol. 3 (1992), pp. 125–150, and Donald Stabile,
“Veblen and the Political Economy of the Engineer: The Radical Leader and Engineering
Leaders Came to Technocracy at the Same Time,” American Journal of Economics &
Sociology, vol. 45 (January 1986), pp. 41–52, agree on Veblen’s long-standing interest in
the opportunities faced by engineers in a technical society, whereas Rick Tilman,
“Veblen’s Ideal Political Economy and Its Critics,” American Journal of Economics &
Sociology, vol. 31 (July 1972), pp. 307–317, and same author, “Incrementalist and Uto-
pian,” American Journal of Economics & Sociology, vol. 32 (December 1973), pp. 155–
169, suggest Veblen’s interest was an aberration from his early work. Janet Knoedler and
Anne Mayhew, “Thorstein Veblen and the Engineers: A Reinterpretation,” History of
Political Economy, vol. 31 (Summer 1999), pp. 255–272, attempt to set the record straight
on where Veblen actually stood on this matter.
J. E. Biddle, “Twain, Veblen and the Connecticut Yankee,” History of Political Econ-
omy, vol. 17 (Spring 1985), pp. 97–108, draws a tenuous link between Mark Twain and
Thorstein Veblen, particularly the shared view that human actions are motivated more
by custom and habit than by reason. On the other hand, divergence between Veblen and
Commons on how to treat a specific form of business property is the subject of A. M.
Endres, “Veblen and Commons on Goodwill: A Case of Theoretical Divergence,” History
of Political Economy, vol. 17 (Winter 1985), pp. 637–650.
Veblen’s judgment that classical-neoclassical economics was pre-Darwinian and
that his analysis provided a new evolutionary theory is disputed in a paper by L. B.
Jones, “The Institutionalists and On the Origin of Species: A Case of Mistaken Identity,”
Southern Economic Journal, vol. 52 (April 1986), pp. 1043–1055. On the basis of informa-
tion recently come to light in Darwin’s early diaries, Jones argues that it was Adam
Smith’s theories of competition and the division of labor that led Darwin to develop the
theories of speciation and natural selection. The prior conventional wisdom held that
Malthus was the source of Darwin’s evolutionary concepts. Stephen Edgell and Rick Til-
man, “The Intellectual Antecedents of Thorstein Veblen: A Reappraisal,” Journal of Eco-
nomic Issues, vol. 23 (December 1989), pp. 1003–1026, maintain that Darwin was the
major influence on Veblen; see also same authors, “John Rae and Thorstein Veblen on
Conspicuous Consumption: A Neglected Intellectual Relationship.” History of Political
Economy, vol. 23 (1991), pp. 167–180. G. M. Hodgson, “Thorstein Veblen and Post-Dar-
winian Economics,” Cambridge Journal of Economics, vol. 16 (September 1992), pp.
285–301, tries to explain what Veblen meant when he referred to economics as an “evolu-
tionary science.” William Waller and Ann Jennings, “The Place of Biological Science in
Veblen’s Economics,” History of Political Economy, vol. 30 (Summer 1998), pp. 189–217,
establish the specific and restricted role of biology in Veblen’s social theories, despite his
frequent use of biological terminology. Alain Marciano, “Economists on Darwin’s Theory
of Social Evolution and Human Behaviour,” The European Journal of the History of Eco-
nomic Thought, vol. 14 (2007), pp. 681–700, provides an overview of how economists
have looked at Darwin (that is, how they mention or quote him). Only recently, he
argues, has economics begun to incorporate both the social and biological aspects of
Darwin’s thinking on evolution.
Veblen applied the concept of technological displacement and the reduction of capi-
tal values to business cycles, and Commons used the idea in a regulatory framework that
has been buttressed with a modern (neoinstitutionalist) defense of the regulatory pro-
cess by Victor Goldberg; see his “Regulation and Administered Contracts,” Bell Journal
of Economics, vol. 7 (Autumn 1976), pp. 425–448. The writings on capitalist dynamics of
another great “evolutionist,” Joseph A. Schumpeter, are contrasted with Veblen’s in L. A.
O’Donnell’s “Rationalism, Capitalism and the Entrepreneur: The Views of Veblen and
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Chapter 19 ■ British Historicism, Veblen, and American Institutional Economics 505

Schumpeter,” History of Political Economy, vol. 5 (Spring 1973), pp. 199–214. An interest-
ing paper contrasts the contemporary “radical critique of economics” (mainly of 1960s’
origin with Marxian overtones) with the theoretical structure of Veblenian economics,
showing why Veblen has had so little influence on the radicals; see J. E. Pluta and C. G.
Leathers, “Veblen and Modern Radical Economics,” Journal of Economic Issues, vol. 12
(March 1978), pp. 125–146. Leathers has also compared Veblen and Hayek, concluding
that Veblen’s theory of cultural evolution was one of institutional drift, whereas Hayek’s
theory was one of efficient selection of institutions; see C. G. Leathers, “Veblen and
Hayek on Instincts and Evolution,” Journal of the History of Economic Thought, vol. 12
(Fall 1990), pp. 162–178. On the continuing relevance of Veblen beyond his time, see
Doug Brown (ed.), Thorstein Veblen in the Twenty-First Century: A Commemoration of
the Leisure Class (Cheltenham, UK: Edward Elgar, 1998), a collection of twelve articles
on various aspects of Veblen’s work.
On Commons, see Jeff Biddle, “Purpose and Evolution in Commons’s Institutional-
ism,” History of Political Economy, vol. 22 (Spring 1990), pp. 19–47. The renaissance of
interest in Commons-type legal analysis is discussed in Victor Goldberg’s “Commons,
Clark, and the Emerging Post-Coasian Law and Economics,” The Journal of Economic
Issues, vol. 11 (December 1976), pp. 877–893. A real insight into the theoretical structure
of Commons (and into his substantial ego) may be sifted from his autobiography, Myself.
Mitchell was the “economist’s economist” of his generation. Jeff Biddle, “A Citation
Analysis of the Sources of Wesley Mitchell’s Reputation,” History of Political Economy,
vol. 28 (Summer 1996), pp. 137–169, found that from about 1915 to 1930 Mitchell was
among the economists most frequently cited in the journal literature. That he was a
superb historian of thought is reflected in his lecture notes, edited by Joseph Dorfman in
the two-volume Types of Economic Theory (New York: A. M. Kelley, 1967). Kelley has
also reprinted a number of Mitchell’s works, including The Backward Art of Spending
Money and Other Essays [1937], which is a very fine Mitchell “sampler.” One of Mitch-
ell’s specialties was monetary economics, and an essay by Abraham Hirsch brings out
the interrelations of Mitchell’s unique views of theory, policy, and economic verification
in this area; see “Mitchell’s Work on the Causes of the Civil War Inflations in His Devel-
opment as an Economist,” History of Political Economy, vol. 2 (Spring 1970), pp. 118–
132. Hirsch also examines Mitchell’s ambivalence toward methodology and his use of
mainstream economic theory in “The A Posteriori Method and the Creation of New The-
ory: W. C. Mitchell as a Case Study,” History of Political Economy, vol. 8 (Summer 1976),
pp. 152–206. Perhaps the best assessment of Mitchell as an economist and quantity theo-
rist is the tribute of his admirer Milton Friedman; see “Wesley C. Mitchell as an Eco-
nomic Theorist,” The Journal of Political Economy, vol. 58 (December 1950), pp. 465–
493. Also see Eli Ginzberg, “Wesley Clair Mitchell,” History of Political Economy, vol. 29
(Fall 1997), pp. 371–390, for an evaluative essay written by one of Mitchell’s admiring
students in 1931. An institutionalist-labor theorist contemporary of Mitchell at Chicago,
Robert F. Hoxie, is discussed in P. J. McNulty’s essay, “Hoxie’s Economics in Retrospect:
The Making and Unmaking of a Veblenian,” History of Political Economy, vol. 5 (Fall
1973), pp. 449–484. Hoxie and others influenced by Veblen’s ideas were somewhat influ-
ential in forming FDR’s economic policies over the Depression years. FDR’s “brain trust”
was heavily influenced by institutionalist ideas.
C. E. Ayres’s full and quietly rebellious life is aptly chronicled by W. L. Breit and W.
P. Culbertson in “Clarence Edwin Ayres: An Intellectual’s Portrait,” Science and Cere-
mony (Austin: University of Texas Press, 1976). In addition to the Coats essay on Ayres,
this volume contains essays on Ayres by a number of leading social and economic schol-
ars, including Talcott Parsons, James M. Buchanan, Gordon Tullock, Joseph J. Spengler,
and Alfred F. Chalk (the epistemology of Ayres is clearly revealed in Chalk’s essay).
While most of these papers do not concern Ayres’s thought per se, they are very much in
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506 Part V ■ Twentieth-Century Paradigms

the spirit of the broad inquiries he sponsored. Three other papers on Ayres provide help-
ful background: W. L. Breit, “The Development of Clarence Ayres’ Theoretical Institu-
tionalism,” Social Science Quarterly, vol. 54 (September 1973), pp. 244–257; D. A.
Walker, “The Institutionalist Economic Theories of Clarence Ayres,” Economic Inquiry,
vol. 17 (October 1979), pp. 519–538; and, same author, “The Economic Policy Proposals
of Clarence Ayres,” Southern Economic Journal, vol. 44 (January 1978), pp. 616–628. In
the latter paper Ayres is shown to have become a rather commonplace “liberal” with
respect to policies designed to alter income distribution, although his “minimum income
proposal” contained a negative income tax provision. The influence of John Dewey on
Ayres is chronicled by Floyd McFarland, “Clarence Ayres and His Gospel of Technology,”
History of Political Economy, vol. 18 (Fall 1986), pp. 617–637.
Some works by Galbraith not cited in this chapter are The Great Crash, 1929 (Bos-
ton: Houghton Mifflin, 1955); A Theory of Price Control (Cambridge, MA: Harvard Uni-
versity Press, 1952); Economics and the Art of Controversy (New Brunswick, NJ: Rutgers
University Press, 1955); The Liberal Hour (Boston: Houghton Mifflin, 1960); and Eco-
nomics and the Public Purpose (Boston: Houghton Mifflin, 1973). For an insightful
assessment of Galbraith’s “system” see Scott Gordon’s “The Close of the Galbraithian
System,” Journal of Political Economy, vol. 76 (July/August 1968), pp. 635–644; and Gal-
braith’s reply, “Professor Gordon on ‘The Close of the Galbraithian System,’” Journal of
Political Economy, vol. 77 (July/August 1969), pp. 494–503. Veblen and Galbraith are
compared and contrasted by C. G. Leathers and J. S. Evans, “Thorstein Veblen and the
New Industrial State,” History of Political Economy, vol. 5 (Fall 1973), pp. 420–437, while
Harold Demsetz makes a provocative attempt to discover and test the empirical content
of Galbraith’s theory in “Where Is the New Industrial State?” Economic Inquiry, vol. 12
(March 1974), pp. 1–12. Finally, lucid overviews of Galbraith and Veblen are contained in
W. L. Breit and Roger Ransom, The Academic Scribblers (New York: Holt, 1982).
Ekelund-Hebert 6E.book Page 507 Thursday, August 1, 2013 11:03 AM

20

Competition Revised
Chamberlin and Robinson

Of the numerous directions taken in twentieth-century microeconomics, perhaps the

most important one has been the search for models descriptive of actual markets.
Alfred Marshall, as we recall from chapter 16, devoted the lion’s share of his attention
to models of perfect competition on the one hand and pure monopoly on the other.
Perfect competition is a model premised on a large number of sellers that pro-
duce a homogeneous product. Because the number of firms is indefinitely large, no
one seller can affect the price and profits of other firms; that is, the actions of one
firm have no effect on the price and output decisions of other firms. Since the model
assumes complete freedom of entry and exit, neither long-run economic profits nor
economic rents exist. In contrast, the monopoly model, first accurately described by
Cournot and Dupuit and subsequently expanded by Marshall and others, is charac-
terized by a single firm with exclusive control over the output of the good in ques-
tion. Economic profits are greater under this market structure than under any other
because economic power is greater and more concentrated than under any market
structure that includes more than one seller.
These two models, the essentials of which had been worked out fairly early in
the nineteenth century, are polar extremes. Although he displayed some awareness
of a middle ground between the two extremes, Marshall perpetuated the cultivation
of these two diverse models of the firm, and economists through 1933, with a few
important exceptions, did not bother to analyze price and output equilibriums of
firms whose decisions had an effect on one another’s policies. But in 1933 two
important (and independently written) books appeared in America and England
whose titles and central themes addressed this very problem: Edward H. Chamber-
lin’s Theory of Monopolistic Competition and Joan Robinson’s Economics of Imper-
fect Competition. Their ideas were spawned by the thinking and debates of others,
which we discuss next.

■ DUOPOLY ANALYSIS
Augustin Cournot was probably the first writer to analyze an imperfect market.
In Cournot’s case of duopoly (see chapter 13), there were two sellers whose profit-
maximizing behavior depended upon each thinking the other’s output would
remain constant. Cournot found a solution, but it was dependent on this rather

507
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508 Part V ■ Twentieth-Century Paradigms

naive assumption. Cournot stimulated other writers to take up the issue, but only
after a lag of almost fifty years. Chief among the early writers to formulate alterna-
tive models of duopoly were Joseph Bertrand in 1883 and F. Y. Edgeworth in 1897.
Bertrand, a French mathematician, argued that given the assumption that the prices
of the rival seller are assumed constant (by each of the sellers), price and output will
reach competitive levels. Edgeworth, on the other hand, placed output constraints
on each of his duopolists, producing an indeterminate range over which prices and
outputs of the two sellers oscillate.
The Cournot-Bertrand and Edgeworth results depended on the special assump-
tions that each made concerning the behavior of the duopolist/competitors. Perhaps
it was this tenuousness of result that led Alfred Marshall to avoid contributing to
duopoly theory (though he was certainly aware of Cournot’s solution). Nonetheless,
Marshall unwittingly encouraged other economists to pursue the matter. Recall that
in the Principles, Marshall discussed the possibility of the existence of industries
characterized by increasing returns, or decreasing costs. A debate ensued princi-
pally in the 1920s, involving several important disciples of Marshall, over whether
competitive equilibrium was compatible with increasing returns.

Sraffa and Imperfect Competition

Marshall’s successor at Cambridge, A. C. Pigou, participated in this fresh
debate, but Cambridge economist Piero Sraffa defined the issues clearly in 1926 in
an article entitled “The Laws of Returns under Competitive Conditions.” Sraffa had
proved elsewhere that decreasing-cost conditions were indeed incompatible with
long-run Marshallian competitive equilibrium. One or the other had to be given up.
But in 1926 he noted a significant gap in economic theory attributable to the exclu-
sive cultivation of the market models of competition and monopoly. Sraffa concen-
trated on market imperfections that defenders of the competitive model dismissed
as “frictions.” He denied that these obstacles are frictions, declaring that they “are
themselves active forces which produce permanent and even cumulative effects” on
market prices and outputs. Establishing the groundwork for models of imperfect
competition, Sraffa further argued that these obstacles to competition “are endowed
with sufficient stability to enable them to be made the subject of analysis based on
statistical assumptions” (“Laws of Returns,” p. 542).
Sraffa also suggested some obstacles that might affect monopoly strength or the
elasticity of the demand curve faced by the imperfectly competitive seller: possession
of unique natural resources, legal privileges, the control of a greater or lesser propor-
tion of the total production, and the existence of rival commodities. Thus, out of a con-
tradiction in Marshall’s analysis of competition, Sraffa teased a new approach to
market theory. In 1933, Joan Robinson (another important Cambridge economist)
explicitly credited Sraffa and the increasing-returns controversy as the impetus to her
analysis of imperfect markets. For his part, E. H. Chamberlin’s development of monop-
olistic competition was not directly influenced by Sraffa, but by Cambridge economist
A. C. Pigou—more specifically, by an imbroglio over the explanation of railway rates
generated by a debate between Pigou and American economist Frank Taussig.

Taussig and Pigou on Railway Rates

The Taussig–Pigou controversy centered on the question of whether the
observed pattern of multiple railway rates could best be explained by the Mill–Mar-
shall theory of joint supply (see chapter 8), which was Taussig’s position, or by the
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Chapter 20 ■ Competition Revised 509

presence of high railway common costs and corresponding ability to price-discrimi-

nate between buyers (Pigou’s position).
In 1891, scarcely a year after the publication of Marshall’s Principles, F. W.
Taussig of Harvard University attempted to explain multiple railway rates in the
United States by means of the joint-cost argument, an integument of orthodox com-
petitive theory. Taussig entered the debate over railway rates in order to thwart the
widely accepted notion that the government should own the railroads, an idea
encouraged by the belief that monopoly and discriminatory rates were inherent in,
and exclusive to, any system of private control. Against this sentiment, Taussig
argued because a railroad’s expenses are preponderantly joint, varying rates for rail
service would persist even under government ownership.
The essentials of Taussig’s supportive reasoning may be set out simply. First,
Taussig noted (correctly) that railroads have high fixed costs that do not change
with the level of traffic, a feature that sets railroads apart from most other firms.
Taussig asserted:
We have here [on the railroads] commodities produced in part at least, at joint
cost. For the explanation of the values of commodities produced under such condi-
tions, the classic economists developed a theory which they applied chiefly to
cases like wool and mutton, gas and coke, where practically the whole of the cost
was incurred jointly for several commodities. But obviously it also applies, pro
tanto, to cases where only part of the cost is joint. The conditions for its application
exist in any industry in which there is a large plant, turning out, not one homoge-
neous commodity, but several commodities, subject to demand from different quar-
ters with different degrees of intensity. (“Contribution,” p. 443, italics supplied)

Consequently, the “law of one price,” an element of the competitive model, clearly
does not apply to railroads; this fact, however, does not constitute prima facie evi-
dence of monopoly. Taussig insisted that railroads were conforming to the theory of
competitive joint supply by asserting that: (1) the unit of output offered by a rail-
road is heterogeneous, not homogeneous, and (2) different demand elasticities for
rail service contribute to, or are the sole cause of, this heterogeneity.
He concluded that, excepting a small element of direct costs, demand price for
the separate transport services offered by a railroad inevitably must allocate the
joint costs of all outputs, just as a competitive market sets prices for wool and mut-
ton. Different rates would persist for the transport of copper and coal under a
regime of competition, and although such price differences would be magnified
within monopolistic market structures, they could not be eliminated by government
ownership or regulation because monopoly is not the prime source of differential
rates. These principles, Taussig concluded, explain pricing in many other industrial
operations as well, but railways “present on an enormous scale a case of the pro-
duction at joint cost of different commodities” (“Contribution,” p. 453).
A. C. Pigou rejected the view that rates could be explained on the basis of joint
cost, and he blamed Taussig for the persistence of this error (Wealth and Welfare
1912). Devoting an entire chapter to the issue of railway rates, Pigou argued that:
(1) Taussig was mistaken in identifying rail costs as preponderantly joint, and (2) he
was led to this error by regarding the transport service supplied as a heterogeneous
unit of output. Pigou was convinced that multiple rail rates were explained instead
by monopoly, coupled with the presence of the necessary conditions for price dis-
crimination. He maintained that the large mass of railway common costs were allo-
cated by differing demand elasticities for the homogeneous unit of output.
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510 Part V ■ Twentieth-Century Paradigms

Although it is generally conceded that Pigou won the debate and that price dis-
crimination is the essential explanation for rail rates, F. W. Taussig’s reasoning con-
cerning the heterogeneity of railroad output encouraged E. H. Chamberlin to revise
the theory of competition. In a 1961 essay, Chamberlin attributed the origin of his
theory of imperfect competition to the Taussig–Pigou controversy. He admitted that
Pigou had the upper hand in the debate but argued that “a very slight element of
monopoly” would have supported Taussig’s position. This slight element of monop-
oly—some ability to control price—may be the result of the ability to differentiate
products. In the course of the debate Taussig said: “We speak of railways and the
like industries as ‘monopolies.’ Yet they are far from being industries to which the
strict theory of monopoly price can be applied” (“Railway Rates,” p. 383). Railroads
are subject to degrees of competition, from other railroads and from other modes of
transportation. But the degree of product differentiation in existing markets was
something worthy of more investigation.

■ CHAMBERLIN’S QUEST FOR A NEW THEORY

Chamberlin presented his new theory as “monopolistic competition,” which is a
bit of an oxymoron. But the core idea is sound. The new theory emphasized that in
many markets elements of monopoly and competition combine in ways that don’t fit
the definition of either pure competition or pure monopoly. On the one hand, mar-
kets composed of many sellers, typically characterized as competitive, may be
marked by degrees of monopoly to the extent that products can be differentiated in
a way to make each product unique in some manner. On the other hand, markets
composed of a single seller may be marked by degrees of competition to the extent
that barriers to entry are not absolute.

Product Differentiation
One of the most important insights of Chamberlin’s new theory of monopolistic
competition was that most firms engage in nonprice competition as well as price
competition. Though a large number of firms might exist in a market (the competi-
tive element), each was viewed by Chamberlin as having a unique product or advan-
tage that gave it some control over price (the monopoly element).
Sraffa had already anticipated this development in a general way, but Chamber-
lin specifically noted that products achieve some degree of “uniqueness” by copy-
rights, trademarks, brand names, and location (i.e., in economic space products
might be identical but buyers, because of the distances involved, may have loca-
tional allegiances). Chamberlin clearly perceived the duality of many markets:
In this field of “products” differentiated by the circumstances surrounding their
sale, we may say, as in the case of patents and trademarks, that both monopolistic
and competitive elements are present. The field is commonly regarded as competi-
tive, yet it differs only in degree from others which would at once be classed as
monopolistic. In retail trade, each “product” is rendered unique by the individual-
ity of the establishment in which it is sold, including its location (as well as by
trademarks, qualitative differences, etc.); this is its monopolistic aspect. Each is
subject to the competition of other “products” sold under different circumstances
and at other locations; this is its competitive aspect. Here, as elsewhere in the field
of differentiated products, both monopoly and competition are always present.
(Theory, p. 63)
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Chapter 20 ■ Competition Revised 511

Many examples of Chamberlin’s theory come to mind. Aspirin is the generic

name for acetylsalicylic acid, but goes by many different brand names: Anacin,
Bayer, Ecotrin, Excedrin, and many others. Through advertising and packaging,
each brand is established and differentiated, thus creating a market of buyers who
demand a specific product. Depending on the size and intensity of demand in each
case, the seller can charge a (monopolistic) price that may differ from that of his or
her competitors. Although a large number of substitutes compete for the con-
sumer’s aspirin dollar, price differentials can, and do, exist.
These differences can persist even though the chemical compound that consti-
tutes aspirin is the same in all aspirin products. Consumers may be persuaded or
convinced that differences exist, even if they do not. Aware of this, sellers attempt to
engender brand loyalty, or customer allegiance, so that purchasers will not be
deterred if the seller charges a price slightly higher than a competitor’s brand. In
this manner, profits can be increased (in the short run, at least).
Location may also be used to differentiate products that are otherwise the same.
Suppose, for example, five drugstores exist in a large city and further assume they
are alike in service and range of offerings. Each drugstore may offer the same phys-
ical product, but Chamberlin recognized that particular store locations might con-
vey special advantages, thus differentiating the product. The degree of monopoly
and the degree of freedom with which any store can price its products will depend
on the number and dispersion of drugstore demanders, as well as on the location of
competing sellers. Store location is then part and parcel of product differentiation.1
A multiplicity of other examples of differentiation could be cited. Automobiles
are differentiated, but substitutability still exists. Markets for furniture, toothpaste,
fine china, groceries, fitness centers, clothing, and so on, are all differentiated
somehow. Chamberlin’s point was well made and may be summarized as follows:
There exists practically no market that is not characterized by monopoly elements.
These monopoly elements are manifested by some form of differentiation: product,
location, or service, for example. This fact means that each seller has some control
over price, however small. When much (little) substitutability exists, the demand for
the product is more (less) elastic, giving the individual seller less (more) control
over price. Whereas Marshall regarded price as the sole variable under analysis in
value theory, Chamberlin regarded both price and the product itself as variables
under the control of firms in markets characterized by elements of both competition
and monopoly. This was a fundamental and critical departure from standard micro-
economic orthodoxy.

Advertising as a Means of Differentiation

A little reflection will reveal that competitive advertising is largely unnecessary
under either pure competition or pure monopoly (a single seller with no substi-
tutes). In fact, because it would reduce profits, it would be counterproductive. By
definition, the purely competitive firm produces and sells a homogeneous product
and is able to sell all of its output at the given market price. Under these conditions,
brand loyalty is not an issue. There would be no need to advertise, and by doing so
a firm would increase its costs without changing its revenues. The perfectly compet-
itive model assumes that wants are given and known to all market participants.

1
One of the authors lives in a city that has three different (chain) drugstores across from each other
at a major four-way intersection. Is this a conscious attempt among competitors to eliminate each
other’s locational advantage?
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512 Part V ■ Twentieth-Century Paradigms

Firms therefore have no incentive to discover or change consumers’ wants. Like-

wise by definition, a pure monopolist faces no competitors and no substitutes; it
would not need to advertise and would reduce profits by doing so.
Chamberlin recognized, however, that advertising is the modus operandi of
monopolistic competition, and he lumped advertising with other measures into
what he called “selling costs.” Of such costs he said: “Advertising of all varieties,
salesmen’s salaries and the expense of sales departments, margins granted to deal-
ers (retail and wholesale) in order to increase their effort in favor of particular
goods, window displays, demonstrations of new goods, etc., are all costs of this
type” (Theory, p. 117). The purpose of all these costs is clear: to alter the position
and/or elasticity of the demand function facing the individual firm.
The individual entrepreneur’s reasons for advertising are obvious: “to shift to
the right the demand curve for the advertised product by spreading knowledge of
its existence, by describing it, and by suggesting utilities it will provide the pur-
chaser” (Theory, p. 119). Chamberlin claimed that advertising affects demands by
manipulating wants. Some ads are simply not informative at all, in other words, but
are competitive in attempting to rearrange wants.2 Today, such advertising is com-
mon fare on television, radio, and the Internet, as well as on billboards. Its intent is
to shift the demand curve of the advertised good to the right, at the expense of sub-
stitute goods in the product group. In this way advertising allocates demand among
competing sellers, but unless the consumer’s total expenditures rise (i.e., saving is
reduced), it does not increase aggregate demand. Advertising, in sum, plays a cru-
cial role in establishing and maintaining product differentiation in the monopolisti-
cally competitive firm.

Chamberlin’s Two Demand Curves

Let us consider now the demand situation facing the monopolistically competi-
tive firm. Chamberlin suggested that the product-differentiated firm faces two
demand curves, although he behaved as if only one is relevant. Figure 20-1 depicts
two demand functions, DD and dd, which intersect at point C. Both of these func-
tions are negatively sloped because the firm is assumed to have some control over
price. Suppose that the firm, which is assumed to be in a monopolistically competi-
tive market, is charging price PM and selling quantity QM. How does the firm
(whose product faces a large number of competing substitute products) view the sit-
uation? Given that all firms in his product group produce substitutable goods, the
seller believes that he could increase sales considerably by lowering his price below
PM. However, the seller also believes that a marked reduction in sales will result
from raising his price above PM, because he believes that none of his competitors
will follow. Thus, assuming that the seller believes that his action will go unnoticed
by his rivals, the demand curve facing the firm would be dd.
The problem is that such an assumption is unwarranted. If our representative
seller can profit from a price reduction, so can any of his rivals, assuming, as Cham-
berlin did, that costs for all firms are identical. Thus, it is reasonable to expect that all
monopolistic competitors would have an incentive to reduce prices. If every firm in
the product group followed the price cut of our representative seller, sales would ex-

2
Social unrest in underdeveloped countries is often said to rest on a “demonstration effect.” The
advertisement of expensive automobiles, household conveniences, and luxury goods in these coun-
tries is said to alter the individual’s “utility function” or want pattern. Finding such goods unobtain-
able under the constraints of existing institutions, individuals take steps to alter these institutions.
Ekelund-Hebert 6E.book Page 513 Thursday, August 1, 2013 11:03 AM

Chapter 20 ■ Competition Revised 513

pand for each firm only Price D‫׳‬

from the general price
reduction and not at the d‫׳‬
expense of rival firms. D
DD depicts the demand
curve, given that rival F
firms follow the price ac- d
tions of any one firm.
Both curves dd and
DD are drawn under the C d‫׳‬
PM
assumption that adver-
tising expenditures are
at a constant level for D‫׳‬
each firm. Should the
d
firm under consideration
increase its amount of
competitive advertising, D
given that other firms do
O QM Output
not react similarly, the
demand functions fac-
ing the firm in figure 20- Figure 20-1 A monopolistically competitive firm can
1 would shift to the increase its sales along demand curve dd by reducing
right, and profits could its price below PM . However, if rival firms follow the
be increased. Advertis-
price actions of any one firm, the demand curve will
ing expenditures would
change to DD.
be optimized for the firm
when $1 of additional
selling costs added exactly $1 to the firm’s receipts.

Long-Run Equilibrium in a Chamberlin Regime

We are now in a position to discuss Chamberlin’s famous “tangency solution” to
the market model of monopolistic competition. Once his solution is described, its
conclusions may then be contrasted to those of the perfectly competitive Marshal-
lian model. First let us collect the assumptions of the model. Chamberlin focused on
a single firm in an industry composed of many sellers producing and selling closely
related and substitutable products.3 Each seller has some control over price, and
since he is in a large group of sellers, he assumes that his price actions will not pro-
voke any reaction from competitors. He would, in short, view his demand curve as
dd or dd of figure 20-1, and assuming that the degree of product differentiation
had been determined, he would manipulate prices in order to increase profits. Like
Marshall, Chamberlin made use of the “representative firm” fiction, so that every
firm’s cost and demand were treated as identical.
Figure 20-2 on the following page shows a model replicating demand curves dd,
dd, and DD from Figure 20-1, as well as a long-run average cost LRAC, which
closely follows Chamberlin’s presentation (Theory, p. 91).4 Let the representative

3
It is perhaps worth repeating that products or product groups do not have to have similar physical
characteristics. A new boat may be highly substitutable for a vacation in Hawaii. Although the two
are obviously not physically similar, they could constitute a product group in Chamberlinian terms.
4
See Ferguson, Microeconomic Theory, chap. 10, for a discussion of the dynamics of this equilibrium.
Ekelund-Hebert 6E.book Page 514 Thursday, August 1, 2013 11:03 AM

514 Part V ■ Twentieth-Century Paradigms

D seller (in a field of, say, 100 sellers)

Price, find herself at the intersection of
costs
curves dd and DD (point C), charging
d
price P1 and producing quantity Q1.
P1 C Each firm will produce the same price
and quantity, and each will earn prof-
its of ABCP1. Now consider the man-
d‫׳‬
B ner in which any one of the firms
A
views its situation. The seller believes,
d
P2 E erroneously it turns out, that she may
LRAC
increase her profits by lowering price;
i.e., she believes that demand curve
d‫׳‬ dd is relevant because her rivals will
not reduce prices when she does. But
D each rival does in fact reduce prices,
O Q1 Q2 Q3 Output and instead of expanding along curve
dd, the firms expand along DD.
Each seller continues to believe
Figure 20-2 At price P1, and output Q1, each that he or she could increase profits
seller will make profits of ABCP1. If a seller low- by lowering price, and each one does
ers the price below P1 and rival sellers follow so. The dd function continues sliding
suit, the dd function will slide down the DD down the DD function until it (now
function until it (new schedule dd) intersects dd) intersects DD at point E. Here the
DD at point E. firm’s demand curve is tangent to the
long-run average costs, and economic
profits are eliminated. If the dd func-
tion fell below its position in figure 20-2, losses would ensue and price would subse-
quently increase. In short, the tangency equilibrium is stable. Quantities greater than
Q2 would produce a loss to the firm since long-run average cost would be greater
than average revenue or demand.5 Chamberlin’s equilibrium exists uniquely at the
tangency of dd with LRAC and simultaneously at the intersection of dd and DD.

Monopolistic Competition: A Waste of Resources?

A charge often leveled at monopolistic competition is that its economic effects
are inefficient compared with those of perfect or pure competition. Specifically, it is
alleged that excess capacity exists at a monopolistically competitive equilibrium
such as point E in figure 20-2. Let us look into the nature of this charge.
Figure 20-3 abstracts some of the functions of figure 20-2, including the dd de-
mand function and the long-run average-cost function. The LRAC function, as the
reader might recall from chapter 16, is often called an “envelope” or “planning” curve.
It is composed of a series of tangencies of points on the short-run average-cost curve.
SRAC1 and SRAC2 are two such short-run curves, and for simplicity assume that be-
tween any two short-run U-shaped curves, another could be drawn for a slight altera-
tion in scale of plant. The firm is producing an optimum rate of output when it utilizes
the existing scale of plant (i.e., existing resources invested) to produce at the lowest
average cost of production. Given a scale of plant characterized by SRAC1, this opti-
1
mum rate of output would be Qm . Since, from the point of view of the firm, output Qm

5
The total number of sellers was kept constant throughout the analysis. See Chamberlin’s Theory,
p. 92.
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Chapter 20 ■ Competition Revised 515

is a profit-maximizing Price,
equilibrium state, from costs d
society’s viewpoint the
plant is being under-
utilized in that Qm 1 is
SRAC1
not being produced. E LRAC
Pm
A second reason SRAC2
proffered for the inef-
ficiency of monopolis-
tic competition is that Pc C dc
it does not produce a
competitive rate of
output, i.e., one that
d
achieves an optimum
scale of plant from so- O Qm Qm 1
Qc Output
ciety’s point of view.
Recall that under per-
fect competition, firms’ Figure 20-3 A monopolistically competitive firm will
demand curves are maximize profits at price Pm and output Qm , but given the
horizontal, or infinitely scale of plant represented by SRAC1, the optimum rate of
elastic. Such a demand output from society’s point of view will be Qm 1 . “Excess
curve is represented in social capacity” is measured by QmQc , where Qc is the
figure 20-3 as the hori- competitive rate of output.
zontal line Pcdc. The
long-run output for the
purely competitive firm would be Qc, corresponding to both an optimum rate of output
and an optimum scale of plant from society’s point of view. Thus, it is alleged, waste ex-
ists for two reasons: (1) because the monopolistically competitive firm does not utilize
its existing resources to produce a socially optimum rate of output and (2) because a
socially optimum scale of plant is rendered impossible as a result of product differenti-
ation, which creates a negatively sloped demand function. “Excess social capacity” is
then measured as QmQc.
Chamberlin did not agree with this conclusion, however. Product differentia-
tion, he argued, introduces variety and expands the continuum of the consumer’s
choices, factors that must be taken into account in any comparison of social bene-
fits delivered by pure competition versus monopolistic competition. Variety might
be utility-enhancing for its own sake but would not be possible in a regime of per-
fect competition in which every firm offers a homogeneous product. The increased
social welfare from variety that monopolistic competition represents may well be
greater than the loss in terms of excess social capacity that the market model neces-
sitates. The theorist can only speculate.6

Chamberlin: A Tentative Evaluation

Chamberlin’s Theory of Monopolistic Competition was an important benchmark
in the development of value and a provocation for development of the theory of

6
The whole foundation of monopolistic competition has been questioned in a number of important
recent contributions (see notes for further reading at the end of the chapter). The substance of this
modern argument is that what may appear to be excess capacity is simply a competitive market’s
working out of a means to reduce transaction costs, “waiting time,” or other time-associated costs.
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516 Part V ■ Twentieth-Century Paradigms

industrial organization. A great deal of interest developed in models of monopolistic

competition in the 1930s, 1940s, and 1950s. Fritz Machlup, Robert Triffen, William
Fellner, Arthur Smithies, and many others built on Chamberlin’s work. Practically
every text in first-level economics and in intermediate microeconomic analysis
devotes space to Chamberlin and his ideas.7 Chamberlin devoted his entire life to
the selling of his theory. In article after article he amplified, corrected, expanded,
and contrasted issues surrounding monopolistic competition, and many of these
appeared as appendixes to successive editions of The Theory of Monopolistic Com-
petition (it went through seven editions).
Although a number of theorists continue to work Chamberlinian “realism” into
value theory, a large and ever-growing coterie of writers has come to defend an
expanded model of perfect competition as a more consistent and useful approach to
microeconomic problems. Why? Not because the assumptions of perfect competi-
tion seem more realistic, but because a modified competitive analysis seems to yield
very fruitful predictions concerning the behavior of price and quantity in individual
markets. At the time, however, Chamberlin struck a responsive chord in economic
analysis by emphasizing monopolistic elements in the competitive process. He
thereby stimulated interest in the market conditions of specific industries, which in
turn gave impetus to industry studies and to the field of industrial organization.
Many of his ideas have raised questions that are still relevant to economic analysis.
Chamberlin’s major achievement, then, seems to have spawned interesting new
paths of analysis rather than to have provided economics with a well-cultivated and
finished alternative to the competitive model. As such, his contributions are note-
worthy, substantial, and important for the future of economic theory. (On the filia-
tion of ideas between Chamberlin and Austrian/Chicago approaches, see the box,
The Force of Ideas: Imperfect Competition Meets Industrial Organization.)

■ JOAN ROBINSON AND IMPERFECT COMPETITION

The history of science is replete with situations in which multiple discoveries of
the same principle occur more or less simultaneously. An example of this in eco-
nomics is provided by the cotemporaneous contributions of E. H. Chamberlin and
Joan Robinson. Robinson’s early training in Marshallian economics at Cambridge
University, reflecting the influence of A. C. Pigou and Piero Sraffa, led her to a com-
parative analysis of monopolistic and competitive markets that culminated in a
work called The Economics of Imperfect Competition. Published in 1933, Robinson’s
Economics of Imperfect Competition is an analytical tour de force. In the main, she
contributed little to the roles of product differentiation and advertising as elements
of monopolistic markets, but her book introduced and used, in her own invented
phrase, a “set of tools” that has become valuable in the partial-equilibrium analysis
of markets and market structures. Specifically, Robinson reintroduced Cournot’s
untitled concept of marginal revenue into the theory of the firm and gave it form
under different types of market structure.
Fully cognizant of the fact that degrees of monopoly exist, Robinson chose the
pure monopoly model as a proxy for all those intermediate structures that Cham-

7
The reader is encouraged to read Chamberlin’s Theory of Monopolistic Competition and to
remember that the ideas presented here are only a sample. His assessments of the duopoly models
of Cournot, Bertrand, Edgeworth, and Hotelling are particularly recommended.
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The Force of Ideas: Imperfect Competition Meets Industrial Organization

E. H. Chamberlin stands on the cusp of not one but two approaches to the contemporary
study and practice of industrial organization. One might call these two approaches the “old”
and the “new” views of industrial organization. The “old” view emphasized the conduct, struc-
ture, and performance of real-world markets within a static, Marshallian context. The practical
import of this old view is that it encased industries within a rigid taxonomy that categorized a
single firm as “least competitive”; a three-firm oligopoly as a bit more competitive; large num-
bers of firms as most competitive; and so on. This approach has led to the characterization of
real-world industries, such as autos and pharmaceuticals, in terms of “concentration” ratios, the
idea being that the degree of competition or lack thereof can be made formulaic. The Federal
Trade Commission and the U.S. Justice Department have approved or denied mergers between
firms on the basis of measured concentration ratios. Chamberlin’s perceived contribution to
this paradigm was the invention of a method of market taxonomy wherein market structures
between the extremes of “competition” and “monopoly” could be classified and arrayed.
For many years Chamberlin’s contribution was considered to have exerted a profound
effect on the early development of industrial organization theory and practice. Much of this
development took place at Harvard University, where Chamberlin taught for many years.*
However, the alignment of Chamberlin with the Harvard paradigm is misguided. Chamberlin
was primarily concerned with such essentially dynamic market phenomena as product differ-
entiation and advertising. As a consequence he attempted to develop a “rivalrous” theory of
competition, which placed major importance on products, product qualities, information, and
other elements of “full price” in assessing market performance. This “new” theory of rivalrous
competition does not identify competitiveness with numbers of competitors. Two competing
rivals may be as “competitive” in terms of results as 1,000 competitors.
Economists in the Austrian tradition had long looked at markets as a process of entrepre-
neurial activity. Starting with Menger and Wieser (see chapter 14), and continuing through
Mises and Hayek (see chapter 23), this tradition has flourished, despite being regarded by
many as outside the mainstream. At the University of Chicago, however, Frank Knight gave
these concerns incipient legitimacy by expanding the concept of entrepreneurship and
establishing the institutional backdrop that encouraged expanded ideas about competition.
Led by heirs apparent George Stigler and Gary Becker, these “new” neoclassicists pioneered
the economics of information, adding several important nonprice elements to the standard
theories of consumption and production (see chapter 26).
The unifying theme of this Chicago tradition in industrial organization theory resides in
Chamberlin’s original assertion that quality variability, aided and abetted by advertising, and
other measures that may appear to be anticompetitive, are indeed the very things that com-
prise the dynamic, competitive process. Ironically, the new industrial organization theory, nur-
tured by a combination of Austrian and Chicago influences, is more in keeping with the basic
contribution of Chamberlin than the old version pioneered at Harvard University.
Chamberlin himself recognized unresolved problems occasioned by the attempt to place
the dynamic notions of product differentiation and advertising into the static mold of Mar-
shallian economics. Neglect of these analytical shortcomings led his followers to emphasize
structure, conduct, and performance rather than to confront the complexities of product dif-
ferentiation. Had his theory been properly interpreted, Chamberlin’s work might have led to a
more timely understanding of the competitive process in which quality, product, distance,
time, and other competitive dimensions must be included in order to produce a correct and
full understanding of what comprises an industry, as well as how competition works within it.
*See, in particular, E. G. Mason, “Price and Production Policies of Large-scale Enterprise,” pp. 61–74; J. S.
Bain, Barriers to New Competition; and R. E. Caves, American Industry.
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518 Part V ■ Twentieth-Century Paradigms

berlin had begun to classify.8 In this sense, Robinson’s approach was both more tra-
ditional and more general than Chamberlin’s. Nevertheless, within the confines of
her method of analysis she was able to make first-rate contributions to the theory of
the firm under all imperfectly competitive market structures. Her analysis was espe-
cially penetrating on the nature and role of monopoly and price discrimination.

Pigou, Robinson, and the Theory of Price Discrimination

In chapter 13, Dupuit’s analysis of price discrimination was discussed at some
length. We saw that his contribution was concerned primarily with the welfare
advantages of price discrimination over simple monopoly pricing. In other words, it
had a distinct policy focus, albeit outside Marshall’s sphere of influence, yet closely
aligned with it. Following in the footsteps of Marshall, A. C. Pigou and Joan Robin-
son refined and developed the purely theoretic foundations of price discrimination.
We caution the reader that their detailed analyses might perhaps best be left to spe-
cialists in the field of economic theory, but we nevertheless present a verbal over-
view of the Pigou–Robinson theory.9
Price discrimination is an activity carried on by a firm with monopoly power
because it is profitable. Essentially it involves the selling of identical units of a com-
modity to different individuals and groups of individuals at different prices. Discus-
sion of its causes and effects begins with recognition of the formal conditions
necessary for price discrimination to exist.
Conditions Necessary for Price Discrimination. First, a degree of monopoly
power is required. The firm need not be a single seller, but it must face a downward-
sloping demand curve for its product. Any firm (including the whole range from
monopolistically competitive to pure monopoly) that has any degree of control over
the price of its product possesses one of the prerequisites for price discrimination.
Second, the firm must be able to discern (or artificially create) more than one market
for its product. These markets must be separable and customers must be assigned to
separate markets. For example, age allows movie theatres to charge one price for
children, another for adults, and another for “seniors.” Retrading between consum-
ers in the several markets must not occur, either because it is too costly or impossi-
ble. In the movie example, tickets cannot be interchangeable between age groups.
(Such retrading might be effectively disallowed by the use of different-colored tick-
ets and/or by an age check at the theater door.) A third prerequisite for price discrim-
ination is that the relative profitability in the separate markets must be different,
measured at simple monopoly price. Specifically, the elasticities of demand, or the
ratios of simple monopoly price to marginal revenue, must be different in two (or
more) markets facing the monopolist. This condition makes good economic sense. If
a monopolist is selling some given quantity X and if he or she can identify and sepa-
rate two markets, one of which will yield a higher addition to revenue for every unit
sold, it will be profitable for the monopolist to transfer units of output from the mar-
ket yielding lower revenues to the one producing higher revenues. Transfers of this
type will continue until marginal revenue in each market reaches the same level.
Figure 20-4 is a model that illustrates the basic principles of Robinson’s price-
discrimination analysis. Here we are presented with demand curves of two separa-

8
Chamberlin’s classifications of market structures (polypoly, etc.) were expanded by Fritz Machlup
and others. See the references at the end of this chapter.
9
We direct the reader interested in the intricate details to Robinson’s Economics of Imperfect Com-
petition, chaps. 15 and 16, or to other sources listed in the references at the end of this chapter.
Ekelund-Hebert 6E.book Page 519 Thursday, August 1, 2013 11:03 AM

Chapter 20 ■ Competition Revised 519

Price
Figure 20-4 A sin-
gle-price monopolist
will produce output MC
Xm and charge price
Pm , selling output Xbm Pa
and Xam in the two Pm
markets. A discrimi- Pb
nating monopolist E
AD
will equate the single-
value marginal cost to m
the marginal revenue F
AMR Da
in each market, and
produce output Xa for Db
market A at price Pa , MRa
MRb
and output Xb for mar-
ket B at price Pb . O Xm
b Xb Xa X am Xm Output

ble markets, represented by Da and Db. The aggregate demand and marginal reve-
nue facing the monopolist are found by summing (horizontally) the demand and
marginal revenue functions of the two separable markets. These two aggregate
functions are represented by the dashed curves AD and AMR, respectively. These
are the only curves relevant for a monopolist who charges only one price, and under
this system he or she would produce output Xm, which corresponds to the equating
of marginal cost (MC) with aggregate marginal revenue AMR. In the single price
case, price would be equal to Pm (read off AD at output Xm). Total output Xm would
be allocated in the two markets from the demand curves Da and Db. In other words,
if price Pm is charged for the product, Xmb will be sold in market B, and output Xm
a
will be sold in market A, yielding a total monopoly output of Xm.
The Discriminating Monopolist. We can now evaluate the situation facing the
monopolist. If the necessary conditions exist for price discrimination in the situa-
tion represented in figure 20-4 (i.e., segmented markets, etc.) the monopolist can
increase his or her profits by transferring sale units from market A to market B!
Why? Because the addition to revenue from an additional sale in market B is greater
than that in market A. Figure 20-4 verifies this point. At simple monopoly price Pm
the marginal revenue of sales in market B corresponds to some value, E, and the
marginal revenue in market A corresponds to value F. Since E > F, the transfer of a
unit of output from A to B would add more to the firm’s revenue (E, approximately)
than the firm would lose by doing so (F, approximately). Thus, the profit-maximiz-
ing monopolist would find it in his or her interest to adjust sales and price in the two
markets so that the revenues produced there were exactly the same. This result is
accomplished by equating MC and AMR as before, but also by equating this single
value MC to the marginal revenues in the two separate markets. Graphically, in fig-
ure 20-4, this single value of MC is shown as the line drawn to point m on the verti-
cal axis from the point where MC = AMR. Discriminating outputs and prices are
determined by the intersection of this line with the MR’s in the separate markets.
Output Xa for market A is produced and sold at price Pa, and output Xb is sold at
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520 Part V ■ Twentieth-Century Paradigms

price Pb in market B. Note that output is increased in market B by the same amount
as it is decreased in market A. Thus, in the case described in figure 20-4, total out-
put remains unchanged, irrespective of whether the monopolist discriminates.
However, monopoly profits are clearly increased by price discrimination.

Output Effects: Robinson’s Contribution

With the model of figure 20-4 firmly in hand we are in a position to evaluate
Robinson’s contribution to price discrimination. Pigou had clearly described this
model as early as 1912 in his Wealth and Welfare (a revised version entitled The
Economics of Welfare was published in 1920). In the case depicted in figure 20-4,
the simple monopolist redistributes utility to itself from consumers by way of price
discrimination. This utility redistribution takes the form of increased profits and
decreased consumer surplus. This is so because the total quantity sold remains the
same before and after a two-price system is employed.10
One of the most frequent arguments raised against monopoly in the economic
literature (by Dupuit, Wieser, Marshall, and many others) is that it reduces eco-
nomic welfare by reducing output below levels that would result under competitive
conditions. If we seek to apply the same comparative criterion within monopoly, we
find that the case depicted in figure 20-4 does not provide any objective social basis
for choosing simple monopoly structures over discriminating monopoly structures,
or vice versa. Output remains the same in either case. Possibly the redistribution
achieved through price discrimination outrages a popular sense of equity; but on
pure economic grounds it is hard to justify a definitive stance against price discrim-
ination on the basis of Pigou’s analysis.
However, we should point out that in his analysis of price discrimination Pigou
used only linear curves (like those in figure 20-4) in concluding that the introduc-
tion of price discrimination leaves output unchanged. Robinson demonstrated that
the linear-curve situation was only a special case. She showed that compared to
simple monopoly pricing price discrimination could result in greater or less output
depending on circumstances. Her proof of this crucial point is fairly complex, but
the method and conclusions of her analysis are fairly straightforward. Basically,
whether or not output changes is a question that hinges on the concavity of the
demand curves in the separate markets. Concavity relates to the change in the slope
of the demand curves. In succinct terms, Robinson established that price discrimi-
nation will result in more output than simple monopoly pricing if the demand curve
in the more elastic market is relatively more concave, and smaller if the demand
curve in the more elastic market is relatively more convex than the demand curve in
the less elastic market.11 If the demand curves are linear, as in Pigou’s case (i.e., fig-
ure 20-4), Robinson demonstrated that the curves are of equal concavity and that
output remains unchanged by price discrimination.
Because the theoretical models employed by Robinson are complex and some-
what esoteric, one might justifiably wonder whether the whole issue is of purely aca-
demic interest. Stated differently, does her difficult theoretical analysis of relative
concavities in monopoly have anything to do with the real world? The answer, as
with many economic questions, depends on the empirical evidence respecting the
shapes of demand curves in noncompetitive markets. But in light of government pol-

10
At this point the reader might profit from rereading those sections of chap. 13 dealing with price
discrimination.
11
The concavity of the demand curves in the two markets is to be evaluated at simple monopoly price.
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Chapter 20 ■ Competition Revised 521

icies against prima facie price discrimination, the issue takes on practical signifi-
cance. An unequivocal ban against all forms of price discrimination may reduce
social welfare if price discrimination does in fact produce higher outputs than simple
monopoly. Robinson cited international trade as one arena where this might be true:
This is probably a common case where the more elastic market is an export mar-
ket in which the exported goods are in competition with those produced locally. It
will often happen that only a small amount can be exported at relatively high
prices but that as the price of the exported goods approaches and falls below the
price of the local rival goods the demand for them increases very rapidly—in short
the demand curve is highly concave. (Economics of Imperfect Competition, p. 205)

Other instances in which the relevance of Robinson’s analysis might apply include
the transportation and public-utilities sectors, where price discrimination on the
basis of different elasticities of demand might well result in increases in output.
There is a large body of legislation in the United States that outlaws price dis-
crimination without establishing any kind of welfare “test” that Robinson’s analysis
could afford. The Clayton Act of 1914, and its extension, the Robinson-Patman Act
of 1936,12 prohibit certain types of price discrimination on the premise that price
discrimination is prima facie harmful to the public interest. Indeed, prohibitions
against price discrimination have become one of the most important parts of anti-
trust legislation. Since antitrust legislation is designed to deal with monopoly mar-
ket structures wherein discrimination or the expansion of discriminatory pricing is
a possibility, these laws deny the welfare gains of potential output increases. In
short, informed analysis of the type pioneered first by Dupuit and later by Robinson
suggest that the traditional presumption against price discrimination in antitrust
enforcement should be reevaluated whenever the policy alternatives are between
single-rate monopoly pricing and multiple-pricing schemes. Only careful empiri-
cism can sort out the probable results in any particular case.
This chapter has considered only a few of the unique features of Joan Robin-
son’s book, and at only a superficial level. Her discussions of rent and comparisons
of monopoly and competitive output, for example, are important parts of received
microanalysis. Her book, like Chamberlin’s, was destined to become a classic in the
annals of economic theory.

■ KNIGHT, CHAMBERLIN, ROBINSON, AND ENTREPRENEURISM

We saw in chapter 13 that Dupuit linked the entrepreneur to the process of
product differentiation early in the nineteenth century but the idea did not gain
much traction thereafter until Chamberlin and Robinson brought product differenti-
ation into mainstream neoclassical economics. Robinson and Chamberlin showed
that profits may be earned and retained by entrepreneurs who achieve a privileged
monopolistic position in the selling market or, in the case of Robinson, a monop-
sonistic position in the factor market. But it was Frank Knight (1885–1972) who cre-
ated an eclectic theory of profit a decade earlier, which integrated all the previous
theories of profit and entrepreneurship. Knight treated profit as a residual return
earned by the entrepreneur as a consequence of correct decisions taken in the pres-
ent to bear fruit sometime in the uncertain future. His theory rests on a sharp dis-

12
The surname “Robinson” attached to this legislation bears no relation to the author of The Eco-
nomics of Imperfect Competition. Yet it is ironic that legislation bearing the same surname as Joan
Robinson was formulated in complete disregard of her contribution.
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522 Part V ■ Twentieth-Century Paradigms

tinction between risk and uncertainty. Risk exists when the future outcome of a
present action is unknown but adequate data exist to make a probability calcula-
tion. For example, a businessperson can insure against fire or flood loss in order to
protect her factory. Certain risks can be insured against because there is a sufficient
historical sample of previous incidents to permit an actuarial calculation. Apart
from insurable risk Knight defined uncertainty as a situation involving uninsurable
risk. A person confronts uncertainty when she takes a present decision under con-
ditions that do not permit a probability calculus. In such instances the decision
maker must rely on her own judgment, intuition, and whatever data she may accu-
mulate.13 Knight’s rational, profit-maximizing entrepreneur will reduce the area of
uncertainty as much as she can by insuring against risk, making forward contracts
wherever possible, and accumulating as much data as possible. Nevertheless, there
always remains an area in which true uncertainty persists. It may be some element
of costs that is incalculable; more likely, the strategies of competitors cannot be
determined. It is in the face of this kind of uncertainty that the entrepreneur proves
her mettle.
In the end Knight’s theory frees the entrepreneur from (insurable) risk, but
assigns her the difficult task of decision making under (uninsurable) uncertainty. In
a market economy, the entrepreneur’s good decisions are rewarded by profit; bad
decisions are penalized by loss. Profits may result from decisions concerning the
state of the market, decisions that result in increasing the degree of monopoly, deci-
sions about the forward holding of liquid stocks that give rise to windfall gains or
decisions about introducing new techniques or innovations that, if successful, give
rise to profits. In the final analysis all types of profits, whether they originate in the
market structure; in general movements of the price level; in changes in govern-
ment, commercial, fiscal, or monetary policy; or in successful innovation, may be
subsumed in this general concept of profit as the entrepreneur’s reward for suc-
cessful decision making under conditions of uncertainty. Persistent losses mean
that the entrepreneur is not likely to continue in her decision-making capacity.
Although Chamberlin and Robinson did not make entrepreneurship the focal
point of their analyses, they inevitably shifted attention that way because it is hard
to imagine product differentiation, price discrimination, attempted demand manip-
ulation (through advertising), and other strategies of imperfect competition without
assigning a prominent role to the entrepreneur. Because of Knight, Chamberlin, and
Robinson, the entrepreneur began to move steadily away from “manager” toward a
“unique and vital cog” in the theory of market behavior.

■ CONCLUSION
Taken as a broad reorientation of economic theory, the fate of the imperfect
competition movement remains uncertain. One presumably unintended conse-
quence was to narrow and harden the legacy concept of competition. Israel Kirzner,
for example, complained: “The perfectly competitive model was never dominant in
neoclassical economics until E. H. Chamberlin and Joan Robinson brought us
imperfect competition. Then, they retroactively attributed perfect competition to

13
Some mathematicians maintain that the difference between risk and uncertainty is not of kind but
of degree, depending only on the amount of data available to inform a probability calculus. The
point cannot be debated here, but we believe our discussion in this section can be sustained with-
out definitive resolution of the debate.
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Chapter 20 ■ Competition Revised 523

those that preceded them” (“Between Mises and Keynes”). This criticism echoed
earlier in Chamberlin’s assessment of Robinson’s work.
Imperfect Competition followed the tradition of competitive theory, not only in
identifying a commodity (albeit elastically defined) with an industry, but in
expressly assuming such a commodity to be homogeneous. Such a theory involves
no break whatever with the competitive tradition. The very terminology of “imper-
fect competition” is heavy with implications that the objective is to move towards
“perfection.” (“Product Heterogeneity,” p. 87)

Chamberlin regarded his own work as more revolutionary and spent much of
his remaining career trying to distance his work from Robinson’s despite the eco-
nomics profession’s tendency to lump them together. We find that despite important
differences between the two approaches to imperfect competition, there is less con-
tinuity between Marshall and Robinson than implied by Chamberlin—and less rup-
ture between Chamberlin and competitive theory than we might be led to believe.
Marshall and the Marshallians had, of course, studied monopoly as an extreme in
value theory. But Robinson’s insistence on the pervasiveness of monopoly and
degrees of monopoly power certainly departs from Marshall’s general characteriza-
tion of markets. Though she did not view monopolistic competition or anything
approaching it as a norm or as a general theory of value (as Chamberlin did), it is
clear that she accepted the inevitability of a continuing world of monopolies. Thus,
she recommended policies (minimum-wage legislation, etc.) that would soften their
impact or partially increase welfare (allowance of price discrimination when output
increased over simple monopoly). Such attitudes are hardly traditional, because it
made monopoly, not competition, the key subject of analysis. All in all, it would per-
haps be best to combine Chamberlin’s and Robinson’s approaches, calling the whole
mélange “imperfect competition.” Apart from a distinct difference in emphasis, and
in levels of analysis, the two works do in fact have a single message: The competitive
model is, in the main, inappropriate for describing observable pricing structures. In
its stead, monopoly models are what economists should develop and expand.
Notwithstanding the initial surge of interest in models of imperfect competition,
more recently the focus of many economists has turned back to the competitive
model. It would, of course, be an overstatement to suggest that the nadir of such
models is at hand, but it is the case that realism in model building often brings com-
plexities that theory and empiricism cannot handle. Such is probably the case in
some areas of imperfect competition. Indeterminacies in duopoly-oligopoly models
of the type suggested by Chamberlin have repelled some theorists interested in firm
behavior. The competitive model and its accoutrements, on the other hand, offer
appealing and simple explanations of firm behavior. Many economists are attracted
to simple, analytically satisfying, models. (Perhaps this is why Robinson has fared
better than Chamberlin, since her tool kit was more like Marshall’s.)14 Still, Cham-
berlin’s and Robinson’s theoretical contributions have become staples of contempo-
rary books and courses on price theory. It is probably much too soon to judge the
outcome of the value revolution. But whether it is viewed as a simple skirmish
within the neoclassical tradition or as a full-fledged flight from that tradition, the
Chamberlin–Robinson reorientation continues to play a major role in contemporary
economic thought.

14
As for herself, Robinson questioned the value of most of partial-equilibrium price theory, includ-
ing her own! (See Robinson, “Imperfect Competition Revisited.”)
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524 Part V ■ Twentieth-Century Paradigms

REFERENCES
Bain, Joseph S. Barriers to New Competition. Cambridge, MA: Harvard University
Press, 1956.
Caves, Richard E. American Industry: Structure, Conduct, Performance. Englewood
Cliffs, NJ: Prentice-Hall, 1967.
Chamberlin, Edward H. “Product Heterogeneity and Public Policy,” American Economic
Review, vol. 40 (May 1950), pp. 85–92.
———. The Theory of Monopolistic Competition: A Re-orientation of the Theory of Value,
8th ed. Cambridge, MA: Harvard University Press, 1962.
Ferguson, C. E. Microeconomic Theory, 3d ed. Homewood, IL: Irwin, 1972.
Kirzner, I. M. “Between Mises and Keynes,” The Austrian Economics Newsletter, vol. 17,
no. 1 (Spring 1997). Retrieved from http://mises.org/journals/aen/aen17_1_1.asp.
Machlup, Fritz. The Economics of Sellers Competition. Baltimore: Johns Hopkins, 1952.
Mason, Edward G. “Price and Production Policies of Large-scale Enterprise,” American
Economic Review, vol. 29 (1939), pp. 61–74.
Pigou, A. C. Wealth and Welfare. London: Macmillan, 1912.
Robinson, Joan. The Economics of Imperfect Competition. London: Macmillan, 1933.
———. “Imperfect Competition Revisited,” Economic Journal, vol. 63 (September 1953),
pp. 579–593.
Sraffa, Piero. “The Laws of Returns under Competitive Conditions,” Economic Journal,
vol. 36 (December 1926), pp. 535–550.
Taussig, Frank. “A Contribution to the Theory of Railway Rates,” Quarterly Journal of
Economics, vol. 5 (1891), pp. 438–465.
———. “Railway Rates and Joint Cost Once More,” Quarterly Journal of Economics, vol.
27 (1913), pp. 378–384.

NOTES FOR FURTHER READING

E. H. Chamberlin was not the first or the only important American “eclectic” to
emerge over the early Marshallian period in America. We have already seen that Veblen
(chapter 19) was one of these. But a number of others might be mentioned, including
Arthur Twining Hadley (1856–1930). Hadley, whose “principles” textbook, Economics:
An Account of the Relations Between Private Property and Public Welfare (New York: G.
P. Putnam’s Sons, 1896), was very influential at American universities early in the cen-
tury, was the inventor of a number of important ideas that were to influence the course of
economics in the twentieth century. In this and in an earlier book on railway economics,
Railway Transportation: Its History and Its Laws (New York: G. P. Putnam’s Sons, 1885),
Hadley (1) established property rights as the organizing principle of economic behavior
and theory in a Coasian framework; (2) developed a process notion of competition that
includes limit pricing and the concept of contestable markets; (3) recognized that politics
and bureaucracy were endogenous to the system; (4) made advances in the theory of the
firm; and (5) presented a complete development of business cycles under capitalism fea-
turing the lack of efficient property rights as a chief element in the process of competi-
tion. These kinds of contributions laid the basis for the dominance of American
economics over the twentieth century. With regard to Hadley and others, see A. B. David-
son and R. B. Ekelund, Jr., “America’s Alternative to Marshall: Property, Competition, and
Capitalism in Hadley’s Economics of 1896,” Journal of the History of Economic Thought,
vol. 16 (Spring 1994), pp. 1–26; Melvin Cross and R. B. Ekelund, Jr., “A. T. Hadley on
Monopoly Theory and Railway Regulation: An American Contribution to Economic Anal-
ysis and Policy,” History of Political Economy, vol. 12 (Summer 1980), pp. 214–233; and,
same authors, “A. T. Hadley: The American Invention of the Economics of Property
Rights and Public Goods,” Review of Social Economy, vol. 39 (April 1981), pp. 37–50.
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Chapter 20 ■ Competition Revised 525

A good place to start delving into the subject of imperfect competition is J. J. Gabsze-
wicz and J.-F. Thisse, (eds.), Microeconomic Theories of Imperfect Competition: Old Prob-
lems and New Perspectives, (Cheltenham, U.K.: Edward Elgar, 1999), a collection of 44
articles, dating from 1838 to 1988. The collection provides a broad overview of the major
theoretical concepts in the field and includes contributions from W. J. Baumol, J. P. Bena-
ssy, E. H. Chamberlin, A. Cournot, A. Dixit, F. Y. Edgeworth, J. Stiglitz, J. Tirole, and oth-
ers. Today there exist a number of alternative theories of imperfect competition,
depending on the premises established and the market to be analyzed. Fritz Machlup,
The Economics of Sellers Competition (see references), and William Fellner, Competition
among the Few (New York: A. M. Kelley, 1960), provide excellent treatments of monopo-
listic competition, imperfect competition, and oligopoly theory, along with many theoret-
ical extensions. The question of efficiency and monopolistic competition is discussed in
a number of papers by Harold Demsetz. See, for example, “The Nature of Equilibrium in
Monopolistic Competition,” Journal of Political Economy, vol. 67 (February 1959), pp.
21–30. Also see A. S. DeVany, “An Analysis of Taxi Markets,” Journal of Political Econ-
omy, vol. 83 (February 1975), pp. 83–94, for an extension of the theme of monopolistic
competition in a particular market, that of taxicabs.
A neglected pioneer in the development of monopolistic competition theory is Hein-
rich von Stackelberg, a German economist. See his Marktform and Gleichgewicht
(Vienna: Julius Springer, 1934), published just one year after the appearance of Cham-
berlin’s and Robinson’s works. Von Stackelberg developed a Cournot-type graphic tech-
nique to analyze the market results from various types of conjectural assumptions on the
part of competitors. Concluding that instability and disequilibrium characterize many
markets, von Stackelberg urged state intervention. His book is reviewed in Wassily
Leontief’s “Stackelberg on Monopolistic Competition,” Journal of Political Economy, vol.
44 (August 1936), pp. 554–559. This article provides a mathematical treatment of von
Stackelberg’s theory. The best nontechnical exposition of his alternative models may be
found in Fellner, Competition among the Few (op cit). Von Stackelberg geometry has
been put to use in analyzing certain aspects of public-goods theory. See William L. Breit,
“Public Goods Interaction in Stackelberg Geometry,” Western Economic Journal, vol. 6
(March 1968), pp. 161–164. Von Stackelberg’s Theory of the Market Economy has been
translated by A. T. Peacock (London: William Hodge, 1952).
An even earlier pioneer in duopoly/oligopoly analysis must also be mentioned. In
1929 the American economist Harold Hotelling, in “Stability in Competition,” Economic
Journal, vol. 39 (March 1929), pp. 41–57, constructed a model wherein location of firms
itself is a variable. He demonstrated the quasi-monopolistic power of each firm to set
price on the basis of locational advantages (akin to product differentiation). Paul Sweezy
utilized Chamberlin’s two-demand curve analysis (see figure 20-1) to discuss the alleged
rigidity of oligopoly prices in his “Demand under Conditions of Oligopoly,” Journal of
Political Economy, vol. 47 (August 1939), pp. 68–73. One of the most exciting develop-
ments in twentieth-century economic theory can be applied to the analysis of duopoly-
oligopoly behavior. John von Neumann and Oskar Morgenstern’s Theory of Games and
Economic Behavior (Princeton, NJ: Princeton University Press, 1943) combined the con-
siderable talents of a mathematician and an economist to produce a mathematical theory
of business and social organization. The far-reaching implications of the book extend to
decision strategies on the part of duopolist/oligopolist competitors.
The early history of the theory of price discrimination, so closely tied to product dif-
ferentiation and imperfect competition, is analyzed by Robert B. Ekelund, Jr., “Price Dis-
crimination and Product Differentiation in Economic Theory: An Early Analysis,”
Quarterly Journal of Economics, vol. 84 (May 1970), pp. 268–278. Along with Dupuit,
Pigou, and Robinson, F. Y. Edgeworth also pioneered in the theory of price discrimina-
tion; see his “Contribution to the Theory of Railway Rates,” Economic Journal, vol. 22
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526 Part V ■ Twentieth-Century Paradigms

(June 1912), pp. 198–218. An outstanding survey of the contemporary theory of price dis-
crimination is contained in Louis Phlips, The Economics of Price Discrimination (Cam-
bridge: Cambridge University Press, 1981). Among other things, this survey reveals the
richness of modern theory with its emphasis on quality variations, an innovation that
may be traced to Dupuit. On this last point, see T. R. Beard and R. B. Ekelund, Jr., “Qual-
ity Choice and Price Discrimination: A Note on Dupuit’s Conjecture,” Southern Eco-
nomic Journal, vol. 57 (April 1991), pp. 1155–1163.
Two articles by C. P. Blitch trace the influence of the neglected economist Allyn
Young (Chamberlin’s dissertation director) on the development of Chamberlin’s theory of
monopolistic competition. See Blitch, “Allyn A. Young: A Curious Case of Professional
Neglect,” History of Political Economy, vol. 15 (Spring 1983), pp. 1–24; and same author,
“The Genesis of Chamberlinian Monopolistic Competition Theory: Addendum,” History
of Political Economy, vol. 17 (Fall 1985), pp. 395–400. A somewhat different view, which is
highly speculative and does not fit the historical evidence, is offered by T. P. Reinwald,
“The Genesis of Chamberlin’s Monopolistic Competition Theory,” History of Political
Economy, vol. 9 (Winter 1977), pp. 522–534; and same author, “The Genesis of Chamber-
linian Monopolistic Competition Theory: Addendum—A Comment,” History of Political
Economy, vol. 17 (Fall 1985), pp. 400–402. Two articles by A. S. Skinner delve more
deeply into the origins of Chamberlin’s analysis: “The Origins and Development of
Monopolistic Competition,” Journal of Economic Studies, vol. 10 (1983), pp. 52–67; and
“Edward Chamberlin: The Theory of Monopolistic Competition: A Reorientation of the
Theory of Value,” Journal of Economic Studies, vol. 13 (1986), pp. 27–44. In the latter
appraisal, Skinner explores Chamberlin’s reaction to the Marshallian perspective. Nahid
Aslanbeigui and Guy Oakes, “Hostage to Fortune: Edward Chamberlin and the Recep-
tion of The Theory of Monopolistic Competition,” History of Political Economy, vol. 43
(Fall 2011), p. 471–512, describe Chamberlin’s hostility toward Joan Robinson’s theory
and why he believed it different from, and inferior to, his own. They also examine the
reception of Chamberlin’s work, and his failure to convince others regarding Robinson.
R. B. Ekelund, Jr., and R. F. Hébert, “E. H. Chamberlin and Contemporary Industrial
Organisation Theory,” Journal of Economic Studies, vol. 17 (1990), pp. 20–31, trace the fil-
iations of Chamberlinian theory to Austrian economics and the concerns of the Chicago
School. R. D. Peterson, “Chamberlin’s Monopolistic Competition: Neoclassical or Institu-
tional?” Journal of Economic Issues, vol. 13 (September 1979), pp. 669–686, explores
Chamberlin’s debt to Veblen (see chapter 19) and the affinity of monopolistic competi-
tion to institutional economics.
Several edited volumes of essays in honor of Joan Robinson have been written. For a
collection of assessments by an international team of economists who analyze various
aspects of Robinson’s thought, including her contribution to the development of the
Keynesian tradition at Cambridge University, her works on the economics of the short
period, and her critique of Pigou, see Maria Cristina Marcuzzo, Luigi Pasinetti, and Ale-
sandro Roncaglia (eds.), The Economics of Joan Robinson (London: Routledge, 1996). In
the same vein, G. R. Feiwel (ed.), Joan Robinson and Modern Economic Theory (New
York: New York University Press, 1989), collected essays, some critical, some laudatory,
from across a wide spectrum of economic theorists in relation to Robinson’s philosophy,
methodology, macroeconomics, and economic theory and specifically the notions of
equilibrium, time, capital and growth, and unemployment and the theories of general
equilibrium, trade, imperfect competition, games, credit markets, and finance. I. H. Rima
(ed.), The Joan Robinson Legacy (Armonk, NY: M. E. Sharpe, 1991), presents a mixed
collection of essays, mostly by persons who would style themselves “post-Keynesian,” on
various aspects of Robinson’s many contributions to economic doctrine and method. A
bit more biographical is M. S. Turner, Joan Robinson and the Americans (Armonk, NY: M.
E. Sharpe, 1989); and A. A. Asimakopolous, “Joan Robinson and the Americans,” Journal
of Post-Keynesian Economics, vol. 13 (Fall 1990), pp. 111–124.
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Chapter 20 ■ Competition Revised 527

A sampling of the periodical literature on Robinson includes F. G. Hay, “The Joan

Robinson Legacy: A Review Article,” American Journal of Economics and Sociology, vol.
51 (October 1992), pp. 399–400; G. C. Harcourt, “Joan Robinson’s Early Views on
Method,” History of Political Economy, vol. 22 (Fall 1990), pp. 411–428; same author,
“Joan Robinson 1903–1983,” Economic Journal, vol. 105 (September 1995), pp. 1228–
1243; and again, “Joan Robinson and Her Circle,” History of Economic Ideas, vol. 9
(2001), pp. 59–71; Vivian Walsh, “The Economics of Joan Robinson,” Science and Soci-
ety, vol. 65 (Summer 2001), pp. 229–235; J. E. King, “Your Position is Thoroughly Ortho-
dox and Entirely Wrong: Nicholas Kaldor and Joan Robinson, 1933–1983,” Journal of the
History of Economic Thought, vol. 20 (December 1998), pp. 411–432; Zohreh Emami,
“Joan Robinson’s Views on Teaching Economics,” History of Political Economy, vol. 26
(Winter 1994), pp. 665–680. Andrea Maneschi, “The Place of Lord Kahn’s Economics of
the Short Period in the Theory of Imperfect Competition,” History of Political Economy,
vol. 20 (Summer 1988), pp. 155–171, contends that Richard Kahn’s 1929 doctoral disser-
tation at Cambridge University (though never published in English) “represents a signif-
icant stage in the development of the theory of imperfect competition which began with
the pioneering paper by Piero Sraffa (1926) and culminated in the magna opera of Joan
Robinson (1933) and Edward Chamberlin (1933).”
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21

John Maynard Keynes

and the Development of
Modern Macroeconomics

One of the most compelling developments in twentieth-century economic analysis

has been the resurgence of the classical economists’ interest in aggregate econom-
ics—that is, in both monetary and macroeconomic theory. For well over two hun-
dred years the quantity theory of money was the chief mechanism for organizing
economists’ thoughts about the aggregate economy. But events both internal and
external to the discipline led to the emergence of a different approach to the macro-
economy in the mid-1930s. This movement, encompassing both economic theory
and economic policy, took on the name of its leader, the British economist John
Maynard Keynes. For decades, beginning in the 1950s and 1960s, Keynesian thought
dominated fiscal policy in the United States and many other Western nations. How-
ever, with the emergence of strong inflationary pressures in the 1970s and 1980s,
the policy emphasis shifted once again to money and to the reassertion of the under-
lying principles of the quantity theory. The theoretical shift to monetarism occurred
even earlier. Both paradigms coexist in contemporary thought on aggregate eco-
nomics. We cannot hope to air all of these views in detail here. We seek only to sur-
vey some major ideas in contemporary macroeconomics in this chapter and the
next. This chapter is devoted to Keynes and Keynesian theory, and the following one
considers the twentieth-century development of quantity-theory/monetarist thought.

■ OVERVIEW OF KEYNES AND HIS ECONOMICS

John Maynard Keynes was one of the most famous and influential economic
theorists of the twentieth century. While many economists today would minimize
the analytical importance of his contribution, probably none would deny that his
impact inside and outside the profession has been as great as Ricardo’s, Mill’s, or
even Keynes’s mentor, Alfred Marshall. Modern fiscal policy—the manipulation of
government taxation and expenditures to affect prices, employment, and income—
owes much to Keynes. His importance as a thinker is thus undeniable, and so we
devote an entire chapter to an introduction to Keynesian theory and policy. But
readers need to be aware of certain features and limitations of our treatment of
Keynes in the present chapter.

528
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Chapter 21 ■ Keynes and the Development of Modern Macroeconomics 529

First, although Keynes’s magnum opus, The General Theory of Employment,

Interest and Money (which we refer to as the General Theory), is popularly thought
to represent a great break with past ideas, it is more likely that Keynes’s ideas on
economic theory evolved over a fairly long period of time. This chapter focuses
solely on the Keynesian economics that appeared in the General Theory and
neglects the transitional aspects of his thought.
Second, our treatment is based on a standard and popular version of what
Keynes “really” said in the General Theory. This standard version is known as the
“income-expenditure model,” and it has been a staple of Keynesians almost since
the General Theory was published. The main popularizers of this model have been
Nobel laureate John R. Hicks and Harvard economist Alvin H. Hansen. Both writers
were early propagators of Keynesian ideas, and the graphs used to depict these
ideas are often called Hicks–Hansen diagrams. Our discussion derives much from
the Hicks–Hansen approach to Keynes, but the reader is forewarned that several
studies published after Hicks’s and Hansen’s have provided alternative interpreta-
tions of Keynes’s intent in the General Theory.1
Third, the reader should also be aware that the Keynesian legend has a distinct
policy theme. The legend has it that Keynes was the first (at least with respect to the
Great Depression of the 1930s) to advise governments to engage in discretionary
spending and taxation (budget deficits) to cure depression and unemployment. But
the policy legend has been open to question. It has even been convincingly demon-
strated that typically Keynesian advice regarding compensatory spending was
forthcoming in the early 1930s, but from economists at the University of Chicago
and elsewhere who have, in the lore of economic thought, been pictured as extreme
defenders of orthodox, neoclassical, and monetarist government policies (see J.
Ronnie Davis, The New Economics and the Old Economists). Our discussion, owing
to space constraints, perpetuates the (inaccurate) legend of a typically Keynesian
policy, however.
Fourth, the reader may well wonder how Keynes’s ideas could still be the sub-
ject of so much debate. One might think that what Keynes really thought should be
well settled by now. At least two important factors contribute to modern contro-
versy. The first is the fact that Keynes’s own statements of his ideas were often
ambiguous. Moreover, he left many lines of analysis undeveloped or underdevel-
oped. A second, related point is that interpretations of Keynes’s ideas by influential
post-Keynesians have fixed opinions about what Keynes thought, rendering his fate
not unlike that of Ricardo, whose ideas were and are the subject of debates. The
reader should always bear in mind the simple fact that there may be vast differ-
ences between Ricardo and Ricardians, Saint-Simon and Saint-Simonians, Keynes
and Keynesians, and so on. Naturally, all this implies that a definitive assessment of
Keynes and Keynesian economics or history of economic thought is not yet possi-
ble. Here we seek only to provide a simple introduction to basic Keynesian thought
and policy. In order to orient ourselves, however, let us first consider Keynes’s very
interesting life.

1
For the most interesting of these alternative interpretations, the serious student should consult
Axel Leijonhufvud’s On Keynesian Economics and the Economics of Keynes. Leijonhufvud argues
that Keynes’s chief concern was a presentation of a macroeconomic quantity adjustment model
rather than an analysis of unemployment equilibrium per se, which has been the traditional inter-
pretation of Keynes’s interests.
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530 Part V ■ Twentieth-Century Paradigms

■ J. M. KEYNES, DILETTANTE AND ECONOMIC THEORIST

John Maynard Keynes (1883–1946) was born ten years after Mill’s death and
seven years before Alfred Marshall published his Principles of Economics. If hered-
ity has an important impact on mental achievement, John Maynard was certainly as
fortunate as John Stuart Mill. His father, John Neville, and his mother, Florence Ada,
were both intellectuals. John Maynard’s father was a famous logician and writer on
economic methodology best known for his work, The Scope and Method of Political
Economy, published in 1890. John Maynard inherited from his parents a great intel-
lectual curiosity and a lifelong love for the arts, especially the theater. His devotion
to his father, who outlived him (J. N. Keynes died in 1949), was poignant and lasting.
Keynes was educated at Eton, arguably the most prestigious of English prep
schools. He was alternatively immersed in classical literature, logic, mathematics,
dramatics (he once played Hamlet), and in the high jinks of school life. He carried
over his frenetic intellectual activity to King’s College, Cambridge, where he
received his university education. In a letter to his good friend B. W. Swithenbank
Keynes described his collegiate pace:
Immediately after hall I went to a Trinity Essay Society and heard a most brilliant
satire on Christianity. From there I went to an informal philosophical debating
society of interesting people where I stayed till nearly twelve; I then went to see
Monty James where I stayed till one; from there I went on to another man with
whom I talked till half past four. At half past seven I got up and read the Lesson in
Chapel. I had four hours’ work that morning, and rowed half a course in the after-
noon. In the evening I went as a visitor to the Political Society to hear a paper on
the Jesuits. (Harrod, Life, p. 68)

And so it was during his whole career, first as a student and then as an author, gov-
ernment official, and fellow at King’s College.
Keynes was always surrounded by individuals of similar interests. Friendship
was very important to him, and as a member of the famous Bloomsbury group
(named for a London neighborhood), he was in intimate and stimulating contact
with leading British intellectuals. In addition to Keynes, the original Bloomsbury
group included Leonard and Virginia Woolf, Duncan Grant, Clive and Vanessa (Vir-
ginia Woolf’s sister) Bell, E. M. Forster, and, perhaps its most influential member,
Keynes’s good friend Lytton Strachey. Anti-Victorian and bohemian, the Blooms-
bury group considered all issues (philosophy, social convention, art, literature, and
music) with the utter frankness and conceit generated by a firm belief in their own
intellectual superiority. Although his major interest and achievements were to
depart significantly from those of the Bloomsbury set, Keynes clearly contributed
to, and drew cultural sustenance from, the group.
Economics had always interested him. He took courses from Alfred Marshall,
and in 1905, Marshall wrote of his pupil to J. N. Keynes: “Your son is doing excellent
work in Economics. I have told him that I should be greatly delighted if he should
decide on the career of a professional economist. But of course I must not press him”
(Harrod, Life, p. 107). Marshall probably did not find it necessary to press much, for
Keynes’s interest grew steadily. He was a natural. And, moreover, he knew it.
Keynes’s precociousness and wide range of activities carried over into his entire bril-
liant career, which by 1906 was leading him toward civil service as well as econom-
ics. In that year, Keynes passed the civil service examination and was assigned to a
position in the Indian office. Quickly bored with his administrative duties, Keynes
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Chapter 21 ■ Keynes and the Development of Modern Macroeconomics 531

devoted ever more of his time to a study of probability theory, which culminated in
his Treatise on Probability (1921), highly praised by Bertrand Russell and others.
In 1911 Keynes joined F. Y. Edgeworth as co-editor of the Economic Journal, the
official organ of the Royal Economic Society, a position he retained until 1945. In
1913 he published Indian Currency and Finance, a work on international finance
related to the gold exchange standard. Rapidly gaining fame as a monetary expert,
Keynes entered the treasury department in 1915 and remained there until the end of
World War I. He served as British treasury representative to the peace treaty confer-
ence of Versailles. With grave forebodings concerning the terms of European recov-
ery, he resigned from the treaty conference. He later attacked the conditions of the
treaty, and Prime Minister Lloyd George’s policies, in The Economic Consequences
of the Peace (1919). Keynes urged the victors to moderate their pressing demands
on defeated Germany—a position that made the book an immense critical success.2
During the 1920s, Keynes taught at King’s College, Cambridge. He was an enthu-
siastic and successful lecturer, but he soon reduced his teaching load in order to
engage in a multitude of other activities. Keen to be independent of salaried employ-
ment, he began speculating in the foreign exchanges and amassed a fortune of
approximately half a million pounds by 1937. He later served as chairman of the board
of the Nation, a liberal weekly; and assumed the duties of bursar (financial analyst and
manager) of King’s College, for which he received, at the outset, £100 per year.
In 1923, Keynes published his A Tract on Monetary Reform, which was a
polemic in favor of discretionary management of the internal money stock and
against the gold standard as a capricious determinant of the internal economy. In
1925, he married a Russian beauty, Lydia Lopokova, one of the great Diaghilev’s
prima ballerinas. With his marriage, Keynes’s interests between economics and the
Bloomsbury group began to separate, and thereafter economics became and
remained the major focus of his life. In 1930 Keynes published a book that he
intended to crown his lifework in the field of money. His Treatise on Money was
only a “still” picture of his ideas at that time; yet, it anticipated and even developed
some of the mature ideas that were later displayed in the General Theory. Specifi-
cally, the Treatise explores the key roles of saving and investment in influencing the
level of income—ideas that owe much to the influence of Keynes’s friend and col-
league Dennis H. Robertson. After 1930 Keynes ramped up his output even more. In
addition to his magnum opus, The General Theory of Employment, Interest and
Money, he displayed his pedagogical and persuasive skills in Essays in Persuasion
(1931), and again in Essays in Biography (1933), both of which can still be read for
enlightenment and enjoyment. In addition to his writing during this time, Keynes
continued his lecturing, civil service, and college duties.
In the late 1930s Keynes became increasingly concerned with the financial bur-
dens imposed by the impending war with Germany. He tackled the problems of
reordering wartime resource priorities and the ensuing excess demand it creates in
How to Pay for the War (1940). Between 1941 and 1946, he negotiated wartime lend-
lease financing, and in 1946 he was instrumental in arranging loans to Great Britain
under the U.S. Marshall Plan of reconstruction. That same year Keynes was made a
vice president of the World Bank, at which he took a leadership position, along with

2
In other ways, Keynes had turned a handsome profit from his wartime experience. While Big Ber-
tha was shelling Paris, Keynes was at an art auction representing London’s National Gallery. (The
auction was to improve France’s exchange position.) On that occasion, he acquired a number of
fine pieces for the gallery, but he bought a Cézanne and an Ingres for himself. As Keynes’s biogra-
pher Harrod reports, the shelling depressed prices.
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532 Part V ■ Twentieth-Century Paradigms

Harry Dexter White, in formulating plans to restore the international monetary sys-
tem (which led to the Bretton Woods Agreement). This dizzying array of activities
took its toll on a heart, weakened by a previous attack, and in the summer of 1946,
Keynes died at the age of sixty-three. The world lost a mind that probably could
have reached high flights of achievement in any one of a number of areas, but
Keynes himself chose economics.

■ THEORETICAL OUTLINE OF THE GENERAL THEORY

As noted earlier, the actual writing of the General Theory took place in the
midst of the Great Depression. From the beginning of the 1930s, Keynes had been
much concerned about the employment crisis, which was deepening drastically in
the United States and England. He voiced concern in several communiqués to Pres-
ident Roosevelt, including a famous open letter to him in The New York Times.
Keynes’s advice was to make vigorous use of fiscal policy (government tax and
expenditure policy) to supplement the private-sector economy, which, in Keynes’s
view, was failing to confront the employment problem. Roosevelt appeared to follow
Keynes’s advice, but guardedly. Whatever other meaning the episode had, it clearly
indicates that the environment of the early 1930s was much on Keynes’s mind prior
to writing the General Theory.
As an independent discipline economics was experiencing internal pressures in
the 1930s. Marshallian microeconomics was going through some radical extensions,
including the revisions of E. H. Chamberlin and Joan Robinson (see chapter 20).
Keynes himself had raised questions concerning the adequacy of neoclassical mone-
tary theory in his Treatise on Money, and several of his colleagues were focusing on
the importance of expenditures in aggregate output determination. Richard Kahn
had developed a concept of an investment multiplier, and he, along with other lead-
ing Cambridge economists (Joan Robinson, R. G. Hawtrey, and R. F. Harrod), was
steadily engaged in discussions of departures from standard economic theory. A gen-
eral rethinking of neoclassical economic theory, and specifically Marshall’s econom-
ics, must have contributed to Keynes’s seminal work. Thus, a confluence of internal
and external pressures led him to offer an alternative to neoclassicism. Keynes
firmly believed that he was making a significant departure, but it was not an easy
one. He spoke of a “long struggle of escape” from traditional methods of thought and
expression, and he was at pains to explicate and emphasize these differences.

Keynes’s Reaction to the Classics

In an attempt to dramatize his break with the past, Keynes used the term clas-
sics to refer to a long line of orthodox writers from Smith and Ricardo through Mar-
shall and Pigou (Keynes treated his senior colleague, Pigou, as the repository of the
entire orthodox tradition). Moreover, in Keynes’s frame of reference classical eco-
nomics was reduced to an idealized model not unlike the one considered in chapter
7 of this book.3 He promptly rejected this idealized model of classical macrotheory
even though he freely acknowledged several anticipators of his ideas.4

3
Refer back to the section entitled “The Elegant Dynamics of the Classical System” at the end of
chapter 7.
4
Keynes’s anticipators were, for the most part, dissenters from the classical tradition. A superb his-
torian of thought, Keynes reviewed and evaluated these heretics in chap. 23 of the General Theory,
“Notes on Mercantilism.” In this connection, see chap. 3 of the present book.
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Chapter 21 ■ Keynes and the Development of Modern Macroeconomics 533

Keynes’s essential break with the classics was over the notion of Say’s Law,
which, broadly and naively stated, holds that supply creates its own demand. Say’s
Law (with all its accoutrements) implied that as a long-term proposition unemploy-
ment could not be permanent because the free enterprise economy was self-adjust-
ing; any disturbances from a full-employment-full-production equilibrium would be
only temporary. The classics had reasoned that in real terms the economy func-
tioned much like a barter system. Goods were exchanged for goods, and money
represented simply a standard of value and a medium of exchange. In Pigou’s
words, money was a “veil.” It hid the real workings of the economy. It was the
grease of trade, not the wheel.5
An equivalent way of stating Say’s Law is to say that aggregate savings (income
removed from the expenditure stream) will always equal investment (income
returned to the expenditure stream) at full employment. As Böhm-Bawerk stressed,
people generally prefer present consumption to future consumption, but given that
savings is a function of the reward for savings, or a rate of interest, they can be
induced by a positive rate of interest to hold more assets in the form of savings.
Thus, the classics reasoned that the amount of savings was positively related to the
rate of interest.
Investment, however, is negatively related to the interest rate because, among
other reasons, the productivity of given investments decline with incremental
increases in investment expenditure (technology being constant, of course). These
relationships are summarized in figure 21-1, in which economy-wide saving and
investment schedules are represented as functions of the rate of interest. The clas-
sics reasoned that at interest rate r0 savings equaled investment, which meant that
what is not spent on consumption goods (saved) was invested (spent on capital
goods). A flexible interest rate mechanism guaranteed this result. Flexibility in this
context means that if investment exceeds savings, say, at interest rate r1, the rate of
interest would be bid up to r0 by investors. Conversely, if savings are greater than
investment, savers will bid the interest rate down to r0.

Interest
rate Savings

r0*

Figure 21-1 At inter-

est rate r0 , savings equal
investment. If invest- r0
ment increases from I to
I, the new equilibrium r1 I‫׳‬
rate of interest rises to r0*
and the amount of sav-
Investment
ings and investment
increases to s0* and i0* ,
respectively. O s0 , i 0 s0* , i0* Savings, investment

5
Again, refer back to chap. 6, which dichotomizes the real from the monetary aspects of the macro-
economy.
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534 Part V ■ Twentieth-Century Paradigms

The classical model reasoned that an increase in investment (which might have
resulted from inventions or innovations) caused an upward shift in the investment
schedule (shift to I in figure 21-1), causing the level of investment to increase and the
level of consumption to decrease. Society is induced to save more (and consume less)
by a rising rate of interest. At the new equilibrium the rate of interest rises to r*,
0 and
the amount of savings and investment increases to s*0 and i*, 0 respectively. The real
increase in savings (s*0 – s0) represents the decrease in consumption, but the
decrease in consumption caused thereby is exactly matched by the increase in invest-
ment (i*0 – i0). In equilibrium the economy would neither overproduce nor underpro-
duce. Given free markets, general laissez-faire, and rapid interest rate responses,
Say’s Law was a sure thing. A ready demand for goods (consumption and investment)
could always be depended on. The market would always clear at full employment.
The interest-rate-adjustment mechanism provided one assurance of the validity
of Say’s Law. Another was the classical proposition of flexible wages and prices in
the economy. If, for some reason, the economy was sluggish in adjusting to funda-
mental changes in savings and investment (say, as a result of a massive change in
the desire to save), flexible prices and wages would guarantee a smooth short-term
adjustment. With a dearth of aggregate demand, money, wages, and prices would
fall such that full employment and full production would be resumed. Entrepre-
neurs would be willing to accept lower prices in order to sell their goods, and work-
ers would be willing to take lower money wages, provided prices fell in the same
proportion. Any disturbance that caused unemployment and output reductions was
bound to be temporary since the competition in labor and product markets would
always adjust the real variables of the system to equilibrium.
Keynes flatly and boldly rejected these classical adjustment mechanisms. In his
two-pronged attack on Say’s Law he maintained: (1) that the equilibrium of savings
and investment did not depend solely on the interest rate but was determined
instead by a complex host of additional factors, meaning there was no guarantee
that the two would necessarily be equal at a level of economic activity that produced
full employment; (2) rigidities in the economy such as seller monopolies and labor
unions thwarted the fluid movement of wages and prices, thus preventing the
smooth adjustment assumed by the classical model. Keynes believed that laborers
operated under “money illusion,” meaning their behavior was related to the money
wage (W) rather than to the real wage (W/P) they received. Because workers would
refuse to take cuts in their money wages, he reasoned, the self-equilibrating tenden-
cies of the classical model would not work. Because the level of employment was
inversely related to the real wage rate (on this Keynes and the classics agreed), the
refusal of laborers to take money wage cuts was a direct denial of the classical
wage-rate-adjustment mechanism.
Keynes pushed the argument further, arguing that even if workers were pre-
pared to take cuts in their money wages, such wage cuts meant lower real wages and
increased employment (a movement down the demand curve for labor) if and only if
prices remained constant. But prices could not remain constant in the face of falling
money wages since lower wage incomes mean less demand for goods and services,
which in turn forces prices down. Now if prices fall at the same time that wages fall,
real wages (and therefore employment) might not change (unless the Keynes effect,
which we shall consider later on, was operative). In other words, Keynes felt that the
adjustment of money wage rates was ineffective in reducing unemployment.
Keynes believed that unemployment could be efficiently attacked only by
manipulating aggregate demand. Given stable money wage rates workers would be
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Chapter 21 ■ Keynes and the Development of Modern Macroeconomics 535

willing to accept increases in prices that resulted from an increase in demand. Such
increases would lower real wages, thereby stimulating employment. Keynes turned
the classical proposition around. Employment is not increased by lowering real
wages, but real wages will fall when employment increases due to greater aggregate
demand. A more complete explanation of this important point will be given later in
this chapter, but in order to understand Keynes’s critique of classical employment
theory, we must first look at some distinctly Keynesian inventions that laid the
groundwork for his system. First we look at a concept to which we have already
alluded, aggregate demand.

Aggregate Demand
In reformulating the concept of aggregate demand Keynes turned away from
the quantity-theory-of-money framework favored by the classics and embarked on a
new approach that stressed the component parts of aggregate expenditures. The
first major component he analyzed was aggregate consumption, which took the
name of consumption function. A consumption function relates the consumption of
all private goods and services to the aggregate level of income in a positive way. It is
conveniently expressed as C = f(Y), to be read as consumption (C) is a function of
aggregate income (Y). Consumption, as Keynes well knew, is related to a host of
other factors—price expectations, the utility of saving for future consumption ver-
sus present consumption, income expectations, institutions, habits, and so on. But
Keynes wished to hold these other variables in abeyance in order to look at the
close connection of consumption and income. Aggregate income is generated by
returns to the factors of production (i.e., wages, interest, rent, and profits) and as
such may be consumed or saved. It follows, therefore, that saving, too, is a function
of income in the same manner as consumption. Figure 21-2 gives graphic represen-
tation to these Keynesian functions.
The assumptions Keynes made with respect to these functions are as follows.
The average propensity to consume (i.e., total consumption divided by total income)
declines as income falls. However, the marginal propensity to consume, or the ratio
of a change in consumption to an incremental change in income (i.e., c/y)

Aggregate
Consumption, supply C+I
Figure 21-2 investment
A Consumption
The intersection tment
of aggregate Inves
demand and Δc
Δy
aggregate supply Savings
schedules (point
A) determines an
equilibrium level + Investment
of income, Y0. If O 45º
Income
income exceeds – Y0
Y0 , then aggre- Δs
gate supply will Δy
exceed aggregate
demand.
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536 Part V ■ Twentieth-Century Paradigms

remains constant. Any alteration in the marginal propensity to consume would cre-
ate alterations (shifts or rotations) in the consumption and savings functions. Any of
the aforementioned nonincome determinants of consumption (tastes, price, and
income expectations) would have this effect.
Keynes defined an aggregate supply function as the aggregate supply price of
output from employment of N workers, or Z = (N) in functional notation. This
function is represented by a 45° line in figure 21-2, so that the demand for goods at
given prices exactly equals the supply of goods.6 In addition to consumption, the
total aggregate demand for goods and services in the private sector also includes
investment (i.e., demand for plant, equipment, etc.). Keynes believed that for the
most part (at least in the short run) investment spending could be regarded as
autonomous, or independent of the level of income. This assumption might be rea-
sonable if large businesses make long-term investment commitments irrespective of
purely short-term income conditions. Autonomous investment assumes the shape of
a horizontal line, as shown in figure 21-2. When added to the consumption function,
total demand takes the form of C + I, which represents the vertical sum of con-
sumption and investment at each level of aggregate income.
If we confine our analysis to a closed (no external trade), private-sector (no
government) economy, we can identify equilibrium level of income Y0 at the inter-
section of aggregate demand (C + I ) and aggregate supply (45° line). At point A the
aggregate sale proceeds of Y0 level of output precisely equal the aggregate cost (fac-
tor payments) of producing output Y0. If the level of income were greater than Y0,
aggregate supply would exceed aggregate demand. In other words, the aggregate
cost of producing that higher level of output would exceed the receipts obtainable
from consumption and investment expenditures at that level. This is so because
consumption would not increase sufficiently to absorb the increased supply. Barring
price changes (which are ignored in this simple model), unsold inventories would
pile up, and entrepreneurs would cut back production to Y0. For the opposite and
analogous reason, output would increase to Y0 should it temporarily fall below Y0.
The aggregate output level is thus considered stable. A central element in Keynes’s
theory is that the economy could reach a stable equilibrium output level, such as Y0,
but it would not necessarily constitute a full-employment level of national output.
An economy could be, Keynes concluded, in an “unemployment equilibrium.” This
conclusion was totally at odds with classical economic theory.

The Role of Investment

The simple Keynesian model outlined in the preceding section ignores two
major sectors of a modern economy: government and international trade. Keynes
kept things simple at the outset in order to establish the essential working compo-
nents of his “new” theory. Of the two components of aggregate demand recognized
so far, Keynes viewed investment demands as by far the more volatile. Investment
demands are determined by a host of factors besides the interest rate, including
expected future returns. Indeed, a well-known Keynesian concept, the marginal effi-
ciency of capital (actually investment), relates the cost of investment capital to the
expected returns over the life of investment projects. Expectations, often volatile
and dependent on capricious psychological factors, have direct, important effects
on investment and hence on income.

6
This representation departs from standard theory in which aggregate supply is a function setting
output produced against alternative price levels of output.
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Chapter 21 ■ Keynes and the Development of Modern Macroeconomics 537

A more fundamental problem at the heart of Keynes’s alternative theory is that

expenditures have multiple (repetitive) effects on income. A change in investment
expenditures, for example, does not result in a “one-shot” change in income by the
amount of the spending change but, rather, by some multiple. Keynesian macroeco-
nomics therefore sought to account for these multiplier effects. In order to grasp the
basic principle of a spending multiplier, consider figure 21-3, which is similar to the
one preceding it. The initial spending level, C + I, determines an equilibrium level
of income Y0. This level is stable in the sense described in the previous section.
Now, suppose that one of the determinants of investment changes—say, expecta-
tions—and that investment increases from I to I by an amount labeled I. The effect
on total expenditures causes an upward shift in the aggregate demand function to
the level C + I, causing a new equilibrium to be reached at Y1.
The multiplier effect is theoretically predictable because it depends on the
numerical value of the marginal propensity to consume. The dependence is easily
explained. The initial injection of investment (I) is received as income by factor-
share recipients. That means that income is increased by I. These recipients have
marginal propensities to consume and save that, of necessity, add up to 1. Imagine
that the marginal propensity to consume is 75 percent, in which case 75 percent of
the initial new receipt of income is spent. At this point income is generated in the
amount I + 3/4(I). But the process does not stop there. The 3/4(I) spent by the
initial recipients is received as income by other factors, who spend a portion and
save a portion.
Multiple rounds of spending are thereby touched off by a single injection of
expenditure into the system. When the process approaches the limit, the change in
income Y is equal to 1/(1 – MPC), or, in our example, 1/(1 – 3/4) = 4, times the ini-
tial investment increase. If the initial investment injection was $10 billion, the ulti-
mate change in income would be $40 billion. The value of the multiplier is obviously
4. If we designate this multiplier as k, then it follows that k = Y/I.

C+I Aggregate
supply

C + I‫׳‬

C+I
ΔI

Figure 21-3
If investment
increases from I to I,
the aggregate
demand function will
shift upward by I. ΔY
Income will also
increase from Y0 to Y1. O Y0 Y1 Y
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538 Part V ■ Twentieth-Century Paradigms

It can be seen, therefore, that following Keynesian logic, the capriciousness of

private investment, coupled with its multiplier effects on income, means that predic-
tion of aggregate income is complex and difficult. But even if income levels and
changes could be predicted with a high degree of accuracy, such levels would only
be full-employment levels by accident. To see why, we delve a bit deeper into
Keynes’s theory.

Unemployment Equilibrium
The classical writers believed that the demand for labor was equivalent to the
marginal productivity of labor and that labor supply was an increasing function of
the real wage. This classical view of labor functions is reproduced in figure 21-4a.
Equilibrium real wage (W/P)0 produces full employment of labor inputs N0. Should
the equilibrium real wage be displaced, say, to (W/P)1, unemployment would occur
in the amount AB. Workers would competitively bid the money wage down and
reestablish full employment at N0.
We have already seen that Keynes rejected this hypothesis. He argued that
laborers could be involuntarily unemployed. Theoretically, Keynes accepted the
classical notion of the demand for labor as determined by labor’s marginal product.
But he insisted workers were motivated to supply labor by the money wage offered,
not the real wage. And because workers suffered from money illusion they would
not take cuts in their prevailing money wage. These premises are incorporated into
figure 21-4b, where money wage W0 is a floor. The employment level N* represents
full employment of labor, and the labor demand functions DN and DN are now the
value of the marginal product of labor (because the demand is set against the
money wage instead of against the real wage).
The question is whether there could be any involuntary unemployment in the
economic system. The classical economists recognized that at an equilibrium real
wage, such as (W/P)0 in figure 21-4a, voluntary and frictional unemployment could
exist. Unemployment could be voluntary in the sense that certain amounts of labor
would choose to exempt themselves from the labor force at wage (W/P)0. But
Keynes viewed the matter differently. In figure 21-4b, labor would supply quantity

W
P
W
S
SN
A B
( WP )1
A
W0 B
( WP )0
DN‫ = ׳‬MP • P*1
DN = MP • P0
DN = MPN

O N0 N O N0 N* N
(a) Classical Labor Market (b) Keynesian Labor market

Figure 21-4 The classical labor market automatically adjusts itself to full employ-
ment, whereas the Keynesian labor market does not automatically adjust.
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Chapter 21 ■ Keynes and the Development of Modern Macroeconomics 539

N* at money wage W0, but demand might be such that only a lesser quantity N0
would be demanded at real wage (W/P)0. The result would be what Keynes called
“involuntary unemployment.” Here we have the anomalous effect that labor is invol-
untarily unemployed in the amount AB, and yet the labor market is in equilibrium in
the sense that no automatic tendency for employment to change from N0 could be
expected. No unique full-employment level of output could be presupposed, there-
fore. Economy-wide equilibrium could be achieved at any labor utilization level.
Laborers, in the first place, would not take money wage cuts, thereby reducing the
real wage rate for increased employment. In the second place, even if they did,
prices would likely fall in the same proportion, causing the labor demand function
to shift to the left and leaving the unemployment level unchanged.
Thus, a situation like that described in figures 21-5a and 21-5b might be
observed. Outputs Y0 and Y* are functions of inputs (labor and capital). An equilib-
rium occurs at input and output levels N0 and Y0 , but at these levels involuntary
unemployment exists in the amount AB. Aggregate demand would have to increase
by MN in order to bring the economy to full employment. Keynes believed that pri-
vate investment alone would not be likely to bring this about, and he suggested
compensatory government expenditures and taxation (fiscal policy) in order to
relieve unemployment and underproduction. We will discuss these aspects of
Keynesian policy later, but before that we must probe further into Keynes’s beliefs
about individuals’ motivations for holding money and how they respond to mone-
tary changes.

C, I W
Aggregate supply S
M
C + I‫׳‬

N A
W0 B

DN‫׳‬
DN
0

O Y 0 = f (N0) Y* = f (N*) O N0 N* N

(a) Product Market (b) Labor Market

Figure 21-5 At equilibrium levels N0 and Y0 , involuntary unemployment exists in the

amount AB. Aggregate demand would have to increase by MN to bring the economy to
full employment.

Liquidity Preference and the Role of Money in the Keynesian System

The neoclassical economists adhered to a long-established and well-known the-
ory about money, the so-called quantity theory of money. The oldest version of the
theory was given shorthand expression by the equation, MV = PY, where M stands
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540 Part V ■ Twentieth-Century Paradigms

for the stock of money, V for velocity (annual turnover of the money stock), P for
the price level, and Y for some index of aggregate output. Keynes himself had
adhered to the Cambridge version early in his academic life. The Cambridge equa-
tion, M = kPY, is a simple mathematical transformation of the older version but
emphasizes holding money for transaction purposes (k is the reciprocal of velocity
and represents the demand for transactions balances). In the typical treatment, peo-
ple were assumed to hold a constant proportion of their income as cash to finance
transactions. As incomes rise, people hold more cash, but the cash-balance propor-
tion of higher incomes remains the same. An increase in transactions demand for
money, or an increase in the average amount of cash balances individuals hold as a
percentage of income, means that velocity, or the turnover of the average dollar
facilitating national income, is reduced.
Economists before Keynes did not regard velocity as a strict numerical con-
stant, but they did assert that it was relatively stable and predictable. If true, the
implications for economic theory and policy are clear. If V is constant or predict-
able, M is controllable, and P is (relatively) stable up to full employment, then M can
be adjusted to produce changes in income (Y) when there are unemployed
resources in the economy.7 Keynes accepted the premise that people hold money for
transactions purposes and that the transactions demand for money is related to
income. He argued, however, that individuals hold money for other reasons as well
and that an important reason to hold money is to speculate in the bond market. In
other words, while the classical economists considered that individuals hold money
for transactions and even for precautionary (saving for a rainy day) motives, Keynes
argued that they would hold money as an alternative to holding bonds. He called
this “liquidity preference” and asserted that the chief determinant of speculative
money balances is the interest rate, not income. This is because the interest rate
represents the opportunity cost of holding cash balances.
Figure 21-6 shows a typical liquidity preference function, LS. In this representa-
tion the only alternative to holding money is to hold bonds. Keynes theorized that at
high interest rates (i.e., low bond prices) individuals would prefer to hold bonds
rather than money because the opportunity cost of holding money is relatively high.
As the interest rate falls, however, bond prices rise, pushing down their yields and
making bonds less attractive to buy. But now selling bonds becomes more attractive
because of the rise in bond prices (capital gains). Thus, as the interest rate falls indi-
viduals will choose to hold more of their assets in the form of money and less in the
form of bonds. This inverse relationship between interest rates and money holdings
is traced out by LS in figure 21-6.
Keynes’s demand for money function has a unique feature, namely the liquidity
trap, which is represented by the horizontal portion of the liquidity preference func-
tion. Keynes’s followers emphasized this feature far more than Keynes himself, but
the argument is clearly his. He had argued in the General Theory that the interest
rate might fall so low (price of bonds so high) as to induce all investors to withdraw
from the bond market. Everyone, in short, would want to hold the more liquid asset,
money. If this were indeed the case, it means that there is a kind of floor to interest

7
At all other times, of course, the classical economists viewed money as having a stabilizing role
and as oiling the wheels of trade. Proposals by Milton Friedman and others, related to a rule of a
constant growth rate in the money stock, reflect this traditional concern; see chapter 22 for
more details.
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Chapter 21 ■ Keynes and the Development of Modern Macroeconomics 541

r M0 M1 M2
Interest
P0 P0 P0
rate

Figure 21-6
Increasing the nomi- r0
nal money stock from
M0 to M1 will reduce Liquidity trap
the interest rate from r1 Ls
r0 to r1, but increasing
the money stock fur-
ther, to M2 , will not
have any effect on the
interest rate. O Speculative Money Balances

rates so that below that level, no further reductions in the interest rate can induce
more capital investment via the bond market.8
What has all this to do with monetary policy and its effectiveness? Keynes
argued that although the rate of interest was determined by a combination of real
and monetary factors in the economic system, the existence of the speculative
demand for money meant that the mechanism by which money influenced income
and employment in the economic system was not as simple and predictable as the
classical economists believed. Specifically, one of the major impacts of money on
spending, income, and employment was through its effect on interest rates. Lower
interest rates ordinarily meant, ceteris paribus, higher levels of investment and con-
sumption (since lower interest rates made present consumption more attractive rel-
ative to future consumption, i.e., saving). Typically, monetary policy might lower the
interest rate and thereby increase spending to a full-employment level.
Consider a liquidity trap in place, as in figure 21-6. If there is unemployment at
the prevailing interest rate r0 the standard economic argument is that increasing the
real money stock (M/P) drives down the equilibrium interest rate and stimulates
more business investment. If prices remain the same, the real money stock can be
increased by increasing the nominal money stock (M). Hence the increase from M0
to M1, assuming that prices remain constant, reduces the interest rate from r0 to r1.
So far, so good. But if unemployment exists at interest rate r1, the same policy will
not work. Increases in the real money supply from that point (e.g., from M1/P0 to
M2/P0) do not lead to a change in the interest rate because the return on investment
is considered too low to be worth the risk. Hence, society will hold all the new
assets in the form of money balances. Since the interest rate does not fall, invest-
ment and consumption—for this reason at least—will be unaffected. Given the
liquidity trap, Keynes concluded that monetary policy designed to work through
interest rate changes is helpless in the face of widespread unemployment and a
depressed economy.

8
Sir Dennis Robertson once provided an amusing description of the liquidity trap: “The rate of
interest is what it is because it is expected to become other than it is; if it is not expected to
become other than it is, there is nothing left to tell us why it is what it is” (Essays, p. 174).
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542 Part V ■ Twentieth-Century Paradigms

Prices: Flexible or Inflexible?

Did the liquidity trap exist? Keynes and many of his followers believed that the
monetary and psychological conditions accompanying the Great Depression sug-
gested the existence of such a trap. (Subsequent empirical evidence does not sup-
port the existence of a trap.) For this reason and a bevy of other reasons, Keynes
rejected a policy that relied solely on monetary measures and supported a strong
fiscal policy instead to promote economic stabilization. Whether intended or not,
his stance then created a bias toward fiscal policy to combat recessions ever since.
We turn now to theoretical matters regarding prices and stabilization. We saw
earlier that Keynes regarded prices as fairly inflexible downward, which he attrib-
uted to resistance maintained by monopoly elements and collusive practices in sev-
eral segments of the economy. But what if prices were flexible downward? As a
theoretical proposition, Keynes agreed that falling prices could improve the situa-
tion faced by a depressed economy. In fact, this phenomenon has taken the name of
the Keynes effect. If the money stock is held constant, a reduction in prices would
increase the real stock (M/P) of money. As is easily seen from figure 21-6, the inter-
est rate would fall with a constant M and a lower P. If the economy does not face a
liquidity trap and investors and consumers are in fact responsive to lower interest
rates, a greater stock of real money would have the effect of raising the level of
aggregate demand, income, and employment (as, indeed, the classics argued).
While Keynes agreed in theory, he chose to stress the practical effects of falling
prices. He appeared to believe that a declining price level would have other, oppo-
site, and harmful effects on the economy. For example, falling prices would have the
effect of raising the real level of fixed business indebtedness. Moreover, falling
prices could be extremely detrimental to business expectations regarding future
profits. Because he believed that aggregate investment is conditioned largely by
price and profit expectations, a rapid decline in the price level may, practically
speaking, reduce the level of investment even in the face of declining interest rates.
Bankruptcies and adverse business conditions would almost certainly follow falling
prices. In sum, Keynes did not believe that economic catastrophe could be averted
merely by a flexible and falling price level.

Fiscal versus Monetary Policy

As the whole tenor of our discussion reveals, Keynes did not regard the eco-
nomic mechanisms of the private sector as infallible guards against prolonged
unemployment. He believed an economy could be stuck in an unemployment equi-
librium. The existence of downwardly flexible wages and prices could not be
assured and, even if it could, it would not guarantee full employment. Because of
other limitations established by the investment function and the liquidity trap, mon-
etary policy was not reliable as a corrective measure. How, then, might the unem-
ployment gap in aggregate demand (see MN in figure 21-5a) be bridged?
If one is convinced that solutions will not come from the private sector or from
the monetary authorities, where else do you look except the government sector?
Backed by his theoretical arguments, Keynes asserted the government should use its
powers to tax and spend in order to influence the business cycle. Government
spending is a direct injection of public investment into the income stream. Govern-
ment spending could be financed by taxation (which would reduce consumption, but
by less than the amount of the tax), by the sale of bonds to the Federal Reserve, or by
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Chapter 21 ■ Keynes and the Development of Modern Macroeconomics 543

some other means. The income- and employment-generative effects of all these
alternatives could then be assessed and action taken to achieve economic stability.
Keynes did not believe that single injections, or “pump priming,” would be
enough to correct a seriously depressed economy. What was required was a full-
scale and planned program of discretionary fiscal policy as well as a strengthening
of built-in stabilizers (such as progressive taxation). The government must stand
ready, in short, to provide the conditions for full employment. Keynes’s basic mes-
sage is clear. He believed in fiscal activism. (For a challenge on this posture from
one of Keynes’s contemporaries, see the box, Method Squabbles 5: Twentieth-Cen-
tury Titans, Keynes vs. Schumpeter.)

Method Squabbles 5: Twentieth-Century Titans, Keynes vs. Schumpeter

Joseph A. Schumpeter (1883–1950) and John Maynard Keynes (1883–1946) were born
only a few months apart. But each was schooled in a different tradition, and both may, for very
different reasons, be justly viewed as the most important and influential economists of the
twentieth century.
Keynes, as we have seen in this chapter, was a “Cambridge man” all the way—ensconced
within the great English neoclassical tradition identified with Alfred Marshall. Although he later
rejected the Marshallian mode of “equilibrium theorizing,” Keynes cannot be understood apart
from the Cambridge tradition. His great insight rested on the central abstraction of aggregate
demand. Keynes believed, unlike his Cambridge predecessors, that insufficient demand (i.e.,
aggregate spending) by consumers and investors would leave the economy in a kind of per-
verse equilibrium, stagnating permanently below full employment. In consequence, as dis-
cussed in this chapter, Keynes focused on means to increase demand through government
policies and interventions in the economy. How far Keynes would go to achieve these results is
uncertain, although today’s governments in the Western World have embraced deficit finance
as a way of life. We know that Keynes himself was distrustful of central planning, although he
most certainly underestimated the strength of bureaucratic and political incentives.*
Schumpeter was different on all counts. Steeped in the Austrian tradition of Carl Menger,
Frederick von Wieser, and Eugen Böhm-Bawerk, Schumpeter wrote a brilliant doctoral disser-
tation in 1911, The Theory of Economic Development (see chapter 23), which, later translated
into English, brought him worldwide attention as a leading economic theorist. After World
War I, Schumpeter served as Austria’s finance minister, and throughout the 1920s, he lectured
across Europe, with a protracted stay in England. In 1932 he emigrated to the United States to
escape Nazi persecution. He joined the faculty at Harvard University, where he remained until
his death in 1950.
Both theorists had their eyes on macroeconomics. Whereas Keynes might be said to have
played the role of economist-tinkerer in rescuing a stagnant economy, Schumpeter elevated
the entrepreneur’s role to the prime mover of economic development. Keynes viewed the
economy chiefly as an abstraction wherein individuals could be cleverly manipulated by gov-
ernment actions designed to produce full-employment equilibrium. Schumpeter, in contrast,
viewed the economy from “below”—from the perspective of individuals whose risk-taking
and profit-seeking behavior spurred innovations and new growth opportunities. Accordingly,
Schumpeter looked for ways to ensure free enterprise, not to manage it. In Austrian fashion he
understood the essence of capitalism as a process that held the keys to prosperity. Stationary
state equilibria did not interest him. Schumpeter said: “The problem that is usually being visu-
alized is how capitalism administers existing structures, whereas the relevant problem is how
it creates and destroys them.Ӡ
(continued)
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544 Part V ■ Twentieth-Century Paradigms

To Schumpeter, the tendency of an economy to fall below levels of full employment

resulted from shrinking opportunities to earn profits. As breakthroughs in technology or pro-
duction occur they inspire new investment and greater opportunities for profit, thus generat-
ing economic development. In such a dynamic economy, government intervention and
central control are impediments to the growth process. Far more mistrustful than Keynes of
the results of fiscal management, Schumpeter argued that tyranny would inevitably follow
government intervention. In his mind, the first victim of such tyranny would be the entrepre-
neurial spirit.
The opposing views of Keynes and Schumpeter have shaped virtually all twentieth-cen-
tury thinking, debate, and policy regarding the role of government in the economy. Moreover,
these debates continue. They rage on a daily basis in various guises in newspapers, on TV talk
shows, and in blogs. As such, the essential concerns of both Keynes and Schumpeter live on.
*He wrote the following in response to criticisms by economist Friedrich Hayek that an overplanned
economy represents tyranny: “Moderate planning will be safe enough if those carrying it out are rightly
oriented in their own minds and hearts to the moral issue [of tyranny]” (quoted in Robert Heilbroner, The
Worldly Philosophers, p. 244). This opinion is visionary but dubious in a world where Marshallian self-inter-
est applies to both politicians and bureaucrats. Empirically, we know that extreme forms of planning have
not worked in Eastern Europe and the (former) Soviet Union.
†See Joseph A. Schumpeter, Capitalism, Socialism, and Democracy, p. 81.

Eventually, all these ideas became part of a new economic orthodoxy. Even the
most academically untrained legislator in today’s advanced economies is at least
aware of Keynesian policy prescriptions, if not of their theoretical underpinnings.
Keynes’s ideas eventually permeated most institutions of higher learning in the
United States and elsewhere during the postwar period. They were commonplace in
the United States thanks to their relatively early introduction into one of the most
successful contemporary textbooks since Alfred Marshall’s Principles—Paul Samu-
elson’s Economics (1st ed., 1948).
Of course Keynesian economic analysis has been continuously tinkered with,
refined, remolded, criticized, and/or maligned. There is even an academic journal,
the Journal of Post-Keynesian Economics devoted to the mission of refining and
extended Keynesian ideas. Nevertheless, as we shall see in the next chapter, mone-
tarism reemerged, especially in the 1970s and early 1980s, as a substantive and sig-
nificant challenge to the Keynesian vision. Just as Marshall’s Principles was the
subject of heated discussion after its publication in 1890, so Keynes’s General The-
ory has undergone a similar fate.

■ PARADIGM SHIFT OR PARADIGM REALIGNMENT?

In a seminal work entitled The Structure of Scientific Revolutions, Thomas
Kuhn explained that the introduction of new paradigms of thought, such as the
Keynesian model, occurs when old paradigms are no longer capable of providing
good answers to the questions posed to them. But old paradigms are often firmly
entrenched, and their defenders frequently rise to protect them and show that a par-
adigm that is considered new may really be just a subset of an old one (thereby, of
course, renewing and rejuvenating it). It appears that, to a certain extent, Kuhn’s
theory of the nature of ideational progress fits the case of John Maynard Keynes.
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Chapter 21 ■ Keynes and the Development of Modern Macroeconomics 545

Recall that Keynes used A. C. Pigou’s Theory of Unemployment as his straw

man in attacking the classical model. But one of Pigou’s ideas, widely known as the
“Pigou effect” and later as the “real-balance effect,” continues to haunt Keynesian
theory. Keynes had argued that prices and wages were not flexible downward
because of the agglomeration of monopoly power on both the input and the output
sides of the market. But he argued further that price and wage declines would likely
not increase income and employment because declining wages would lead to
declining prices (since declining wage income means reduced demand for final out-
put), which would mean that the real wage would not be reduced appreciably. The
Keynes effect, discussed above, was a theoretical possibility, but its impact was lim-
ited by the inelasticity of the investment function and by the liquidity trap, discount-
ing all the practical difficulties with falling prices.
Pigou, however, had identified another effect of falling prices. When prices fall,
individuals’ real balances rise—that is, the real value of their money holdings (M/P)
increases—thereby creating a wealth effect that serves to stimulate consumption. In
short, consumption will increase with increases in real balances. A beach bum with
$1 to his name can become a millionaire (in real terms) if the price level falls low
enough. The theoretical conclusion is inescapable. With falling prices the Keynes
effect might be rendered impotent by the liquidity trap and an inelastic investment
function, but the Pigou effect would kick in. A falling price level, therefore, should
be capable of generating increased expenditures that would push the economy
toward full employment.
As a theoretical proposition, then, the Pigou effect saves neoclassical theory.
Don Patinkin reached this conclusion in his doctoral dissertation at the University
of Chicago in 1947. Patinkin published his elegant and systematic analysis in 1956
in an important book, Money, Interest and Prices. Utilizing a Walrasian general-
equilibrium model comprised of three markets (money, commodities, and bonds), a
Keynesian expenditure approach (in the commodity market), and an expanded
Pigou effect, Patinkin persuasively demonstrated the theoretical consistency of neo-
classical macroeconomics.
Patinkin’s analysis is at a high theoretical level that puts it beyond the reach of
nonspecialists, but his conclusions are clear—namely: (1) given the classical
assumptions of full employment and price flexibility, and the absence of money illu-
sion, the conclusions of the quantity theory of money are valid; (2) Keynes’s analy-
sis of the speculative motive for holding money was a genuine contribution but its
introduction (unless money illusion is introduced) does not upset the conclusions of
neoclassical macroeconomic theory; and (3) because of the stickiness of prices and
wages in an actual economic system, Keynesian policy prescriptions have merit.
Though Patinkin’s contribution was promptly dubbed “Much Ado about Pigou,” its
importance lies in its thoroughness and in its clear exposition of the assumptions by
which Keynes obtained his results. Patinkin demonstrated how the speculative
demand for money along with the expenditure approach to national income, as well
as other Keynesian ideas, could be worked under the umbrella of neoclassicism,
thereby exposing the alleged weakness of naive neoclassical economics.

■ CONCLUSION
The emergence of the Keynesian paradigm (in modern dress) as a preferred
model is problematic because so much depends on empirical estimates of the elas-
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546 Part V ■ Twentieth-Century Paradigms

ticities of the theoretical functions in question—estimates that are difficult and

sometimes impossible to obtain. Price declines of the type required by the Pigou
effect for full employment are not within our historical experience, and even if fea-
sible, they may present the same practical difficulties required for the Keynes effect.
Thus, the Keynesian model itself rests in limbo, but there are strong indications that
the rejuvenated neoclassical model is beginning to win the day theoretically. It is no
secret that in matters of policy, Keynesian ideas on compensatory finance became
the reigning economic orthodoxy in the twentieth century. Orthodox Keynesians
viewed the Employment Act of 1946 as a victory, but it was merely a beginning.
Keynesian ideas continue to permeate the highest policy echelons of government,
especially during Democratic administrations. Most presidential economic advisers
have been schooled in the tradition of Keynes. As a by-product, mountains of data
on unemployment, income, and expenditures have been built up for use by the pol-
icy makers.
Where, then, does Keynes belong in the history of economic thought? As noted
in the introduction, only a tentative assessment is possible at such close distance,
but several facts do stand out. At the very least, Keynes is, and probably will con-
tinue to be, an important figure in the history of economic thought. Apart from the
charismatic quality of Keynesian ideas, out of which a veritable modern legend has
developed, Keynes was an influential economist. Between the ridiculous excesses of
certain Keynesians and the apologetics of certain neoclassicists (who refuse to find
anything of value in Keynes), there is at least a minimum legacy. This legacy is one
of focus on macroeconomic theory and the policy issues it engenders inside and
outside the professional discipline of economics. In many ways, Keynes was a cata-
lyst. The tremendous resurgence of interest in monetarism (and in other macroeco-
nomic concepts) might not have been possible without the counterpoint of
Keynesian thought and policy. He did not live to see the massive influence of his
ideas, but politicians, economists, citizen-taxpayers, and historians of economic
thought have been subjected to his influence. In season and out, Keynes stirred the
waters of economic ideas.

REFERENCES
Davis, J. Ronnie. The New Economics and the Old Economists. Ames: The Iowa State
University Press, 1971.
Hansen, Alvin H. A Guide to Keynes. New York: McGraw-Hill, 1953.
Harrod, R. F. The Life of John Maynard Keynes. New York: Harcourt, Brace, 1951.
Heilbroner, Robert. The Worldly Philosophers, rev. ed. New York: Simon & Schuster, 1961.
Hicks, J. R. “Mr. Keynes and the ‘Classics’: A Suggested Interpretation,” Econometrica,
vol. 5 (April 1937), pp. 147–159.
Keynes, John Maynard. The General Theory of Employment, Interest and Money. Lon-
don: Macmillan, 1936.
Leijonhufvud, Axel. On Keynesian Economics and the Economics of Keynes. New York:
Oxford University Press, 1968.
Patinkin, Don. Money, Interest and Prices, 2d ed. New York: Harper & Row, 1965.
Pigou, A. C. The Theory of Unemployment. London: Macmillan 1933.
Robertson, Dennis. Essays in Money and Interest. London: Fontana Library, 1966.
Schumpeter, Joseph. Capitalism, Socialism, and Democracy, 3d ed. New York: Harper &
Row, 1950.
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Chapter 21 ■ Keynes and the Development of Modern Macroeconomics 547

NOTES FOR FURTHER READING

Although a large and detailed literature exists on Keynes and his ideas, only a small
sample can be mentioned here. We shall not attempt to capture all of the post-Keynesian
amendments and interpretations of the master’s work. Several biographies have been
written about Keynes. The standard biography, by someone who knew Keynes person-
ally, is R. F. Harrod, The Life of John Maynard Keynes (see references). Also see D. E.
Moggridge, Maynard Keynes: An Economist’s Biography (London: Routledge, 1992),
which traces Keynes’s career on all its many levels; and Vincent Barnett, John Maynard
Keynes (London: Routledge, 2012), who argues controversially that a main but often
neglected feature of The General Theory of Employment, Interest and Money was allow-
ing psychology a much greater role within economics and that Keynes’s policy writings
were more concerned with Britain’s national interest than is sometimes recognized. Bar-
nett also recounts the story of Keynes’s colorful private life as a member of the Blooms-
bury group of artists and intellectuals. Craufurd D. Goodwin, “The Bloomsbury Group as
Creative Community,” History of Political Economy, vol. 43 (Spring 2011), pp. 59–82,
adds background by recognizing the organization of the Bloomsbury group as akin to a
policy think tank. Goodwin describes the group’s approach to discussions of several
social problems, including the place of the arts in developed economies, how to improve
the situation of women and minorities, and how to solve environmental problems.
The record on what Keynes was really like still makes interesting and somewhat tit-
illating reading. See Michael Holroyd, Lytton Strachey: A Critical Biography, 2 vols.
(New York: Holt, 1968), which contains a considerable amount of information on
Keynes; E. S. Johnson and H. G. Johnson, The Shadow of Keynes: Understanding
Keynes, Cambridge, and Keynesian Economics (Chicago: University of Chicago Press,
1978); C. H. Hession, John Maynard Keynes: A Personal Biography of the Man Who Rev-
olutionized Capitalism and the Way We Live (New York: Macmillan, 1984); and R. J. A.
Skidelsky, John Maynard Keynes (New York: Viking, 1986).
Gardner Ackley, Macroeconomic Theory (New York: Macmillan, 1961), is a helpful
source on traditional Keynesian economics and post-Keynesian developments in cycle,
growth, investment, and inflation theory. For an abbreviated summary of aggregate anal-
ysis before the General Theory see James L. Cochrane, Macroeconomics before Keynes
(Glenview, IL: Scott Foresman, 1970), who utilizes a model of behavior appropriate to
physiocratic, classical, Marxian, and neoclassical macroeconomics, emphasizing antici-
pators of Keynesian ideas.
The British economist Richard Kahn anticipated Keynes’s multiplier analysis, and it
now seems clear that a number of Swedish authors, including Erik Lundberg and John
Akerman, were toying with ideas very similar to those of Keynes, especially in the field
of monetary theory. Otto Steiger, “Bertil Ohlin and the Origins of the Keynesian Revolu-
tion,” History of Political Economy, vol. 8 (Fall 1976), pp. 341–366, plays up the indepen-
dence of the Stockholm school’s writings, which proceeded, according to Steiger, within
a neo-Wicksellian framework (see ch. 22 on Wicksell). Michaël Assous, “Kalecki’s 1934
Model vs. the IS-LM Model of Hicks (1937) and Modigliani (1944),” The European Jour-
nal of the History of Economic Thought, vol. 14 (2007), pp. 97–118, argues that Kalecki’s
1934 work produced many of the conclusions of neoclassical theory, along with an expla-
nation of unemployment, before the General Theory and that Kalecki explained the dif-
ference between classical and Keynesian theories without reference to either liquidity
preference or the rigidity of wages.
The origins of a stock-in-trade of (what has been thought to be) Keynesian fiscal
theory—the balanced budget multiplier—is explored in two early papers by William A.
Salant and Jørgen Gelting, with commentaries by Walter S. Salant, Bent Hansen, and
Paul Samuelson: see “Origins of the Balanced-Budget Multiplier, I–IV,” History of Politi-
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548 Part V ■ Twentieth-Century Paradigms

cal Economy, vol. 7 (Spring 1975), pp. 3–55. J. Ronnie Davis, The New Economics and
the Old Economists (see references), argues that Keynes was “scooped” by Chicago
economists of the early thirties in regard to fiscal policy. See also B. L. Jones, “Lauchlin
Currie and the Causes of the 1937 Recession,” History of Political Economy, vol. 12 (Fall
1980), pp. 303–315. According to R. T. Nash and W. P. Gramm, “A Neglected Statement of
the Paradox of Thrift,” History of Political Economy, vol. 1 (Fall 1969), pp. 395–400, John
M. Robertson, an underconsumptionist and pre-Keynesian philosopher, stated the para-
dox of thrift as early as 1892.
Of special interest in appreciating Keynes’s differences with classical writers is John
R. Hicks (see references). In a similar vein, see B. T. McCallum, “On the Observational
Inequivalence of Classical and Keynesian Models,” Journal of Political Economy, vol. 87
(April 1979), pp. 395–402. For an ambitious attempt to explain the logic of Keynes’s
rejection of the classical model, see Michel Rosier, “The Logic of Keynes’ Criticism of the
Classical Model,” The European Journal of the History of Economic Thought, vol. 9 (Win-
ter 2002), pp. 608–643. Alessandro Roncaglia, “Keynes and Probability: An Assessment,”
The European Journal of the History of Economic Thought, vol. 16 (2009), pp. 489–510,
presents an overview of Keynes’s contributions to probability theory, particularly in light
of the classical and frequentist theories of probability and the criticisms they received.
Important post-Keynesian developments in the area of economic dynamics include
P. A. Samuelson, “Interactions between the Multiplier Analysis and the Principle of
Acceleration,” Review of Economics and Statistics, vol. 21 (May 1939), pp. 75–78; and J.
R. Hicks, A Contribution to the Theory of the Trade Cycle (London: Oxford, 1950). Also
see M. Fisher, “Professor Hicks and the Keynesians,” Economica, vol. 43 (August 1976),
pp. 305–414; and Paul Mizen and J. R. Presley, “Keynes, Hicks, and the Cambridge
School,” History of Political Economy, vol. 30 (Spring 1998), pp. 1–16. Keynes’s emphasis
on consumption as the major component of total spending initiated a number of alterna-
tive formulations of consumption. For example, see J. S. Duesenberry, Income, Saving,
and the Theory of Consumer Behavior (Cambridge, MA: Harvard University Press,
1949); and Milton Friedman, A Theory of the Consumption Function (Princeton, NJ:
Princeton University Press, 1957).
Detailed assessments of Keynesian economics abound. A provocative place to begin
is T. D. Togati, “Keynes as the Einstein of Economic Theory,” History of Political Economy,
vol. 33 (Spring 2001), pp. 117–138. Luigi Pasinetti and Bertram Schefold (eds.), The
Impact of Keynes on Economics in the Twentieth Century (Cheltenham, UK: Edward
Elgar, 1999), explore Keynes’s legacy to economics. On the genesis and subsequent evo-
lution of Keynes’s ideas, see D. E. Moggridge, “From the Treatise to the General Theory:
An Exercise in Chronology,” History of Political Economy, vol. 5 (Spring 1973), pp. 72–88;
D. Patinkin, “John Maynard Keynes: From the Tract to the General Theory,” Economic
Journal, vol. 85 (June 1975), pp. 249–271; Robert W. Dimand, The Origins of the Keynes-
ian Revolution: The Development of Keynes’s Theory of Employment and Output (Alder-
shot, UK: Edward Elgar, 1988), which also traces the development of Keynes’s monetary
theory as it progressed from the Tract through the Treatise to the General Theory. Other
treatments of a similar nature include Harry G. Johnson, “Keynes’ General Theory: A
Revolution or War of Independence?” Canadian Journal of Economics, vol. 9 (November
1976), pp. 580–594; Maria Cristina Marcuzzo, “The Collaboration Between J. M. Keynes
and R. F. Kahn From the Treatise to the General Theory,” History of Political Economy,
vol. 34 (Summer 2002), pp. 421–447, who concludes on the basis of correspondence that
relations between these two authors were strong, continuous, and fertile, with the student
(Kahn) playing the inverted role of correcting, testing, and refining the master’s ideas.
Numerous assessments of Keynesian economics appeared in the 1960s as Keynes’s
influence in the United States grew. Three are mentioned here: Harry G. Johnson, “The
General Theory after Twenty-Five Years,” American Economic Review, vol. 51 (May
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Chapter 21 ■ Keynes and the Development of Modern Macroeconomics 549

1961), pp. 1–17; Robert Lekachman (ed.), Keynes’ General Theory: Reports of Three
Decades (New York: St. Martin’s, 1964); and, in a much more critical vein, David
McCord Wright, The Keynesian System (New York: Fordham University Press, 1961). On
the relevance of Keynes for successive generations, see James Tobin, “How Dead Is
Keynes?” Economic Inquiry, vol. 15 (October 1977), pp. 459–468; and for a glimpse of
Keynes’s thought in his later years, see John B. Davis, “Keynes’s Later Philosophy,” His-
tory of Political Economy, vol. 27 (Summer 1995), pp. 237–260.
Some elaborations and/or clarifications of Keynes’s work include: Volker Caspari, “A
Marshallian Perspective of Keynes’s General Theory,” Metroeconomica, vol. 40 (June
1989), pp. 101–118; A. A. Asimakopulos, “The Nature and Role of Equilibrium in
Keynes’s General Theory,” Australian Economic Papers, vol. 28 (June 1989), pp. 16–28;
M. E. Brady, “The Mathematical Development of Keynes’s Aggregate Supply Function in
the General Theory,” History of Political Economy, vol. 22 (Spring 1990), pp. 167–172; Bill
Gerrard, “Beyond Rational Expectations: A Constructive Interpretation of Keynes’s
Analysis of Behaviour Under Uncertainty,” Economic Journal, vol. 104 (March 1994), pp.
327–337; S. A. Drakopolous, “Keynes’s Economic Thought and the Theory of Consumer
Behavior,” Scottish Journal of Political Economy, vol. 39 (August 1992), pp. 318–336; and
Kevin D. Hoover, “Relative Wages, Rationality, and Involuntary Unemployment in
Keynes’s Labor Market,” History of Political Economy, vol. 27 (Winter 1995), pp. 653–
685. Nicola Meccheri, “Wage Behaviour and Unemployment in Keynes’ and New
Keynesians’ Views: A Comparison,” The European Journal of the History of Economic
Thought, vol. 14 (2007), pp. 701–724, compares two strands of New Keynesianism in
light of Keynes’s own work, concluding that although all parties agree that involuntary
unemployment is a central problem, the New Keynesians’ views on real and nominal
wages and their effects on employment represent a significant departure from the idea
developed in the General Theory.
Don Patinkin, “A Study of Keynes’ Theory of Effective Demand,” Economic Inquiry,
vol. 17 (April 1979), pp. 155–176, touched off a mini-debate on the proper interpretation
of Keynes’s demand theory. B. Littleboy and G. Mehta, “Patinkin on Keynes’s Theory of
Effective Demand,” History of Political Economy, vol. 19 (Summer 1987), pp. 311–328,
contend that the theory of effective demand is more completely developed by Keynes in
his Treatise on Money than Patinkin gives him credit for. Patinkin’s rejoinder is con-
tained in History of Political Economy, vol. 19 (Winter 1987), pp. 647–658. On the same
issue, see also Claudio Sardoni, “Marx and Keynes on Effective Demand and Unemploy-
ment,” History of Political Economy, vol. 18 (Fall 1986), pp. 419–441; and R. X. Chase,
“Keynes’s Principle(s) of Effective Demand: Redefining His Revolution,” Journal of Eco-
nomic Issues, vol. 26 (September 1992), pp. 865–891. Although American post-Keynes-
ians claim to be the most literal interpreters of Keynes, Jochen Hartwig, “Keynes vs. the
Post Keynesians on the Principle of Effective Demand,” The European Journal of the His-
tory of Economic Thought, vol. 14 (2007), pp. 725–739, argues that significant differences
exist between post-Keynesian versions of the principle of effective demand and Keynes’s
formulation; he offers an alternative model more in line with Keynes’s own views.
Much of Keynesian macroeconomics deals with the theory of investment. The effect
of Keynes’s notion of uncertainty on calculations of expected yields on investments is
discussed by Mark Stohs, “Uncertainty in Keynes’ General Theory,” History of Political
Economy, vol. 12 (Fall 1980), pp. 372–382, who claims that Keynes rejected the idea of
numerical measures of prospective yields but believed some kind of nonnumerical calcu-
lation is possible. This interpretation has been questioned by C. A. Garner, “Uncertainty
in Keynes’ General Theory: A Comment,” History of Political Economy, vol. 15 (Spring
1983), pp. 83–86, followed by Stohs’s rejoinder, in which he argues for a modified Carte-
sian approach to economics. S. F. LeRoy, “Keynes’ Theory of Investment,” History of
Political Economy, vol. 15 (Fall 1983), pp. 397–421, tries to elucidate what Keynes “really
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550 Part V ■ Twentieth-Century Paradigms

meant” by his theory of investment. Among other things, LeRoy claims that Keynes had
in mind a temporary, general-equilibrium, two-sector model with nonshiftable capital,
and that this is at variance with practically all previous interpretations of Keynes’s invest-
ment theory. The curious diffusion of the idea of the investment multiplier is recounted
by Daniele Besomi, “On the Spread of an Idea: The Strange Case of Mr. Harrod and the
Multiplier,” History of Political Economy, vol. 32 (Summer 2000), pp. 347–379.
After Hayek (see chap. 23) joined the faculty at the London School of Economics
(LSE), he became the chief intellectual rival of Keynes and his Cambridge coterie. On
Keynes’s personal and professional relations with LSE in 1920–1946, see Susan Howson,
“Keynes and the LSE Economists,” Journal of the History of Economic Thought, vol. 31
(September 2009), pp. 257–280, which deals mostly with the LSE economists’ reactions
to Keynes, as opposed to Keynes’s opinions of them. Howson claims that Hayek briefly
“inoculated” the LSE against Keynes’s ideas. Nicolò De Vecchi, “Hayek and the General
Theory,” The European Journal of the History of Economic Thought, vol. 13 (2006), pp.
233–258, surveys Hayek’s criticisms of Keynes, especially the relations between con-
sumption and investment, the ideas surrounding liquidity preference, and Keynes’s the-
ory of interest. De Vecchi finds that Hayek’s arguments were already answered implicitly
in the General Theory. For a comparison of how Keynes and Hayek viewed aggregate
price adjustments, see George Selgin, “Hayek versus Keynes on How the Price Level
Ought to Behave,” History of Political Economy, vol. 31 (Winter 1999), pp. 699–721.
Another issue is the entrepreneur’s motivation in initiating new investments. Don
Patinkin, “New Materials on the Development of Keynes’ Monetary Thought,” History of
Political Economy, vol. 12 (Spring 1980), pp. 1–28, argued that Keynes’s entrepreneur
based his decision to expand output on the fact that aggregate receipts exceed aggregate
variable costs; but Harold Dickson, “How Did Keynes Conceive of Entrepreneur’s Moti-
vation? Note on Patinkin’s Hypothesis,” History of Political Economy, vol. 15 (Summer
1983), pp. 229–248, claimed that said decisions are based, instead, on whether or not the
expansion of output is expected to increase profits.
Monetary issues in Keynes’s work come to the fore in Jörg Bilbow, Keynes on Mone-
tary Policy, Finance and Uncertainty: Liquidity Preference Theory and the Global Financial
Crisis (New York: Routledge, 2009), which illustrates how Keynes’s methodology inspired
his economic theorizing and how this led to fundamental insights concerning the role of
money that contrasted with orthodox closed-system modeling. For a review of Bilbow’s
book see Ingo Barens, “Keynes on Monetary Policy, Finance and Uncertainty,” The Euro-
pean Journal of the History of Economic Thought, vol. 19 (2012), pp. 488–490. On a related
monetary issue, P. G. McGregor, “Keynes on Ex Ante Saving and the Rate of Interest,” His-
tory of Political Economy, vol. 20 (Spring 1988), pp. 107–118, defends Keynes’s post–Gen-
eral Theory view of interest rates against charges of confusion and inconsistency.
Although Keynes was not very sympathetic to Marx, several writers have empha-
sized affinities between the two. See Peter Kenway, “Marx, Keynes and the Possibility of
Crises,” Cambridge Journal of Economics, vol. 4 (March 1980), pp. 23–36; and Dudley
Dillard, “Keynes and Marx: A Centennial Appraisal,” Journal of Post-Keynesian Econom-
ics, vol. 6 (Spring 1984), pp. 421–432. Michael Hudson, “German Economists and the
Depression of 1929–1933,” History of Political Economy, vol. 17 (Spring 1985), pp. 35–50,
shows how German economists, particularly Wilhelm Lautebach (the “German
Keynes”), employed Keynesian public policy during the Depression. The Keynesian
model depicted in figure 21-3 of this chapter has become the staple of beginning text-
books, and yet it is considered by some to be analytically weak and unsophisticated. D.
R. Fusfeld, “Keynes and the Keynesian Cross: A Note,” History of Political Economy, vol.
17 (Fall 1985), pp. 385–390, defends the Keynesian cross diagram against its supposed
shortcomings and claims that Keynes himself explicated the strengths of the model,
although he never documented them in his writings.
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Chapter 21 ■ Keynes and the Development of Modern Macroeconomics 551

Disputes on the real nature of Keynes’s system continue among post-Keynesians as

well as among historians of economic thought. On the spread of the Keynesian system
and particularly the role of John R. Hicks in popularizing the Keynesian model, see Far-
had Mahloudji, “Hicks and the Keynesian Revolution,” History of Political Economy, vol.
17 (Summer 1985), pp. 287–308. Leijonhufvud’s interpretation of the Keynesian system
(see references) remains the most provocative, but the entire Journal of Post-Keynesian
Economics is devoted to grappling with interpretative issues of this sort. Those who
would allow Keynes to speak for himself should consult his own summary of the General
Theory, namely Keynes, “The General Theory of Employment,” Quarterly Journal of Eco-
nomics, vol. 51 (September 1937), pp. 209–223.
Keynes was a brilliant biographer and historian of thought as well as a first-rate the-
orist. See his Essays in Biography, rev. ed. (New York: Norton Library, 1951); and Donald
A. Walker, “Keynes as a Historian of Economic Thought: The Biographical Essays on
Neoclassical Economists,” History of Political Economy, vol. 17 (Summer 1985), pp. 159–
186. For those more interested in Keynes’s philosophy than his economics, see J. B.
Davis, Keynes’s Philosophical Development (Cambridge: Cambridge University Press,
1994), which traces the changes in Keynes’s philosophy after he began to concentrate his
energies on economics; and B. W. Bateman and J. B. Davis (eds.), Keynes and Philoso-
phy: Essays on the Origin of Keynes’s Thought (Brookfield, VT: Edward Elgar, 1991). R.
E. Backhouse and B. W. Bateman, “Keynes and Capitalism.” History of Political Economy
Winter, vol. 41 (Fall 2009), pp. 645–671, analyze what Keynes meant by capitalism, espe-
cially in regard to its definition, fragility, and morality, and how his views relate to the
Bloomsbury group.
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22

Contemporary Macroeconomics
Monetarism and Rational Expectations

Despite a few notable exceptions discussed in chapter 6, money in the aggregate

sense was often seen by classical economists as an impediment to proper economic
reasoning. There were important debates about money, such as the bullionist and
currency school arguments, but in such controversies the chief concern was about
the institutions affecting the supply of money. The classical economists wanted to cut
through pure monetary phenomena in order to link the determinants of the wealth of
a nation to real factors involving thrift and productivity. To them, the stock of money
determined the general price level, but as an aggregate variable, it was incapable of
explaining real wealth or relative prices. Moreover, most industrial nations sup-
ported gold or specie standards that were viewed as “self-regulating.” Inflations
could and did occur, but they were attributed to wars and other disasters (during
which the gold standard was usually suspended) or to the money-printing tendencies
of improvident governments or politicians. In classical theory, then, a dichotomy
existed between value theory on the one hand and monetary theory on the other. The
former was determined by real forces; the latter by monetary considerations.
This dominant view began to change in the twentieth century as neoclassical
writers—particularly Irving Fisher, Knut Wicksell, and A. C. Pigou—attempted to
put aggregate monetary theory on a par with value theory. The transmission mecha-
nism from money to prices, the determinants of the velocity of circulation and of the
demand for money, and the general role of interest rates in the process of monetary
expansions and contractions were all matters of concern to these writers. All the
elements of a rather sophisticated version of the quantity theory were on hand well
before Keynes penned the General Theory. But Keynes spurned the existing body of
monetary theory in his attempt to revolutionize macroeconomics. Money mattered
very little or not at all in his revised neoclassical view.
The lack of faith in monetary policy as a central stabilizing device in the macro-
economy persisted through the 1960s. But the Keynesian message introduced a per-
nicious bias into policy making spawned in a political arena. Keynesian suggestions
about deficit spending were easily followed during periods of recession, whereas
the ideas of budget surpluses or balanced budgets (suggested by Keynes during
periods of inflation) proved politically unpopular and extremely rare. The very
Keynesian principles that made the economy deflation- or depression-proof, in
other words, may have made it inflation-prone. Events of the 1960s, especially the
(largely) deficit-financed Vietnam War, led to large increases in the money stock,

552
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Chapter 22 ■ Contemporary Macroeconomics 553

which was accompanied by serious and persistent problems with inflation. Predict-
ably, these events led to a confrontation with Keynesian economics and to a real and
practical resurgence of interest in “monetarism,” which is based on a refinement of
the classical quantity theory. (In theoretical terms, the quantity theory was never
absent from the economic intellectual scene.) The purpose of this chapter is to
chronicle twentieth-century developments that became incorporated into contem-
porary macroeconomics.

■ MONETARY THEORY GOES NEOCLASSICAL

Despite a noticeable lack of unanimity in early formulations of the quantity the-
ory, each representation established a more or less direct relation between money
and prices. With a few notable exceptions, such as John Locke and Henry Thornton,
no classical writer assigned an explicit role to the interest rate as an important
determinant of economic activity. On the other hand, the quantity theory was not
purely mechanical, since increases in the quantity of money were seen by Cantillon,
Thornton, Ricardo, and Mill as affecting the demand for commodities and, through
greater demand, as raising prices. Whereas classical writers often discussed the
forces that would preserve (or destroy) a new equilibrium, they did not explore the
adjustment process in the transition from one equilibrium to the next, nor did they
analyze the stability conditions of new equilibriums following monetary distur-
bances. A large part of this void was initially filled by neoclassical writers Irving
Fisher and Knut Wicksell.

Irving Fisher and the Equation of Exchange

In 1911, Yale University professor Irving Fisher (1867–1947) followed a lead
from John Stuart Mill and derived a mathematical framework for expounding the
workings of the quantity theory. Fisher wrote: MV + MV= PT, where M is the stock
of currency in circulation; V is currency’s annual velocity of circulation, or the rate at
which currency changes hands; M is the volume of demand deposits held by banks;
V is annual demand-deposit velocity of circulation; P is the aggregate price level;
and T is an index of the physical volume of transactions. Since our modern defini-
tion of money includes bank demand deposits, the above equation can be rewritten
more simply as MV = PT, hereafter referred to as Fisher’s Equation of Exchange.
Fisher’s mathematical expression finds its verbal antecedent in Mill, who wrote:
If we assume the quantity of goods on sale, and the number of times those goods
are resold, to be fixed quantities, the value of money will depend upon its quantity;
together with the average number of times that each piece changes hands in the
process. . . . Consequently, the amount of goods and transactions being the same,
the value of money is inversely as its quantity multiplied by what is called the
rapidity of circulation [velocity]. And the quantity of money in circulation is equal
to the money value of all the goods sold, divided by the number which expresses
the rapidity of circulation. (Principles, p. 494)

Fisher realized that his equation of exchange was an accounting identity, there-
fore a truism. But that does not render it useless from the standpoint of economic
theory. In fact, Fisher used it to assert once again the proportionality between
increases in M and increases in P. With certain assumptions the equation of
exchange subsequently became a mathematical expression of the quantity theory.
Fisher’s assumptions were that velocity (V) and the volume of trade (T) were inde-
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554 Part V ■ Twentieth-Century Paradigms

pendent of the money supply and that the price level was a passive rather than an
active variable. Hence he affirmed the strict proportionality between M and P as a
long-run proposition. His specification of the determinants of V and T was incredi-
bly complete. In essence, V and T were assumed determined by real factors (habit
and custom, technology and institutional arrangements), so that changes in the
stock of money did not cause changes in any of the real determinants of V and T.
A Missing Link: The Real-Balance Effect. More important than his mathe-
matical rendition of the strict quantity theory was Fisher’s identification of the con-
nection between an increase in the quantity of money and the ensuing increase in
prices. The missing link that ensures the stability of monetary equilibrium is the
real-balance effect. It can be explained this way. An increase in individual money
holdings disturbs the optimum relation between an individual’s cash balances and
his or her expenditures. In Walrasian terms, more money at the existing price level
creates an excess supply of money balances in individual hands. Thus, individuals
seek to reduce their excess money balances by increasing expenditures. Further-
more, if output remains unchanged (as Fisher assumed), the increased money
demand will push prices up until they have risen in the same proportion as the
increase in money. In this way a new equilibrium is reached and maintained
because individual money balances are returned to their optimal level.
This idea was absent from earlier formulations of the quantity theory, although
having discovered it, Fisher did not exploit the real-balance effect fully. He never
showed, for example, how excess money balances could be used to purchase securi-
ties, thereby pushing security prices up and the interest rate down. In other words,
Fisher never demonstrated how an increase in money could cause increased output
indirectly through lower interest rates (we shall see, momentarily that Wicksell
stepped into this breach). Instead, Fisher turned to the interrelation between infla-
tion, interest rates, expectations, and the holdings of real-cash balances.
Inflation and the “Fisher Effect.” In seminal works such as The Purchasing
Power of Money (1911) and The Theory of Interest (1930), Fisher explored the rami-
fications of actual and expected inflation and its interactions with nominal interest
rates and the demand for real balances. First consider the demand for real-money
balances, which may be expressed as follows:
md = f(y, i)
where md, the demand for real balances, is a function of y, real income, and i, the
nominal rate of interest. Money demand is the reciprocal of velocity. Although
Fisher did not elaborate this functional form of money demand as completely as A.
C. Pigou and Milton Friedman, two writers considered later in this chapter, he did
discover the important process through which the nominal interest rate, which is
the opportunity cost of holding money, is determined.
In a flash of practical wisdom Fisher saw that the nominal interest rate was the
product of two factors: (1) the real rate of interest, which reflects the basic underly-
ing forces of borrowing and lending in the economy, or what the classics called
thrift and productivity, and (2) the expected inflation rate at some point of time. In
some sort of “global equilibrium”—i.e., with constant rates of inflation—the actual
rate equals the expected rate. In general, simplified terms, Fisher’s concept may be
expressed as follows:
i = r + P*
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Chapter 22 ■ Contemporary Macroeconomics 555

where i is the nominal rate of interest, r is the real rate of interest, and P* is the
expected rate of inflation. Naturally, when the expected rate equals the actual rate
of inflation, the nominal interest rate is equal to the real rate.
The logic of Fisher’s equation is quite clear. Lenders insist on a nominal rate of
interest that is equal to the real rate plus whatever inflation is expected to be over
the course of the lending period. If the expected rate of inflation is 5 percent per year
and the real rate of interest is 4 percent, lenders would generally be unwilling to lend
funds at less than 9 percent. If, ex post, the rate of inflation turns out to be 10 per-
cent, the borrower has obtained funds at a negative real rate of interest; and lenders
will adjust their expectations about inflation in succeeding periods. Thus, inflation-
ary expectations affect nominal interest rates. The implications of the “Fisher effect”
will be considered in more detail below, but it is important to note that Fisher discov-
ered a mechanism that could make inflation self-perpetuating. Higher rates of mone-
tary expansion may thus lead, initially, to lower nominal interest rates (through an
increase in the supply of loanable funds), but eventually higher prices lead, through
inflationary expectations, to increases in the nominal rate, and to higher inflation.
This principle has become a stock-in-trade of modern monetarists.

Knut Wicksell and Modern Monetary Theory

While some neoclassical macroeconomists remained true to the Marshallian
tradition, others attempted to put monetary theory into a Walrasian framework. The
most successful at this last task was a Swedish economist, Knut Wicksell (1851–
1926). Wicksell opposed the kind of quasi-mechanistic formulations that Fisher
advanced. He added two elements to the quantity theory that brought it into the
realm of modern monetary economics. First, he took a hint from Thomas Tooke
(1779–1858), an early critic of the quantity theory, and asserted money works
through income to determine the aggregate price level. Second, borrowing from
Henry Thornton (chapter 6), Wicksell used Thornton’s two-rate analysis to under-
score the role of the interest rate in monetary theory.1 Wicksell’s restatement of the
quantity theory was an important step toward integrating monetary theory with
value theory. He constructed an aggregate demand/aggregate supply framework for
investigating changes in prices, describing matters as follows:
Every rise or fall in the price of a particular commodity presupposes a disturbance
of the equilibrium between the supply of and demand for that commodity, whether
the disturbance has actually taken place or is merely prospective. What is true in
this respect of each commodity separately must doubtless be true of all commodi-
ties collectively. A general rise in prices is therefore only conceivable on the suppo-
sition that the general demand has for some reason become, or is expected to
become, greater than the supply. . . . Any theory of money worthy of the name
must be able to show how and why the monetary or pecuniary demand for goods
exceeds or falls short of the supply of goods in given conditions. (Lectures, vol 2,
pp. 159–160)

What is especially noteworthy in this passage is the way in which Wicksell

made the transition from the partial-equilibrium approach of Marshall (i.e., supply
equals demand for a single product) to the aggregate supply/aggregate demand

1
Carl Uhr, a leading student of Wicksell, has concluded that Wicksell was probably never exposed
to Thornton’s writings directly but that he had studied the currency debate between Tooke and
Ricardo at length and was most likely exposed to Thornton’s ideas through Ricardo (Economic
Doctrines, p. 200).
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556 Part V ■ Twentieth-Century Paradigms

framework later employed by Keynes. Moreover, Wicksell responded to the chal-

lenge that he set down in the last sentence of the above passage: He showed how
monetary demand exceeds or falls short of aggregate supply through the effects of
changes in money on cash balances.
Real Balances. In the following passage Wicksell describes vividly the mone-
tary adjustment mechanism known as the real-balance effect. While reading this
passage keep in mind that he was talking about the consequences of a decrease in
the stock of money:
Let us suppose that for some reason or other . . . the stock of money is diminished
while prices remain temporarily unchanged. The cash balances will gradually
appear to be too small in relation to the new level of prices. . . . (It is true that in this
case I can rely on a higher level of receipts in the future. But meanwhile I run the
risk of being unable to meet my obligations punctually, and at best I may easily be
forced by shortage of ready money to forego some purchases that would otherwise
have been profitable.) I therefore seek to enlarge my balance. This can only be
done—neglecting for the present the possibility of borrowing, etc.—through a
reduction in my demand for goods and services, or through an increase in the sup-
ply of my own commodity . . . or through both together. The same is true for all
other owners and consumers of commodities. But in fact nobody will succeed in
realizing the object at which each is aiming—to increase his cash balance; for the
sum of individual cash balances is limited by the amount of the available stock of
money, or rather is identical with it. On the other hand, the universal reduction in
demand and increase in supply of commodities will necessarily bring about a con-
tinuous fall in all prices. This can only cease when prices have fallen to the level at
which the cash balances are regarded as adequate. (Interest and Prices, pp. 39–40)

By establishing the real-balance effect as the equilibrating mechanism that ensures

stability in the wake of monetary disturbances, Wicksell filled in what Don Patinkin
called the “missing chapter” in neoclassical monetary theory (see Patinkin, Money,
Interest and Prices). By emphasizing the relation between savings and investment
in his aggregate demand /aggregate supply analysis, Wicksell also rescued the inter-
est rate (as a monetary variable) from the near-oblivion into which it had sunk after
Thornton. Wicksell did not accept the interest rate as a purely monetary phenome-
non, but he used the two-rate thesis to synthesize nonmonetary theories of the rate
of interest, making the divergence between the natural rate and the actual rate the
main element of his dynamic analysis.
Wicksell’s Cumulative Process. Neoclassical monetary theorists have been
criticized for complacently accepting the comparative-static, mechanical conclusion
of the Hume-Mill-Fisher quantity theory (i.e., 2M = 2P). Although a number of neo-
classical monetary theorists grasped the significance of the real-balance effect,
“they frequently failed,” in Patinkin’s words, “to provide a systematic dynamic anal-
ysis of the way in which the monetary increase generated real-balance effects in the
commodity markets, which propelled the economy from its original equilibrium
position to its new one” (Money, p. 167). Wicksell was the exception. His dynamic
analysis, which focused on the interest rate as the point of departure, constitutes
what he called the “cumulative process.”
Wicksell’s dynamic process involves shifts between the normal and actual rates
of interest based on short-run discrepancies between aggregate supply and
demand. This makes the interrelation between money and product markets explicit.
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Chapter 22 ■ Contemporary Macroeconomics 557

If the banks lend their money at materially lower rates than the normal rate as
above defined [e.g., in Thornton—see figure 6-1], then in the first place saving will
be discouraged and for that reason there will be an increased demand for goods
and services for present consumption. In the second place, the profit opportunities
of entrepreneurs will thus be increased and the demand for goods and services, as
well as for raw materials already in the market for future production, will evidently
increase to the same extent as it had previously been held in check by the higher
rate of interest. Owing to the increased income thus accruing to the workers, land-
owners, and the owners of raw materials, etc., the prices of consumption goods
will begin to rise. . . . What is still more important is that the rise in prices, whether
small or great at first, can never cease so long as the cause which gave rise to it
continues to operate; in other words, so long as the loan rate remains below the
normal rate. (Lectures, vol. 2, pp. 195–196)

By pointing out that the effects of the cumulative process may be irreversible,
Wicksell hinted at the role played by expectations in macroeconomic analysis. He
maintained that entrepreneurs who had been able to pay higher wages and raw
material prices when the loan rate was below the natural rate will, “even if [the]
bank rate reverts to the normal natural rate, on an average be able to offer the same
high price, because they have reason to expect the same increased prices for their
own products in the future” (Lectures, vol. 2, p. 196). Thus, if banks maintain artifi-
cially low interest rates, they merely tempt entrepreneurs to bid up the prices of
labor and raw materials, and thus the prices of final goods.
Despite his innovations, Wicksell’s monetary analysis ran in the same grooves
as those laid down by the classical economists. He set out, in fact, to defend the
quantity theory against its critics, and he did so effectively for the long-run variant
of that theory. He succeeded far better than his predecessors in elaborating a pro-
cess of adjustment by means of the real-balance effect and in assigning prominent
roles to the interest rate and aggregate demand in explaining macroeconomic
adjustments to changes in money—an issue of major concern to Keynes.

The Cambridge Equation

We learned in chapter 16 that Marshall founded a Cambridge tradition in par-
tial-equilibrium analysis near the end of the nineteenth century. This tradition
extended to monetary theory, but Marshall’s incessant delays in publishing his ideas
robbed his monetary theory of its novelty by the time it was published. Neverthe-
less, Marshall spread his ideas concerning the integration of monetary theory and
value theory through an oral tradition at Cambridge University. Pigou wrote in his
biography of Marshall: “He always taught that the value of money is a function of its
supply on the one hand and the demand for it, on the other, as measured by ‘the
average stock of command over commodities which each person cares to keep in
ready form’” (Memorials, p. 29). Ironically, Marshall’s heirs apparent at Cambridge
never succeeded as fully as Wicksell in integrating monetary and value theories. But
Marshall’s supply-and-demand framework is embodied in the famous Cambridge
Equation, which enabled a shift in focus to the demand for money as well as its sup-
ply. In this respect Marshall’s monetary economics is the spiritual father of the
Keynesian theory of liquidity preference (see chapter 21) as well as the modern for-
mulation of the demand for money as a part of a general theory of asset choice.
Marshall taught that the demand for money (i.e., the desired quantity of cash
balances) could be expressed at any time as a fraction of income, which led to the
familiar equation, M = KPT. In this formulation M is the stock of money, which Mar-
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558 Part V ■ Twentieth-Century Paradigms

shall assumed to be an exogenous variable. The right-hand side of the equation is

an expression of the quantity of money supplied: K is the fraction of income that the
community seeks to hold in the form of cash balances and demand deposits; P is
the general price level; and T is total output. Analytically, K in the cash-balance
equation is the reciprocal of V in Fisher’s equation of exchange. Thus, both Fisher
and Marshall accepted the quantity theory as a fundamental truth, and both con-
centrated on the medium-of-exchange function of money while neglecting the inter-
est rate.
Neglect of the interest rate led to some serious shortcomings in neoclassical
monetary analysis, chief of which was the failure to recognize interdependence
between the product and money markets. Wicksell avoided this pitfall, as we have
seen, but the too exclusive emphasis by Marshall and his Cambridge circle2 on the
demand for money may have impeded their systematic analysis of the way in which
changes in real balances are transmitted into the commodity market. This is curious
because the cash-balance effect is inherent in the Cambridge Equation. The equa-
tion can be rearranged, in other words, to express an excess supply of money (Es =
M – KPT) or an excess demand for money (Ed = KPT – M), either one of which is
capable of generating a real-balance effect.
Patinkin found it curious that the Cambridge group did not apply the test of sta-
bility conditions to the monetary sector of the economy, since they never failed to do
so in examining the product markets. This discrepancy is especially obtrusive in the
case of Walras, as Patinkin noted in his critique of neoclassical monetary theory:
Walras was a man who never tired of establishing the stability of his system by
elaborating on the corrective forces of excess supply that would be called into play
should the price lie above its equilibrium value, and the forces of excess demand
that would be called into play should it lie below. He did it when he explained how
the market determines the equilibrium prices of commodities; he did it again when
he explained how the market determines the equilibrium prices of productive ser-
vices; and he did it a third time when he explained how the market determines the
equilibrium prices of capital goods. But he did not do it when he attempted to
explain how the market determines the equilibrium “price” of paper money. And
Walras is the rule, not the exception. (Money, p. 168)

Inexplicable oversights of this nature tended to preserve the chasm between mone-
tary theory and value theory well into the twentieth century. However, some prede-
cessors of Keynes made headway by explaining the dynamic relation between
money, income, and the business cycle.

■ MODERN MONETARISM: THEORY AND POLICY

With the preceding as background, we now return to the main theme of this
chapter and attempt to demonstrate how some of the basic elements of the modern
monetarist position are straightforward extensions of earlier works on the quantity
theory. As pointed out previously, the popularity of monetarism as a policy prescrip-
tion was preceded by continuous and persistent contributions (even during the hey-
day of Keynesianism) to the development of the quantity theory. No writer, perhaps,
has defended the monetarist position in more forceful and elegant terms than Nobel
laureate Milton Friedman, whose ideas have shaped a generation of “monetarists.”

2
Along with Marshall, this group included A. C. Pigou and D. H. Robertson.
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Chapter 22 ■ Contemporary Macroeconomics 559

Friedman’s Theory of the Demand for Money

In 1956 (during the growing dominance of Keynes’s ideas within the academic
community) Chicago economist Milton Friedman published a set of innovative
essays elaborating and modifying the quantity theory of money (Studies in the
Quantity Theory of Money). In his essay entitled “The Quantity Theory of Money: A
Restatement” (contained in Studies) Friedman set out a new version of the demand
for money and gave it the following expression:
md =  (Yp, w, i, P*, P, u)
where the demand for money is presented as a function () of permanent income
(Yp ), the proportion of human to nonhuman wealth (w), the nominal interest rate (i),
expected changes in the rate of change in the price level (P*), the actual price level
(P), and the preference function for money vis-à-vis other goods (u). Friedman
offered this specification as a theory of money demand, and set it up in testable form.
An elaboration of all of the independent variables in Friedman’s equation would
take us too far afield here. (The interested reader is invited to read the original
essay.) But several points about the equation are of principal importance. Unlike the
older version of the quantity theory, Friedman’s restatement is essentially a theory of
demand for money, not a theory of prices. In this respect, his approach to monetary
theory is similar to Keynes’s. There is an important difference, however. Friedman’s
restatement of the quantity theory rests on a basic premise from capital theory: that
“income” is the yield on capital. This means that the concept of income Friedman
uses in his construction of the quantity theory is different from that used by Keynes
in his income-expenditure model. Friedman called his income measure “permanent
income,” which is to say that he treats income as a discounted, present-value stream
of payments derived from an existing stock of wealth, including human capital.
Human capital consists of “qualitative” improvements such as education and train-
ing. Keynes neglected wealth almost entirely, which was more appropriate to the
type of short-run analysis he was interested in than to the long-run analysis Fried-
man favored.3 In the long run, permanent income is a more appropriate variable.
Friedman does not argue that the demand for cash balances (or its reciprocal,
velocity) is constant, as earlier naive formulations of the quantity theory implied. But
he does argue that money demand is a stable and predictable function of the indepen-
dent variables, citing empirical support. Hence, he argues that money is still the cru-
cial variable in predicting prices (as well as short-term fluctuations in output and
employment, as we shall see). In other words, according to Friedman, if velocity is pre-
dictable, changes in the rate of monetary expansion will explain changes in the rate of
inflation (or deflation) as well as short-term alterations in output and employment.4
On closer examination, it is obvious that Friedman’s money-demand equation is
an elaboration of the money-demand function we examined earlier in this chapter.
It can be simplified to include only income (current, not permanent) and nominal

3 Keynes’s matter-of-fact justification for short-run analysis was that “in the long run, we are all
dead.” A favorite retort by modern monetarists is that the reason we are dead in the long run is
because Keynesian policies of inflation and excessive government have killed us.
4
Although Friedman’s statistical evidence has sparked much controversy, his role as a leading
monetary theorist is undisputable. On this point, at least, other leading monetary theorists agree.
Harry Johnson has written that “Friedman’s application to monetary theory of the basic princi-
ple . . . that income is the yield on capital, and capital the present value of income—is probably the
most important development in monetary theory since Keynes’ General Theory” (“Monetary The-
ory and Policy,” p. 350).
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560 Part V ■ Twentieth-Century Paradigms

interest rates (y and i). While this simplification does not do justice to Friedman’s
elegant conception, it will make our elementary explanation of “monetarism” easier.
For example, a very lucid explanation of inflation emerges from the combination of
the Fisher effect and Friedman’s conception of money demand.

A Simplified Monetarist Explanation of Inflation

Recall that Fisher said the nominal interest rate is equal to the sum of the real
interest rate and the expected inflation rate. This immediately raises questions
about how expectations are formed. One popular theory about expectations is the
so-called adaptive expectations theory, which states that price expectations are
formed on the basis of past experience with inflation, with more recent past price
experience weighing more heavily than that of the distant past. Expectations are
dominated by uncertainty about future prices. Laborers, for example, contract for
future wages and businesses set future prices on the basis of some (uncertain)
expectations about future prices. The adaptive expectations theory says that these
expectations will be formed principally by the most recent past experience.
We know that the nominal interest rate is partly a function of price expectations
and that the demand for cash balances is in turn a function of the nominal interest
rate. Higher nominal rates mean higher opportunity costs for holding money, which
means a reduced demand for cash balances (and vice versa). A simplified explana-
tion for inflation may thus be given utilizing the concepts of adaptive expectations,
the Fisher effect, and Friedman’s (modified) money-demand function. Assume (1)
that there is a constant rate of money expansion by the central bank; (2) that
expected inflation rates and actual inflation rates are equal (and equivalent to the
rate of monetary expansion); (3) that the nominal interest rate is equal to the real
rate plus the rate of inflation (or monetary expansion), which is constant; (4) that
actual and desired holdings of cash balances are equal; and (5) that real income is
growing at a constant rate. Given these conditions, assume a once-and-for-all
increase in the rate of monetary expansion.
The initial results of the increase in monetary expansion are to increase actual
cash balances of individuals and firms above their desired levels. This initially
depresses the nominal rate of interest via the “Wicksell effect” (i.e., an increase in
loanable funds temporarily lowers the real rate of interest). The excess of cash bal-
ances leads to increased spending on commodities, securities, and all other assets.
Actual prices (and nominal wages) begin to rise due to the increased nominal
spending. After a time, expectations “adapt” to the price increases, causing the
nominal interest rate, which fell initially, to rise. The process does not end until: (1)
the new rate of inflation is equal to the new and higher rate of monetary expansion;
(2) the nominal interest rate has increased by an amount equal to the difference
between the old and the new inflation rate; (3) actual cash balances are again equal
to desired cash balances; and (4) the real rate of interest is restored to its former
level. Notice that the level of cash balances held will be lower than before because a
higher nominal interest rate means a higher (opportunity) cost of holding money.
There are some obvious implications of this process for economic policy. How
often have we heard that “tight money and high interest rates are the causes of infla-
tion”? Some businesspeople and politicians adhere to this naive view. The monetar-
ist version of events tells us that exactly the opposite is the case. While monetary
expansion initially lowers the nominal interest rate, inflation and the Fisher effect
take over and eventually cause nominal interest rates to rise. The only way that
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Chapter 22 ■ Contemporary Macroeconomics 561

interest rates could be depressed over long periods is to enact higher and higher
rates of monetary expansion, a very dangerous policy in the view of monetarists.
Friedman is famously quoted as saying, “Inflation is always and everywhere a
monetary phenomenon,” and he has convincingly demonstrated this proposition for
the United States in a massive empirical study he and Anna Schwartz published, A
Monetary History of the United States, 1867–1960. As in the earlier and more naive
versions of the quantity theory, inflation can be explained by increased velocity
(reduced money-demand growth), reduced income growth, or an increased rate of
monetary expansion. In the contemporary monetarist’s view, there are limits to the
growth of velocity—people can economize just so much on cash balances. Further,
the growth in income and employment is, in the longer run, determined by real
forces and other factors (see the following section). The remaining culprit is mone-
tary expansion. Ultimately the monetarist interpretation of inflation, as we shall see
momentarily, is that it is produced by erratic discretionary changes in money
growth rates.

Inflation and Unemployment: The Monetarist Reaction

Modern monetarism embraces the problems of employment and income
growth and their relation to inflation. A few years after Friedman unveiled his
restatement of the quantity theory a British economist, A. W. Phillips, published a
paper on the relation between employment and inflation levels, “The Relation
between Unemployment and the Rate of Change of Money Wage Rates in the
United Kingdom, 1861–1957,” which posited an inverse relationship between the
unemployment rate and the inflation rate.5 Phillips concluded that higher and
higher inflation rates were required to reduce the unemployment rate by a given
percentage. If verified, this circumstance would present the ultimate policy maker’s
dilemma. Immediately, problems of definition arose, especially concerning unem-
ployment. Economists in the U.S. faced different definitions, one by the U. S.
Department of Labor, another by the President’s Council of Economic Advisers, and
so forth. Which concept should rule?
Eventually strong doubts developed about the predictive nature of the Phillips
curve in the face of actual macroeconomic events, such as stagflation—a term used
to describe inflation accompanied by low growth, unemployment, or economic
recession. In the 1960s Keynesian economics, and the Phillips curve associated with
it, made stagflations impossible because high unemployment would reduce demand
for goods and services, which would lower prices. Thus, no inflation. Presented
with actual stagflation in the 1970s and 1980s, however, economists began to inves-
tigate the validity of the Phillips curve more closely.
Friedman once again rose to the occasion and offered an elegant alternative
conception of both unemployment and the short-run Phillips curve. In his 1968
presidential address to the American Economic Association (“The Role of Monetary
Policy”) Friedman argued that the long-run Phillips relation was vertical at some
natural rate of unemployment. That is, in the long run, any particular rate of mone-
tary expansion and inflation has little or nothing to do with the natural unemploy-
ment rate. The question of what constitutes the natural rate of unemployment was
defined by Friedman in the following terms. “It refers,” he said,

5
Actually, as the title of Phillips’s paper suggests, he used money wage rates rather than the infla-
tion rate in his relation. Furthermore, it has since been established that Irving Fisher invented the
notion that Phillips claimed as his. See Fisher, “Statistical Relation,” in the references.
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562 Part V ■ Twentieth-Century Paradigms

to that rate of employment which is consistent with the existing real conditions in
the labor market. It can be lowered by removing obstacles in the labor market, by
reducing friction. It can be raised by introducing additional obstacles. The purpose
of the concept is to separate the monetary from the nonmonetary aspects of the
employment situation—precisely the same purpose that Wicksell had in using the
word natural in connection with the rate of interest. (Price Theory, p. 228)

In Friedman’s conception, then, the natural rate of unemployment is determined by

all real conditions affecting the supply and demand for labor. These factors would
include all institutional arrangements, such as degree of unionization, minimum-
wage laws, proportion of women in the workforce, status of worker education, and
so on.
In the short run, however, Friedman noted that the actual unemployment rate
may be higher or lower than the natural rate. To see intuitively how this is possible
we need merely return to our analysis of money and inflation in the previous sec-
tion, changing only the assumption stated there that output and employment
remain constant over the adjustment to a new rate of monetary expansion. The key
to understanding the short-run-inflation–unemployment relation is to note that after
an increase in the rate of money expansion, the price expectations of businesspeo-
ple and workers diverge from their actual price experience. Specifically, as individu-
als begin to rid themselves of excess cash balances, the prices of goods and services
rise. Individual entrepreneurs perceive an increase in demand (and price) for their
own products (not an increase in the general price level) and produce more, simul-
taneously hiring more labor at a lower actual real wage. Why will laborers be will-
ing to supply more labor? (Nominal wages may rise somewhat, but inflation tends
to drive down real wages, indicating a reduced quantity of labor input!) The answer
is that laborers’ perceptions of prices lag behind—workers are, in Keynesian terms,
under money illusion. In other words, increased nominal wages fool laborers into
thinking that real wages have increased, and therefore they supply more labor.
Hence unemployment falls below the natural rate until laborers (and businesses)
catch on and readjust. There is, therefore, a short-run inverse relationship between
unemployment and inflation, but in the long run the Phillips curve is vertical at the
natural rate of unemployment. Monetarists argue that in the long-run employment
and output growth are determined by real factors affecting input markets, thus
returning to the classical perspective. Altering money supply growth rates affects
output and employment only temporarily. However, money supply changes have
long-term effects on the rate at which prices change.

Monetarist Economic Policy

Monetarism also carries a strong policy message. The existence of an “expecta-
tions component” in the argument means that lags of various kinds exist within the
implementation of monetary policy. There are both inside and outside lags in the
monetary policy exercised by central banks. Inside lags exist because it takes time
to recognize adverse macroeconomic developments affecting output, employment,
and prices, and to administer appropriate corrective measures. Monetary policy
may have an advantage over fiscal policy in this regard because, unlike fiscal policy,
it does not have to go through a political/legislative process. But the outside lag may
present a greater problem. Milton Friedman first called attention to the outside
lag—the length of time it takes before actual changes in monetary expansion or
contraction are felt on the “target” variables of inflation, output, and employment.
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Chapter 22 ■ Contemporary Macroeconomics 563

Adjustment of expectations is a time-consuming process. Different studies

present conflicting evidence on the matter, but it is generally believed that there is a
six- to nine-month lag between alterations in monetary policy and resulting changes
in total spending. Output changes are ordinarily thought to be the first target
affected, with the full effects of monetary expansion on the rate of inflation follow-
ing later, taking as long as a year and a half. Comparatively little is known, however,
about the formation of expectations and other factors affecting the length of these
lags. Thus, it is clear that a good deal of uncertainty surrounds the conduct and
effectiveness of monetary policy.
Because monetary policy does not take place in a vacuum, the actions of the
Federal Reserve Board must be considered. The Fed’s attempt to target interest
rates such as the federal funds rate (i.e., to keep it within a certain range) has led to
very costly mistakes. When interest rates are pushed upward by excessive govern-
ment borrowing the Federal Reserve often reacts with a monetary expansion that
temporarily lowers the interest rate but lays the groundwork for more upward pres-
sures on interest rates in the future (preceded, of course, by higher inflation rates).
This problem has led many monetarists, including, and most especially Friedman,
to espouse the targeting of bank reserves and monetary aggregates rather than
interest rates. At this point in the new millennium, however, Friedman’s criticisms of
Federal Reserve policy have failed to change its institutional behavior. At base, mon-
etarists view monetary policy from a “rules-versus-discretion” perspective. Given
the state of existing and (likely) future knowledge of macroeconomic processes they
strongly question whether discretionary monetary policy can ever create stability.
Not surprisingly, the Federal Reserve policy makers resist this allegation.
Rules versus Authority. The United States operates under an independent
monetary authority. The members of the Federal Reserve Board are appointed by
the president of the United States—with the advice and consent of the Senate—but
once chosen, they operate independently of the body politic.6 Friedman sees in this
arrangement a threat to individual liberty because it puts a select few in charge of
the most important thing that affects the price level and employment—the nation’s
money. We might expect Friedman to be led to such a view on the basis of philo-
sophical persuasion alone, but his argument against an independent monetary
authority receives added force from investigation of historical monetary data. For
example, in his lengthy study with Anna Schwartz, A Monetary History of the
United States, 1867–1960, Friedman revealed that during the Great Depression the
Federal Reserve Board allowed the money stock of the United States to fall by one-
third, to which he attributed the severity and duration of the crisis.
A deeper acquaintance with monetary facts in the U.S. and other countries led
Friedman to assert that severe depressions have always been accompanied by sharp
reductions in the money stock and that sharp reductions in the money stock have
always been accompanied by depressions. On the other end of the spectrum, Friedman
feels that severe inflations have always been accompanied by sharp increases in the
money stock and vice versa. With respect to the Great Depression, Friedman opined:
The Great Depression in the United States, far from being a sign of the inherent
instability of the private enterprise system, is a testament to how much harm can
be done by mistakes on the part of a few men when they wield vast power over the
monetary system of a country. (Capitalism and Freedom, p. 50)

6
The degree of independence of the Fed (i.e., its freedom from political influence) is frequently
called into question by its critics.
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564 Part V ■ Twentieth-Century Paradigms

Friedman therefore advocates an alternative that has long been in the Univer-
sity of Chicago tradition. He favors automatic rules in place of independent mone-
tary authority. In a favorite parable Friedman compared the past performance of the
Federal Reserve Board to the actions of a nervous teenager learning to drive: when
pressing on the accelerator (i.e., increasing the money stock), our nervous tyro fre-
quently gives the car too much gas; when stepping on the brakes (reducing the
money stock), he or she pushes too hard. In a phrase, monetary overacceleration
and overbraking are predictable. Rather than proceeding smoothly on a path of eco-
nomic growth, discretionary monetary policy subjects the economy to fits and starts,
cultivating inflation and/or depression, and harming individuals in the process.
As an effective countermeasure Friedman proposed that the Federal Reserve
Board be directed by law to increase the money stock month by month at an annual
rate of between 3 and 5 percent. A rate of increase in this range is consistent, he
judged, with attainable economic growth and relative price stability. Moreover, it
would eliminate the destabilizing effects of, say, a 12 percent increase in the money
supply one month and a 3 percent increase the next.
Not surprisingly, many academicians and policy makers regard the rules-ver-
sus-authority question with suspicion. Friedman’s result, stable economic growth
under the monetary rule, depends crucially on the stability of velocity. Friedman has
marshaled statistical evidence in support of this assumption, but his critics either
dispute the evidence or challenge Friedman’s statistical procedures. Some critics
contend that while velocity may be stable in the long run, it is not stable in the short
run. They therefore argue that discretionary monetary policy is required to head off
short-run, destabilizing changes in velocity. Friedman is no stranger to controversy,
but when all is said and done, monetarism could hardly have a more effective
spokesman.7 (For yet another view of why government intervention is likely to pro-
duce bad results—based in part on monetarism—see the box, The Force of Ideas:
Rational Expectations, or “You Can’t Fool All of the People All of the Time.”)
Supply-Siders and Monetarists—The Bottom Line. This chapter and its pre-
ceding one illustrate that much of modern macroeconomics is unsettled territory.
Keynesians and post-Keynesians support discretionary manipulation of fiscal or
budget policy as the principal tool for macroeconomic stabilization, with discretion-
ary monetary policy in an auxiliary role. Keynesian macroeconomic policy is some-
times referred to as “demand management.” Those who take this position see the
economy in constant need of manipulation and tinkering, with the success of policy
measures taken dependent on a strong governmental apparatus. Monetarists view
the problem from the other way around. They see the economy as basically stable
and self-regulating, requiring little if any government intervention. They view the
proper macroeconomic role of government (especially that of the Federal Reserve)
as providing a predictable and stable environment within which unfettered eco-
nomic processes can work efficiently to maximize economic well-being. Minimal
government, balanced budgets, deregulation of business and industry, and a mone-
tary growth rule are all part of the monetarist policy “package.” Nevertheless,
Keynes influenced both camps by directing attention to, and emphasizing, the
“demand side” of the economy.

7
During his lifetime Friedman's razor-sharp intellect and tenacious debating skills led some admir-
ers to compare him to the philosopher Nietzsche, of whom H. L. Mencken said, “when he took to
the floor to argue it was a time to send for ambulances” (in Breit and Ransom, Academic Scrib-
blers, p. 259).
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The Force of Ideas: Rational Expectations, or

“You Can’t Fool All of the People All of the Time”
Inasmuch as economics deals with human behavior, expectations are fundamental to eco-
nomic theory. A family planning to purchase a home will anticipate its long-run earnings pros-
pects and the likely trend of future rents and mortgage rates. In its negotiations with
employers, a labor union will base its wage demands in part on what it thinks future inflation
will be. In each case, the final individual or group transaction will have an effect on the actual
inflation rate, once it feeds through to prices. Intuitively, you might think that expectations are
forward-looking. Clearly they involve the (largely unknown) future. But until the 1970s econo-
mists modeled expectations as if they were based on the past. For example, it was common
practice to posit that next year’s inflation rate would be a weighted average of current and
past rates. This assumption was dictated by the twin realization that it is impossible to observe
expectations directly, but reasonable to suppose that they will be based largely on experience.
The flaw in this reasoning is that it assumes that people would go on believing what they
know to be false. Several economists were troubled by this “irrational” argument. In the 1960s
John Muth argued that it would be better to assume that people have “rational expectations,”
meaning that true forward-looking expectations will be based on the best information at
hand, and that those shown to be persistently wrong will be discarded.
In the 1970s Robert Lucas (Nobel laureate, 1995) demonstrated the importance of this sim-
ple idea. Lucas challenged the validity of government economic models of the economy
based on the past behavior of households and firms. He argued that when governments
change their policies expectations also change, so that the economy’s response to the new
policy may be different from what governments expect.
This idea has widespread applicability, but it exerted a particularly strong impact on mon-
etary policy. Until the 1970s governments thought they could buy lower unemployment with
a bit more inflation, an idea vigorously attacked by Friedman, as pointed out in this chapter.
But Friedman based his argument on backward-looking expectations. By applying rational
expectations, Lucas killed the argument for good.
According to rational expectations theory, a short-run inflationary monetary policy will
boost jobs only because firms are fooled into thinking that a rise in the price they can charge
for their goods signals stronger demand for their products. In fact, it merely signals a rise in
the overall price level. In the long-run, under rational expectations, there can be no trade-off
between inflation and unemployment because people cannot be fooled forever. They learn
from their mistakes. Once people see that inflation has risen, unemployment will return to its
former level.
Clearly, the insights provided by Muth and Lucas, as well as the other “rational expectation-
ists,” are useful as a warning against naive government policy. But as with all simple yet force-
ful ideas, rational expectations theory raises many fundamental questions. How are
expectations formed? When are governments to be believed? What constitutes efficient infor-
mation? How do people use information? How can economic models capture the limited abil-
ity of people to understand how the economy works?
Partly as a consequence of the rational expectations view, economists are now preoccu-
pied with the issues of credibility and sustainability. Can governments keep their promises,
and for how long? We now recognize more explicitly that governments are perpetually
twisted on the horns of a dilemma: Although tough policies eventually bring the benefits of
low inflation, politicians gain popularity by encouraging a short burst of inflation that tempo-
rarily boosts incomes and employment. But if they succumb to this temptation repeatedly,
their credibility may be lost. It is likely that the great future battles over massive social pro-
grams (e.g., Social Security, Medicare, and Medicaid, etc.) in the United States and elsewhere
will pivot on this basic idea.
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566 Part V ■ Twentieth-Century Paradigms

Theory and policy are almost always affected by actual events. Stagflation
occurred in the United Kingdom in the 1960s and 1970s and in the United States in
the early 1970s. The difficulty of fitting stagflation within a Keynesian framework
led to a greater acceptance of monetarist theories in the 1970s and 1980s. To some
extent the pendulum has swung back in the opposite direction as monetarism had
increasing difficulty predicting the demand for money and the long period of low
inflation and high employment of the 1990s—a kind of reverse of stagflation. Never-
theless, the specter of stagflation continues to haunt Western economies in the
twenty-first century.
But in between these pendulum swings within the “demand-side” paradigm, an
alternate view of the macroeconomy emerged over the 1970s and the 1980s from
another quarter that emphasized supply-side solutions to macroeconomic prob-
lems. Writers in this third camp have acquired the name supply-siders. Rejecting
Keynesian economics and the demand-side orientation of the monetarists, the sup-
ply-siders concentrated on the effect that macroeconomic policies have on incen-
tives to save, invest, and acquire capital. Blaming the inflation of the 1970s in part
on reduced growth in labor productivity, the supply-siders emphasized factors
affecting technology and the labor market.
Supply-siders promote tax and spending cuts and a balanced budget as a major
fiscal tonic. The net result, it is hoped, will be the creation of greater incentives to
save and invest, thus propelling the economy forward. The deregulation of industry,
including reduced business “standards” regulation, an emphasis on private labor-
training programs, and reduced social welfare subsidies that create disincentives to
work and save are also part of most of the supply-siders’ policy prescriptions. The
supply-siders seemed to reach the height of their influence during the administra-
tion of President Reagan in the United States. Since then, the shift in Washington’s
mood has been back in the direction of Keynesianism.

■ CONCLUSION
The French have a saying that “the more things change, the more they remain
the same.” This maxim appears especially appropriate to an evaluation of modern
macroeconomic and monetary theory. Supply-side economics and the fundamentals
of modern rational expectations theory (the idea without its technical accoutre-
ments) were the stock-in-trade of Adam Smith and many of the other important
classical economists! Labor productivity and capital formation were undeniable
foundational elements of classical macroeconomics, which was absorbed by the
issue of economic growth and development. Through their analysis of market econ-
omies classical economists were led to advocate as little government “policy mak-
ing” as possible, consistent with the overarching goal of economic development.
These “classical” principles are very close to the philosophical and theoretical con-
ceptions of modern supply-siders, monetarists, and rational expectationists. As
such, contemporary macroeconomics and monetary theory appear to be returning
to the timeless concerns of any economy. However, they have returned far richer.
We now know, thanks in large measure to the Keynesian interlude and to the refur-
bishment of neoclassical ideas by Milton Friedman and the rational expectationists,
a great deal more about the workings of the aggregate economy. As such, modern
macroeconomics—conceived of as including monetary economics—is a major and
ongoing study of the contemporary economist.
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Chapter 22 ■ Contemporary Macroeconomics 567

REFERENCES
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national Labour Review, vol. 13 (June 1926), pp. 785–792. Reprinted as “I Discov-
ered the Phillip’s Curve,” Journal of Political Economy, vol. 81 (March/April 1973),
pp. 496–502.
———. The Purchasing Power of Money. New York: A. M. Kelley, 1963 [1911].
———. The Theory of Interest. New York: Macmillan, 1930.
Friedman, Milton. Studies in the Quantity Theory of Money. Chicago: The University of
Chicago Press, 1956.
———. Capitalism and Freedom. Chicago: The University of Chicago Press, 1962.
———. “The Role of Monetary Policy,” American Economic Review, vol. 58 (March 1968),
pp. 1–17.
———. Price Theory. Chicago: Aldine, 1976.
———, and Anna Schwartz. A Monetary History of the United States, 1867–1960. Prince-
ton, NJ: Princeton University Press, 1963.
Johnson, H. G. “Monetary Theory and Policy,” American Economic Review, vol. 52 (June
1962), pp. 335–384.
Mill, J. S. Principles of Political Economy, W. J. Ashley (ed.). New York: A. M. Kelley,
1965 [1848].
Patinkin, Don. Money, Interest and Prices, 2d ed. New York: Harper & Row, 1965.
Phillips, A. W. “The Relation between Unemployment and the Rate of Change of Money
Wage Rates in the United Kingdom, 1861–1957,” Economica, vol. 25 (November
1958), pp. 283–299.
Pigou, A. C. (ed.). Memorials of Alfred Marshall. London: Macmillan, 1925.
Uhr, Carl G. Economic Doctrines of Knut Wicksell. Berkeley: University of California
Press, 1962.
Wicksell, Knut. Lectures on Political Economy, 2 vols., L. Robbins (ed.). London: Rout-
ledge & Kegan Paul, 1935.
———. Interest and Prices, R. F. Kahn (trans.). London: Macmillan, 1936.

NOTES FOR FURTHER READING

An excellent survey of monetary theory that in some respects parallels the one pre-
sented in this chapter is contained in Joseph Ascheim and C. Y. Hsieh, Macroeconomics:
Income and Monetary Theory (Columbus, OH: Merrill, 1969). For a broader sweep, see
Charles Rist, History of Money and Credit Theory from John Law to the Present Day, J.
Degras (trans.) (New York: Macmillan, 1940).
Space does not permit our doing justice to the many talents of Irving Fisher, cer-
tainly a prime candidate for “greatest American economist.” A glimpse at the personal
side of Irving Fisher is provided in J. P. Miller, “Irving Fisher of Yale,” in William Fellner,
et al. (eds.), Ten Economic Studies in the Tradition of Irving Fisher (New York: Wiley,
1967). The same volume also contains an instructive and perceptive assessment of
Fisher’s theoretical work by Paul Samuelson. Robert W. Dimand, “Irving Fisher and
Financial Economics: The Equity Premium Puzzle, the Predictability of Stock Prices,
and Intertemporal Allocation Under Risk,” Journal of the History of Economic Thought,
vol. 29 (June 2007), pp 153–166, discusses Fisher’s views on financial economics, his per-
sonal fortunes in the stock market, the loss of his fortune in the Great Depression, and
the resulting decline in his reputation.
Fisher’s role as policy maker and presidential adviser is detailed in W. R. Allen,
“Irving Fisher, F.D.R., and the Great Depression,” History of Political Economy, vol. 9
(Winter 1977), pp. 560–587. Fisher’s very important foundation for the theory of risk and
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568 Part V ■ Twentieth-Century Paradigms

uncertainty is developed in J. H. Crockett, Jr., “Irving Fisher on the Financial Economics

of Uncertainty,” History of Political Economy, vol. 12 (Spring 1980), pp. 65–82. Frank G.
Steindl, “Was Fisher a Practicing Quantity Theorist?” Journal of the History of Economic
Thought, vol. 19 (Fall 1997), pp. 241–260, says yes (before the Great Depression) and no
(after the Great Depression). As a counterpoint to Fisher’s views on the quantity theory of
money, see N. T. Skaggs, “The Methodological Roots of J. Laurence Laughlin’s Anti-Quan-
tity Theory of Money and Prices,” Journal of the History of Economic Thought, vol. 17
(Spring 1995), pp. 1–21. Laughlin was head of the economics department at the University
of Chicago and the leader of anti-quantity theory sentiment in the early twentieth century.
Possibly the best single source of information on Wicksell and his ideas is Carl Uhr’s
Economic Doctrines of Knut Wicksell (see references). See also Ragnar Frisch, Knut
Wicksell: A Cornerstone in Modern Economic Theory (Oslo, 1951). Torsten Gardlund,
The Life of Knut Wicksell (Aldershot, UK: Edward Elgar, 1996), provides additional bio-
graphical details. John C. Wood (ed.), Knut Wicksell: Critical Assessments (London:
Routledge, 1994), collected the major secondary literature on Wicksell, showing the rich-
ness of his work and the significance of his legacy. See also, S. Stern and B. Thalberg
(eds.), The Theoretical Contributions of Knut Wicksell (London: Macmillan, 1979). A
two-volume collection of Wicksell’s economic writings, some previously unpublished,
and available in English for the first time, translated from German or Swedish, appeared
in 2002–2003 under the title Knut Wicksell: Essays in Economics, Bo Sandelin (ed.) (Lon-
don: Routledge, 2002/2003).
On Wicksell’s cumulative process and its significance in monetary theory, see Don
Patinkin, “Wicksell’s ‘Cumulative Process,’” Economic Journal, vol. 62 (December 1952),
pp. 835–847; same author, “Wicksell’s Cumulative Process in Theory and Practice,”
Banca Nazionale del Lavaro Review, vol. 21 (June 1968), pp. 120–131; Claes-Henric
Siven, “Capital Theory and Equilibrium in Wicksell’s Cumulative Process,” History of
Political Economy, vol. 29 (Summer 1997), pp. 201–217. Also see Mauro Boianovsky,
“Wicksell’s Business Cycle,” The European Journal of the History of Economic Thought,”
vol. 2 (Autumn 1995), pp. 375–411; E. J. Nell, “Wicksell’s Theory of Circulation,” Journal
of Political Economy, vol. 75 (August 1967), pp. 386–394; and Jacob Marschak, “Wick-
sell’s Two Interest Rates,” Social Research, vol. 8 (November 1941), pp. 469–478.
Some other aspects of Wicksell’s macroeconomics are discussed by Lars Jonung,
“Knut Wicksell’s Norm of Price Stabilization and Swedish Monetary Policy in the
1930’s,” Journal of Monetary Economics, vol. 5 (October 1979), pp. 459–496; same
author, “Knut Wicksell on Unemployment,” History of Political Economy, vol. 21 (Spring
1989), pp. 27–42; and William Coleman, “Wicksell on Technical Change and Real
Wages,” History of Political Economy, vol. 17 (Fall 1985), pp. 355–366. Mauro
Boianovsky, “Wicksell on Deflation in the Early 1920s,” History of Political Economy, vol.
30 (Summer 1998), pp. 219–275, concluded that worldwide deflation of the 1920s caused
Wicksell to revise some aspects of his cumulative process model.
Alfred Marshall’s monetary theories are best described in his Money, Credit, and
Commerce (New York: A. M. Kelley, 1960 [1923]). Perhaps the best spokesman for the
Cambridge group was Marshall’s student Pigou. See A. C. Pigou: “The Value of Money,”
Quarterly Journal of Economics, vol. 32 (November 1917), pp. 38–65; “The Monetary
Theory of the Trade Cycle,” Economic Journal, vol. 39 (June 1929), pp. 183–194; and
“Marginal Utility and Elasticities of Demand,” Quarterly Journal of Economics, vol. 50
(May 1936), p. 532. D. A. Walker, “Keynes’s Anticipation of Monetarism,” Australian Eco-
nomic Papers, vol. 28 (June 1989), pp. 1–15, attempts to place Keynes at the forefront of
later developments. Don Patinkin’s Money, Interest and Prices (see references) is valu-
able on two counts: (1) it is a monumental effort to fully integrate monetary theory and
value theory, and (2) the supplementary notes at the end of the book provide useful
information on the historical antecedents of neoclassical monetary theory. While the text
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Chapter 22 ■ Contemporary Macroeconomics 569

is heavy going for undergraduates and possibly even graduates, the notes might be read
with much profit.
The literature on modern monetarism and its satellite ideas is vast and growing. J.
Huston McCulloch, Money and Inflation: A Monetarist Approach (New York: Academic,
1975), provides a useful introduction. A more extensive treatment of the monetarist
approach to money and inflation may be found in Leonardo Auernheimer and R. B. Eke-
lund, Jr., The Essentials of Money and Banking (New York: Wiley, 1982). The relation
between modern monetarism and classical economics generally, and David Hume in par-
ticular, is the subject of Thomas Mayer, “David Hume and Monetarism,” Quarterly Jour-
nal of Economics, vol. 95 (August 1980), pp. 89–101. J. Daniel Hammond, “Labels and
Substance: Friedman’s Restatement of the Quantity Theory,” History of Political Econ-
omy, vol. 31 (Fall 1999), pp. 449–471, emphasizes Friedman’s allegiance to Marshall’s
methodology and value theory, and his use of the Cambridge cash balances approach.
Hsiang-Ke Chao, “Milton Friedman and the Emergence of the Permanent Income
Hypothesis,” History of Political Economy, vol. 35 (Spring 2003), pp. 77–104, explains the
development of one of the linchpins of Friedman’s restatement of the quantity theory.
Gilles Dostaler, “Friedman and Keynes: Divergences and Convergences,” The European
Journal of the History of Economic Thought, vol. 5 (Summer 1998), pp. 317–347, com-
pares the two giants of twentieth century macroeconomics.
Economic history from a monetarist perspective is beautifully exposed in the Fried-
man–Schwartz volume (see references). The Great Depression, analyzed from this van-
tage, has stirred up a good deal of controversy. See Milton Friedman and Anna J.
Schwartz, The Great Contraction (Princeton, NJ: Princeton University Press, 1966); then
read Peter Temin’s Did Monetary Factors Cause the Great Depression? (New York: Nor-
ton, 1976).
Rational expectations theory is explained in a clear, nontechnical fashion by Rodney
Maddock and Michael Carter, “A Child’s Guide to Rational Expectations,” Journal of Eco-
nomic Literature, vol. 20 (March 1982), pp. 39–51. Although complex in its advance for-
mulations, the theory of rational expectations developed rapidly over the 1970s: see
Thomas Sargent, “Rational Expectations, the Real Rate of Interest, and the Natural Rate
of Unemployment,” Brookings Papers in Economic Activity 2 (1973), pp. 429–472; Thomas
Sargent and Neil Wallace, “Rational Expectations and the Theory of Economic Policy,”
Journal of Monetary Economics, vol. 2 (April 1976), pp. 169–184; and Robert E. Lucas, “An
Equilibrium Model of the Business Cycle,” Journal of Political Economy, vol. 83 (Decem-
ber 1975), pp. 1113–1144. Michael C. Lovell, “Tests of the Rational Expectations Hypothe-
sis,” American Economic Review, vol. 76 (March 1986), pp. 110–124, has attempted to test
the conclusions of the theory and found them lacking in empirical support.
James Forder, “The Historical Place of the ‘Friedman-Phelps’ Expectations Cri-
tique,” The European Journal of the History of Economic Thought, vol. 17 (2010), pp.
493–511, argues that the expectations critique made famous by Friedman and Phelps in
the 1960s was actually older, and that it was an established principle by the time Fried-
man and Phelps wrote. The argument is that the Keynesians caused the confusion by
responding to Friedman’s arguments about expectations rather than his claims about the
natural rate of unemployment, which were two different problems.
Readers interested in learning more about lags and “targets” in monetary (and fis-
cal) policy would do well to consult L. C. Anderson and J. L. Jordan, “Monetary and Fis-
cal Actions: A Test of Their Relative Importance in Economic Stabilization,” Federal
Reserve Bank of St. Louis Review, vol. 50 (November 1968), pp. 11–24; see also B. M.
Friedman, “Even the St. Louis Model Now Believes in Fiscal Policy,” Journal of Money,
Credit and Banking, vol. 9 (May 1977), pp. 365–367; and J. E. Tanner, “Are the Lags in the
Effects of Monetary Policy Variable?” Journal of Monetary Economics, vol. 5 (January
1979), pp. 105–121.
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570 Part V ■ Twentieth-Century Paradigms

For a general introduction to the aspects of supply-side economics see L. R. Klein,

“The Supply Side,” American Economic Review, vol. 68 (March 1978), pp. 1–7. The “Laf-
fer curve”—showing the relation between tax rates and government revenues—has been
an integral part of modern supply-side economics. Economist Arthur Laffer argues that
lowering tax rates would create additional incentives to work and invest, increased
incomes, and increased revenues for government; see A. B. Laffer and R. D. Ranson, “A
Formal Model of the Economy,” Journal of Business, vol. 44 (July 1971), pp. 247–270; and
the simplified treatment in Jude Wanniski’s “Taxes, Revenues, and the ‘Laffer Curve,’”
The Public Interest, vol. 50 (Winter 1978), pp. 3–16. For a “fiscalist” criticism of Laffer's
logic see Walter Heller, “The Kemp-Roth-Laffer Free Lunch,” The Wall Street Journal
(July 12, 1978), p. 20. Whether the Laffer relation exists or not is debatable, but no one
denies the onset of a productivity problem in the U.S. economy of the 1970s. An excel-
lent overview of the problem is provided in J. A. Tatom, “The Productivity Problem,” Fed-
eral Reserve Bank of St. Louis Review, vol. 61 (September 1979), pp. 3–16. Also, for
contrasting approaches to the productivity problem, see Paul Samuelson and Milton
Friedman, “Productivity: Two Experts Cross Swords,” Newsweek (September 8, 1980),
pp. 68–69.
The reemergence of the quantity theory in the 1950s and 1960s, along with the mon-
etarist school that it spawned, is the subject of a spate of papers, all contained in History
of Political Economy. Three separate papers concerning the effect of statistical and theo-
retical developments on the early quantity theory may be profitably read as a unit. T. M.
Humphrey treats the statistical tests of the theory in the first three decades of this cen-
tury, stressing that the major contribution of such tests was empirical rather than theoret-
ical in nature. See Humphrey, “Empirical Tests of the Quantity Theory of Money in the
United States, 1900–1930,” History of Political Economy, vol. 5 (Fall 1973), pp. 285–316.
Anticipatory and actual contributions to theoretical monetarism are the subjects of two
papers about C. F. Bickerdike and Clark Warburton. On Bickerdike’s anticipatory devel-
opments related to the role of money in business fluctuations see V. J. Tarascio, “Bicker-
dike’s Monetary Growth Theory,” History of Political Economy, vol. 12 (Summer 1980),
pp. 161–173. Clark Warburton was the staunchest defender of monetarism before the
seminal writings of Friedman appeared. Although very much out of the mainstream of
Keynesian times, Warburton deserves credit for kindling the fires of monetarism when it
was most unpopular to do so; see T. F. Cargill’s “Clark Warburton and the Development of
Monetarism since the Great Depression,” History of Political Economy, vol. 11 (Fall 1979),
pp. 425–449. Finally, Reuven Brenner, “The Concept of Indexation and Monetary Theory,”
History of Political Economy, vol. 11 (Fall 1979), pp. 395–405, identifies important paral-
lels between indexation as a hedge against inflation and the development of monetarism.
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23

Austrian Economics

Chapter 14 reviewed the contributions of the “older” Austrian school within the
context of a “marginal revolution” in value theory that occurred in the closing
decades of the nineteenth century. Historians of economic thought have tended to
lump Menger, Jevons, and Walras together as independent discoverers of the same
approach to value. This tendency serves to obscure the essential differences in the
original intent and design of their respective theoretical constructions and in the
influence exerted by each writer, in his own way, on the subsequent development of
economic thought. One important difference is that Walras, alone of the three, was
the architect of a general-equilibrium system. Joseph Schumpeter singled out this
accomplishment as the really important one of the period and concluded that “in
itself, the principle of marginal utility is not so important after all as Jevons, the
Austrians, and Walras himself believed” (History, p. 918). There is some doubt, how-
ever, whether the Austrians ever considered the marginal-utility principle alone to
be as important as Schumpeter seems to think they did. Research has shown the
marginal-utility principle to be incidental to Menger’s economic analysis, not an
integral part of it.1 Menger nowhere concerned himself with the relative maxima or
minima of functions, which many take to be the essence of marginalism. The focus
of his economic analysis, instead, was on the study of institutions and the condi-
tions of disequilibrium.
This last concern constitutes a sharp cleavage between the Austrian brand of
“neoclassical” economics and the French (Cournot–Dupuit–Walras) or English
(Jevons–Marshall) variants of neoclassical theory. Overlooking for the moment the
fact that Walras rode the high road of general-equilibrium theory while Marshall
took the low road of partial-equilibrium analysis, both showed a theoretical concern
for the determination of prices under a hypothetical regime of perfectly free compe-
tition. By contrast, Menger did not try to explain prices nor did he assume that com-
petition could be “perfect.” He forged no analytical link between “the importance of
satisfactions” (i.e., marginal utility) and market prices. In fact, he regarded market
prices as superficial and incidental manifestations of much deeper forces at work in
the exchange of goods and services. He believed that economics should investigate
these deeper forces and essential causes rather than concern itself with mathemati-
cal formalism.
Menger’s view of human beings and their nature inevitably colored his
approach to economic analysis. William Jaffé, an authority on Walras, concluded:

1
For example, see J. T. Salerno, “The Place of Mises’s Human Action” in the references.

571
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572 Part V ■ Twentieth-Century Paradigms

Man, as Menger saw him, far from being a “lightning calculator” [Veblen’s deroga-
tory phrase], is a bumbling, erring, ill-informed creature, plagued with uncertainty,
forever hovering between alluring hopes and haunting fears, and congenitally
incapable of making finely calibrated decisions in pursuit of satisfactions. With his
attention [thus] unswervingly fixed on reality, Menger could not, and did not,
abstract from the difficulties traders face in any attempt to obtain all the informa-
tion required for anything like a pinpoint equilibrium determination of market
prices to emerge, nor did his approach permit him to abstract from the uncertain-
ties that veil the future, even the near future in the conscious anticipation of which
most present transactions take place. Neither did he exclude the existence of non-
competing groups, or the omnipresence of monopolistic or monopoloid traders in
the market. (“Menger,” pp. 520–521)

The institutional component is also of paramount importance in the Austrian

paradigm, albeit in a different way from that conceived by Veblen. The fundamental
goal of Menger’s economics was to make social phenomena intelligible in terms of
individual goals and plans. Economic and social institutions affect human action by
influencing the interaction of individual plans. In Menger’s framework an institu-
tion is any coordinated pattern of individual interaction. A market or a legal system
is an institution, but so is money and so are prices. How does it come about that so
many people of diverse backgrounds come to agree on a certain pattern of interac-
tion? How is it possible that so many individual exchanges take place under mutu-
ally advantageous conditions without central direction? The Austrian tradition is
not a ready-made set of answers to these and other major theoretical questions, but
it is instead a way of conceiving “the economic problem.” It is a research program
with a peculiar gestalt. The key concepts in this particular approach concern the
role and influence of subjectivity, time, uncertainty, disequilibrium, process, knowl-
edge, and coordination.

■ THE GESTALT OF AUSTRIAN ECONOMICS

Although it was Menger who first gave meaning to the phrase “Austrian eco-
nomics,” his influence went far beyond the national boundaries of his native land.
The “Vienna circle” that began with Menger nurtured second-generation Austrians,
most notably two émigrés to America, Ludwig von Mises (1881–1973) and Joseph
Schumpeter (1883–1950). Mises in turn taught a third generation of economists that
includes Friedrich Hayek (1889–1992), Oskar Morgenstern (1902–1977), Fritz
Machlup (1902–1983), Paul Rosenstein-Rodan (1902–1985), and Gottfried Haberler
(1900–1995). In London, Hayek’s influence touched G. L. S. Shackle (1903–1992)
and Ludwig Lachmann (1906–1990), the latter also a holder of a Vienna doctorate.
In the United States, Mises influenced Israel Kirzner and Murray Rothbard (1926–
1995), who attended his seminars at New York University. In this way, successive
generations of “Austrians” were propagated and continue to produce long after the
geographic connotation of the word ceased to have any substantive meaning.
Modern expositors of the Austrian approach underscore five major points of
emphasis that distinguish, in their view, Austrian economics from mainstream neo-
classical analysis. The five distinguishing features are: (1) radical subjectivism, (2)
methodological individualism, (3) purposive human action, (4) casual-geneticism,
and (5) methodological essentialism. Each of these requires some elaboration.
Radical subjectivism is a wide net that ensnares several Austrian themes. Basic
to the Austrian approach is the conviction that all underlying permanent relations of
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Chapter 23 ■ Austrian Economics 573

economic theory are consequences of human choice. Austrians therefore empha-

size the roles of knowledge and error in individual decision making. What is impor-
tant is that people differ with respect to their knowledge, interpretations,
expectations, and alertness, so that subjectivism has a much broader meaning than
implied merely by personal tastes. All decisions are by their very nature subjective.
Certain information cannot be reasonably expected to be held by anyone other than
the individual making a decision, e.g., the intensity and form of his or her prefer-
ences and expectations. Since decision making is the province of the entrepreneur,
entrepreneurship is consequently a major force in Austrian economics.
The most unique and radical aspect of the Austrian approach, however, lies in
its emphasis on the primacy of utility and the denial of costs as a coterminous ele-
ment (with utility) in the determination of value. This last point constitutes the
sharpest break with the English variant (Marshall and Jevons) of neoclassical value
theory. Essentially, Austrians argue that economic costs are themselves subjective,
because they are based on calculations of utility forgone whenever a choice is made.
In other words, Austrians associate costs with a decision, a neutral act, not with an
event or a thing. This means that costs are subordinate to, but inextricably joined
with, utility. Costs are subjective because they are perceived by the decision maker.
The price paid for an item therefore represents the utility of it to the purchaser
alone, not necessarily its utility to anyone else. This line of thought runs against the
strict Marshallian tradition that associates costs with events and therefore regards
costs as in some sense objective.
Methodological individualism asserts that the most appropriate way to study eco-
nomic phenomena is at the level of the individual. If economics is a science of choice,
then one must look to the chooser to understand economic relations. But aren’t some
choices collective in the sense that they are made by a body of people (e.g., a commit-
tee) rather than by a single individual? There are two responses to this question. One
is that any collective decision-making body is composed of persons whose individual
decisions make up the collective judgment. The second concerns the nature of aggre-
gates and what kind of information they convey. Austrians argue that aggregates only
matter where individual considerations don’t matter; yet for Austrians, individual
decisions always matter. In the final analysis the choice between the study of individ-
ual or aggregate choices is at least partly a normative issue, and Austrians are quite
explicit about their methodological preference in this regard.
There is an element of teleology in the Austrian approach expressed in their
emphasis on purposive human action. However, it is a kind of teleology that does
not take goals as absolute. Goals may change over time, and they obviously vary
from one individual to the next. In this connection, the basic proposition defended
by Austrians is that individual choice is not the consequence of some mere gravita-
tional pull toward utility. Rather, individuals act with a purpose, even if that purpose
is frequently frustrated by error or imperfect knowledge. In this regard, Austrians
reject Benthamite principles, for Bentham saw people as being passively pushed
about by pleasure and pain. Austrians regard all choices as forward looking; conse-
quently expectations are very important economic variables. These expectations,
along with the purpose behind each person’s actions, shape individual plans and the
decisions made in order to carry out each plan.
To say that Austrian economics is causal-genetic is to say that it emphasizes
essences rather than functional relationships. Functionalism stresses the working
out of conditions that must be met in order for some end to be fulfilled (e.g., the
enumeration of characteristics that constitute the competitive model). Austrians
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574 Part V ■ Twentieth-Century Paradigms

claim to be more interested in the nature and essence of things and less interested
in their form. There is an Aristotelian strain that runs through the Austrian
approach; for example, attempts to mathematize economic relations are considered
fruitless because mathematics is functional and form-oriented and therefore inca-
pable of contributing any real understanding of basic economic relations.
Finally, methodological essentialism asserts that the proper method of studying
economics is the study of essences, not appearances or superficialities. Because
economics is a social science, its method must be that which is appropriate to the
study of human behavior. Therefore, Austrians reject the application of natural sci-
ences to economics. Hayek coined a word, “scientism” to describe the (illegitimate,
in his view) application of principles of natural science to the study of humans. He
and other Austrians find this attempt to transfer the methodology of natural science
to a social science like economics decidedly unscientific because it involves the
mechanical and uncritical application of habits of thought to fields different from
those in which they have been formed. According to Hayek, “The scientistic as dis-
tinguished from the scientific view is not an unprejudiced but a very prejudiced
approach which, before it has considered its subject, claims to know what is the
most appropriate way of investigating it” (Counter-Revolution, p. 24). He maintains
that the chief culprits in promoting the slavish imitation of the method and lan-
guage of science by the social sciences were Saint-Simon and Comte.
Austrian economics, therefore, claims to be nonscientistic, and its goals are
fairly modest. Unconcerned with predictions, Austrians merely seek to understand
human society and to make it more intelligible. Thus, their methodology separates
them from mainstream neoclassical economics. (See the box, Method Squabbles 6:
Austrians vs. Marshallians: Is There Really a Difference?)

Method Squabbles 6: Austrians vs. Marshallians: Is There Really a Difference?

Some in the contemporary economics profession believe that Austrian economics is an
attempt at a “distinction without a difference,” that is, only a variation on standard neoclassi-
cal (Marshallian) economics. To be sure, Marshallian economics was subsequently modified by
the introduction of asymmetric information, uncertainty, and other factors. Nevertheless, con-
ceptual and philosophical differences clearly exist. Examples include the Austrian emphasis
on utility as the basis for subjective costs and their emphasis on “human action” in contrast to
Marshallian demand and supply analysis. But to be fair, both approaches emphasize rational
maximizing and economizing by individuals. The real question comes down to this: Aside
from some philosophical concerns, do Austrian economists “do” economics differently than
orthodox Marshallians?
There are important differences in the practice of Austrian economics, differences that can
be traced back to ideas of first-generation Austrians. Consider only two examples from their
formulations of microeconomic behavior: the matter of “discontinuities” in consumption and
production, and the pervasive uncertainty that attends economic decisions. Recall that
Menger, Wieser, and Böhm-Bawerk emphasized fixed proportions in consumption and pro-
duction. This “lumpiness” attended all consumables and all inputs due to the observed physi-
cal impossibility of purchasing final goods or resources “continuously.” According to Austrian
tenets, mathematics in the form of the differential calculus is inappropriate—actually impossi-
ble—in abstracting from real-world processes. There is no smooth Marshallian continuity
involved when people make physical additions of goods or resources in consumption and pro-
duction; therefore it is senseless to pretend that such continuity exists. By this reasoning, the
use of calculus will get you into trouble by distorting characteristics of real economic phenom-
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Chapter 23 ■ Austrian Economics 575

ena in the economy. The Austrian rejection of “rational mechanics” and mathematical theoriz-
ing stems as much from this observation about the real world as it does from some
philosophical preconceptions.
Next, consider the Austrians’ (limited) use of modern econometrics. They believe that one
cannot apply the methods of the “hard” sciences to economics primarily because of the uncer-
tainty and limited information (emphasized early on by Menger) that attends all market
exchange. In an attempt at economic prediction, modern Marshallians use probability theory,
which is the foundation of statistics and econometrics, to “test” economic theory. But when
market activity is viewed as an unfolding process and as a result of human action rather than
human design, there is little room for predictability. Thus, the Austrian’s primary objective is to
describe rather than predict. There is, within this paradigm, not much room or tolerance for
modern econometrics. Past events and the data trail they leave (data gathering is yet another
problem) cannot be used to make exact predictions of future events within limits of probability
acceptable to Austrians. Too much uncertainty exists concerning the future course of events
propelled by human action to be able to reduce economic phenomena to mechanistic pro-
cesses. Rather, Austrians rely on logical and scholastic methods of presenting and analyzing
problems, very much in the tradition of how the early Austrians viewed the world. There are, in
short, real differences between Austrian and orthodox Marshallian modes of “doing” economics.

A full discussion of every aspect of Austrian economics would take us beyond

the aim and scope of this book. We confine ourselves in this chapter to a brief
review of several major Austrian themes: money, credit, the trade cycle, and the
nature of competition.

■ LUDWIG VON MISES: THE THEORY OF MONEY AND CREDIT

Classical economics treated money as neutral in its economic effects (see chap-
ter 6), and Walrasian neoclassical economics does not recognize the uniqueness of
money. In Walrasian general-equilibrium models money is merely a numéraire—it
has no properties distinguishing it from the many nonmoney goods in the model. By
contrast, Austrian monetary theory considers money unique because of its intertem-
poral exchangeability. Hence, the Austrians concentrate on the relative price effects
of changes in the money supply. In its contemporary formulation Austrian economics
begins with a theory of the evolution of money and concludes with an analysis of the
effects of changes in money on the fundamental economic decisions of individuals.
Although Carl Menger (see chapter 14) fashioned a theory of the evolution of
money that emphasized the unintended consequences of individual (self-interested)
behavior, he did not succeed in solving the question of what determines the value of
money. Despite promising efforts by Knut Wicksell (see chapter 22), monetary the-
ory remained separated from value theory until the two were integrated by Ludwig
von Mises, one of Böhm-Bawerk’s students at the University of Vienna. Mises
achieved the integration of monetary and value theory by founding both on the
same principle, the marginal utility of subjective individual wants.

Subjective Use Value versus Objective Exchange Value

Mises recognized that the marginal utility of money comes from two separate
sources. On the one hand, money has value derived from the value of the goods it can
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576 Part V ■ Twentieth-Century Paradigms

buy. On the other hand, money has a subjective use value of its own because it can be
held for future exchange. What we call the value of money in common parlance
springs from the ability of money to be exchanged for other things. Mises called this
characteristic of money its “objective exchange value” in order to distinguish it from
money’s subjective use value. Today we call it the purchasing power of money.
How then do we measure the purchasing power of money? Conventional theory
advanced the concept of a unitary (aggregate) price level, whereby the purchasing
power of money (the reciprocal of the price level) is the outcome of the total volume
of transactions in society divided by the velocity of circulation. In terms of the famil-
iar equation of exchange (see chapter 22) where MV = PT, the price level P would
be derived as follows: P = MV/T and its reciprocal (the purchasing power of
money), 1/P = T/MV. Mises recognized the grain of truth in the quantity theory,
namely “the idea that a connection exists between variations in the value of money
on the one hand and the supply of it on the other hand,” but he said, “beyond this
proposition the Quantity Theory can provide us with nothing. Above all, it fails to
explain the mechanism of variations in the value of money” (Theory of Money and
Credit, p. 130).
True to the Austrian tradition, Mises rejected the macroeconomic approach to
monetary theory in favor of an individualistic approach. All valuation is done by indi-
viduals; therefore the key to understanding the value of money must be in the mind
of the individual. The purchasing power of a dollar is the vast array of goods that can
be purchased with that dollar. This array is heterogeneous and specific. At any point
of time a dollar might buy four boxes of salt, three packs of chewing gum, two candy
bars, one-half box of laundry detergent, one-tenth of a music compact disc, and so
forth and so on. The purchasing power of money therefore cannot be summarized in
some unitary price-level figure. At all times a homogeneous good must be defined in
terms of its usefulness to the consumer rather than its technological properties. Like-
wise, price must be related to the specific usefulness of a good, not to its technologi-
cal properties. An apartment with the same technological properties in Manhattan
and in Boise will not have the same price because they are not equally useful to the
purchaser. The apartment in New York is more ideally situated to more extensive
consumption possibilities and therefore will be more highly priced on the market.
Mises emphasized locational (and temporal) aspects in explaining differences in the
value of technologically similar goods, and this emphasis complements the Austrian
notion that the purchasing power of money is equal to an array of goods.
In applying the theory of marginal utility to the price of money, Mises con-
fronted a thorny analytical problem. When an individual ranks coffee or shoes or
vacations on a value scale, he or she values those goods for their direct use in con-
sumption, and each valuation is independent of and prior to its price on the market.
However, people hold money not because it can be used directly in consumption but
because it can eventually be exchanged for goods that will be used directly. In other
words, money is not useful in itself; it is useful because it has a prior exchange
value—a preexisting purchasing power. The demand for money therefore not only
is not independent of its existing market price but derives precisely from its preex-
isting price in terms of other goods and services. Therein lies the problem. If the
demand for money, and hence its utility, depends on its preexisting price or pur-
chasing power, how can that price be explained by the demand? Mises’s critics
accused him of falling into a circular trap.
Mises avoided the trap by invoking a regression theorem. The demand for
money on any given day, say day D, is equal to its purchasing power on the previous
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Chapter 23 ■ Austrian Economics 577

day, D – 1. The demand for money on the previous day, D – 1, in turn is equal to the
purchasing power of money on D – 2, and so on. In other words, the demand for
money always has a historical (i.e., temporal) component. But is this not an infinite
regression backward in time? No, Mises answered, we must push the analysis back-
ward only to that point when the commodity used as money was not used as a
medium of indirect exchange but was demanded instead solely for its own direct
consumption use. Suppose we go back in time to the point when gold was intro-
duced as money. Let us assume that before this day, all trade took place by barter.
On the last day of barter, gold had value only for its direct consumption use, but on
the first day of its use as money, it took on an additional use as a medium of
exchange. In other words, on the first day of its use as a medium of exchange, gold
had two dimensions of utility: first, a direct consumption use; and second, a mone-
tary use that had a historical component in its utility.
Evaluating this regression theorem, Murray Rothbard, a student of Mises,
pointed out the continuity between Mises and Menger, who emphasized the evolu-
tionary and institutional elements of money:
Not only does the Mises regression theorem fully explain the current demand for
money and integrate the theory of money with the theory of marginal utility, but it
also shows that money must have originated in this fashion—on the market—with
individuals on the market gradually beginning to use some previously valuable
commodity as a medium of exchange. No money could have originated either by a
social compact to consider some previously valueless thing as a “money” or by sud-
den governmental fiat. For in those cases, the money commodity could not have a
previous purchasing power, which could be taken into account in the individual’s
demand for money. In this way, Mises demonstrated that Carl Menger’s historical
insight into the way in which money arose on the market was not simply a histori-
cal summary but a theoretical necessity. (“Austrian Theory of Money,” p. 169)

The Effect of Changes in Money on Relative Prices

Utilizing an insight first attributed to Richard Cantillon (see chapter 4), Mises
focused his monetary analysis on the effects of changes in the stock of money on
economic activity. Once again, he rejected the macroeconomic approach in favor of
methodological individualism. In response to the quantity theory advanced by John
Locke, Cantillon had argued that the result of an increase in the stock of money will
not be uniform across the economy but rather will cause prices to rise at uneven
rates in different sectors, thereby changing relative prices in the process. Mises
combined the marginal-utility theory of money with this “Cantillon effect” to eluci-
date the impact of changes in the supply of money.
In modern societies, when governments or central banks increase the supply of
money, they don’t do so in a way that affects everyone equally. Instead, new money is
created by the government or by banks to be spent on specific goods and services.
The demand for these specific goods rises, thereby raising their prices first. (The ele-
ments of this in a Misesian economy should now be clear: As money holdings
increase, the marginal utility of money declines so that certain goods are revalued
ahead of money on subjective preference scales, pushing the prices of these goods
upward.) Gradually the new money ripples through the economy, raising demand and
prices as it goes. Income and wealth are thereby redistributed to those who receive
the new money early in the process, at the expense of those who receive the new
money later, or those who live on fixed incomes and receive none of the new money.
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578 Part V ■ Twentieth-Century Paradigms

Recognizing these relative price effects and the ensuing wealth redistribution
they entail, Mises took a vigorous stand against inflationary expansion of the
money supply. Indeed, he argued that because the exchange services of money are
not increased by a higher stock of money, inflation will always be a zero-sum game,
benefiting some at the expense of others:
The services money renders are conditioned by the height of its purchasing power.
Nobody wants to have in his cash holding a definite number of pieces of money or
a definite weight of money; he wants to keep a cash holding of a definite amount of
purchasing power. As the operation of the market tends to determine the final state
of money’s purchasing power at a height at which the supply of and the demand
for money coincide, there can never be an excess or a deficiency of money. Each
individual and all individuals together always enjoy fully the advantages which
they can derive from indirect exchange and the use of money, no matter whether
the total quantity of money is great or small. Changes in money’s purchasing
power generate changes in the disposition of wealth among the various members
of society. From the point of view of people eager to be enriched by such changes,
the supply of money may be called insufficient or excessive, and the appetite for
such gains may result in policies designed to bring about cash-induced alterations
in purchasing power. However, the services which money renders can be neither
improved nor impaired by changing the supply of money. . . . The quantity of
money available in the whole economy is always sufficient to secure for everybody
all that money does and can do. (Human Action, p. 418)

It is clear from the above passage that Mises’s economic analysis made him wary of
the potential abuse present in every concentration of economic power. Monetary
expansion is a method by which the government, its controlled banking system, and
favored political groups are able to partially expropriate the wealth of other groups in
society. Having witnessed firsthand the German hyperinflation after World War I,
Mises remained skeptical of any government’s willingness to show monetary restraint
over long periods of time. It is for this reason, and not because he attributed any mysti-
cal qualities to gold, that Mises championed a gold standard as the best form of money.

■ F. A. HAYEK AND THE THEORY OF BUSINESS CYCLES

Mises’s theory of money and credit led to an Austrian theory of business cycles
based on changes in the supply of money, a theory elaborated most completely by
one of Mises’s students, Nobel laureate Friedrich A. Hayek. Like Mises, Hayek broke
with the quantity theory tradition because it ignored the effect of money on relative
prices. He continued the integration of monetary theory and value theory that Mises
had begun by exploring the effect of changes in the supply of money on the compo-
sition of output, rather than the quantity of output or the aggregate price level.
Hayek’s business-cycle theory is a blend of the Austrian theories of money, cap-
ital, and prices. In a nutshell, his explanation of the cycle runs like this: A monetary
disturbance (e.g., an increase in the money stock) causes interest rates to fall below
an equilibrium level, which stimulates investment in capital, thereby reallocating
resources away from the production of consumption goods toward production of
intermediate (capital) goods. As a consequence, prices of capital goods rise and
prices of consumption goods fall. This change in relative prices changes the struc-
ture of production. (Hayek viewed the entire process of production as a multistage
activity through which raw materials pass until they finally emerge as end products;
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Chapter 23 ■ Austrian Economics 579

therefore, a change in the number of stages or a reallocation of resources among

the different stages constitutes a change in the structure of production.) Because of
the longer time component of capital, such a change in the structure of production
leads to overinvestment in “longer” or more “roundabout” methods of production
and thereby upsets the coordination of plans between consumers and producers
and between savers and investors.
Although Hayek’s chief technical contribution to economic theory was his mon-
etary theory, his important conception of equilibrium as the coordination of eco-
nomic activities became the unifying theme in all of his writings. Coordination is
achieved when the plans of all economic decision makers mesh. How does this
come about? Decision makers look for signals. The appropriate signals are relative
prices. Hayek argued that if relative prices change due to the “natural” forces of
technology, tastes, time preference, and so forth, the ensuing adjustments will rees-
tablish a coordinated plan. But purely monetary disturbances evoke perverse sig-
nals by artificially raising rates of return on certain types of economic activity.
These rates of return can only be sustained as long as additional monetary stimulus
is forthcoming, so eventually every boom will be followed by a bust.
Hayek centered his business cycle theory on the market signals utilized by sav-
ers and investors to make their decisions. He emphasized that although these deci-
sions are arrived at independently, they are interdependent in terms of their
implications for equilibrium. Cycles occur when a general inconsistency of plans
comes about. In the case of a monetary stimulus, firms tend to switch to more capi-
tal-intensive methods at the expense of consumption-goods production, despite the
fact that no additional planned savings has taken place. According to Hayek:
This sacrifice is not voluntary, and is not made by those who will reap the benefit
from the new investments. It is made by the consumers in general who, because of
the increased competition from the entrepreneurs who have received the addi-
tional money, are forced to forego part of what they used to consume. It comes
about not because they want to consume less, but because they get less goods for
their money income. There can be no doubt that, if their money receipts should
rise again, they would immediately attempt to expand consumption to the usual
proportion. (Prices and Production, p. 57)

Hayek completed his research on monetary theory and business-cycle theory in

the 1930s, at a time when Keynesian macroeconomics was ascending. Eventually
his monetary theory was eclipsed by the so-called Keynesian revolution. In more
recent times, Hayek focused attention on other important analytical issues, espe-
cially the role of information in economic activity. This last contribution has shown
a greater survival value than Hayek’s earlier one, and Hayek has been timely in
anticipating a revival and reformulation of contemporary theories of competition.
Several aspects of the new theory of competition are discussed in chapter 26, partic-
ularly the ideas of knowledge, information, and transaction costs. While present
space and organizational structure prevent a complete discussion of Hayek’s contri-
bution to this literature, his pioneer efforts have had a major influence on the devel-
opment of contemporary economic thought.

■ JOSEPH SCHUMPETER ON COMPETITION, DYNAMICS, AND GROWTH

Joseph Schumpeter (1883–1950) was a third-generation Austrian economist
who rose to prominence as finance minister of the Austrian government. A student
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580 Part V ■ Twentieth-Century Paradigms

of Böhm-Bawerk at the University of Vienna, he later emigrated to the United States

in order to avoid Hitler’s onslaught. Although steeped in the Austrian microeco-
nomic tradition, Schumpeter reopened a classic macroeconomic line of inquiry—
the subject of economic development. In 1911, he published his Theory of Economic
Development, a book that won critical acclaim in Europe but made little impact on
English-speaking economists until it was translated into English in 1934. His second
major work, Business Cycles, followed in 1939.
Schumpeter blended ideas from Marx, Walras, and the German historian and
sociologist, Max Weber, with insights from his Austrian forebearers, Menger, Wie-
ser, and his teacher, Böhm-Bawerk. Like Marx, for whom he professed great admi-
ration, Schumpeter was no mere imitator—although he borrowed ideas from his
intellectual heroes he melded them into something uniquely his own. He shared
Marx’s view that economic processes are organic and that change comes from
within the economic system, not merely from without. He admired the blend of soci-
ology and economics involved in the writings of Marx and Weber. He also extolled
the contribution of Walras, from whom he borrowed the notion of the entrepreneur,
but transformed it into an active agent of economic progress, more in keeping with
the Austrian/German tradition. Schumpeter therefore made the entrepreneur a
dynamic force for economic change, the chief agent who causes disequilibrium (i.e.,
change) in a competitive economy.
Schumpeter regarded economic development as a dynamic process, a disturb-
ing of the economic status quo. Rather than consider economic progress as a mere
adjunct to the central body of orthodox economic theory, he saw it as the basis for
reinterpreting a vital process that had been crowded out of mainstream economic
analysis by the static, general-equilibrium approach. The entrepreneur is a key fig-
ure for Schumpeter because, quite simply, he or she is the persona causa of eco-
nomic development. Although the nature of competition may change over time, the
essential and pivotal role of the entrepreneur does not.

Entrepreneurs and Innovation

Like Menger and the second-generation Austrians, Schumpeter described com-
petition as a process involving mainly the dynamic (and disequilibrating) innova-
tions of the entrepreneur. Schumpeter used the concept of equilibrium as Weber
had used the stationary state—as a theoretical construct, a point of departure. He
coined a phrase to describe this equilibrium state: “the circular flow of economic
life.” Its chief characteristic is that economic life proceeds routinely on the basis of
past experience; there are no forces evident for any change of the status quo.
Schumpeter described the nature of production and distribution in the circular flow
in the following terms:
In every period only products which were produced in the previous period are con-
sumed, and . . . only products which will be consumed in the following period are
produced. Therefore workers and landlords always exchange their productive ser-
vices for present consumption goods only, whether the former are employed
directly or only indirectly in the production of consumption goods. There is no
necessity for them to exchange their services of labor and land for future goods or
for promises of future consumption goods or to apply for any “advances” of pres-
ent consumption goods. It is simply a matter of exchange, and not of credit trans-
actions. The element of time plays no part. All products are only products and
nothing more. For the individual firm it is a matter of complete indifference
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Chapter 23 ■ Austrian Economics 581

whether it produces means of production or consumption goods. In both cases the

product is paid for immediately and at its full value. (Economic Development, pp.
42–43)

In this hypothetical system, the production function is invariant, although fac-

tor substitution is possible within the limits of known technological horizons. The
only real activity that must be performed in this state is “that of combining the two
original factors of production, and this function is performed in every period
mechanically as it were, of its own accord, without requiring a personal element
distinguishable from [mere] superintendence” (Economic Development, p. 45). In
this artificial situation, the entrepreneur is a nonentity. There is nothing for him or
her to do because equilibrium is automatic and permanent. But such a state of being
does not apply to the dynamic world in which we live. Schumpeter wrote in Capital-
ism, Socialism, and Democracy (p. 84) that the really relevant problem is not how
capitalism administers existing structures, but how it creates and destroys them. He
called this process “creative destruction,” and maintained that it is the essence of
economic development. In other words, development is a disturbance of the circular
flow. It occurs in industrial and commercial life, not in consumption. It is a process
defined by the carrying out of new combinations in production. It is accomplished
by the entrepreneur.
Schumpeter reduced his theory to three elemental and corresponding pairs of
opposites: (1) the circular flow (i.e., tendency toward equilibrium) versus a change
in economic routine or data, (2) statics versus dynamics, and (3) entrepreneurship
versus management. The first pair consists of two real processes; the second, two
theoretical apparatuses; the third, two distinct types of conduct. Schumpeter main-
tained that the essential function of the entrepreneur is distinct from that of capital-
ist, landowner, laborer, or inventor. The entrepreneur may be any and all of these
things, but if so it is by coincidence rather than by nature of function. In principle
the entrepreneurial function is not connected to the possession of wealth, even
though “the accidental fact of the possession of wealth constitutes a practical
advantage” (Economic Development, p. 101). Moreover, entrepreneurs do not form
a social class, in the technical sense, although in a capitalist society they come to be
esteemed for their ability.
Schumpeter admitted that the entrepreneur’s basic function is almost always
mingled with other functions. “Pure” entrepreneurship is difficult to isolate from
other economic activity. But “management” does not describe the truly distinctive
role of the entrepreneur. Schumpeter wrote: “The function of superintendence in
itself, constitutes no essential economic distinction” (Economic Development, p. 20).
The function of making decisions is another matter, however. In Schumpeter’s the-
ory, the dynamic entrepreneur is the person who innovates, who makes “new com-
binations” in production. He described innovation in several ways. He first spelled
out the kinds of new combinations that underlie economic development. They
encompass the following: (1) creation of a new good or new quality of good, (2) cre-
ation of a new method of production, (3) the opening of a new market, (4) the cap-
ture of a new source of supply, and (5) a new organization of industry (e.g., creation
or destruction of a monopoly). Over time, of course, the force of these new combi-
nations dissipates, as the “new” becomes part of the “old” in the circular flow of eco-
nomic activity. But this does not change the essence of the entrepreneurial function.
Schumpeter claimed that people act as entrepreneurs only when they actually carry
out new combinations; they lose the character of entrepreneurs as soon as they
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582 Part V ■ Twentieth-Century Paradigms

have built up their business, after which they settle down to running it as other peo-
ple run their businesses.
Later, Schumpeter defined innovation in a more technical sense by means of
the production function. The production function, he said, “describes the way in
which quantity of product varies if quantities of factors vary. If, instead of quantities
of factors, we vary the form of the function, we have an innovation” (Business
Cycles, p. 62). Mere cost-reducing adaptations of knowledge lead only to new sup-
ply schedules of existing goods, however, so this kind of innovation must involve a
new commodity, or one of higher quality. He recognized that the knowledge behind
the innovation need not be new. It may be existing knowledge that has not been uti-
lized before. According to Schumpeter:

There never has been anytime when the store of scientific knowledge has yielded
all it could in the way of industrial improvement, and, on the other hand, it is not
the knowledge that matters, but the successful solution of the task sui generis of
putting an untried method into practice—there may be, and often is, no scientific
novelty involved at all, and even if it be involved, this does not make any difference
to the nature of the process. (“Instability of Capitalism,” p. 378)

In Schumpeter’s theory, successful innovation requires an act of will, not of

intellect. It depends, therefore, on leadership, not intelligence, and it should not be
confused with invention. Schumpeter was explicit on this last point:

To carry any improvement into effect is a task entirely different from the inventing
of it, and a task, moreover, requiring entirely different kinds of aptitudes. Although
entrepreneurs of course may be inventors just as they may be capitalists, they are
inventors not by nature of their function but by coincidence and vice versa.
Besides, the innovations which it is the function of entrepreneurs to carry out need
not necessarily be any inventions at all. (Economic Development, pp. 88–89)

Business Cycles
Schumpeter’s emphasis on the entrepreneur as the active agent for change in a
competitive economy provides a bridge between the microeconomics of the firm
and the macroeconomics of government policy. Within a Schumpeterian frame-
work, the ultimate impact on individual incentives that tax and spending policies
exert is felt through the transmission mechanism. Once again, the entrepreneur is
the focal point. Citing the experience of the U.S. economy in the 1920s, Schumpeter
raised the issue of whether taxes significantly affect the profit motive and economic
progress. The United States inaugurated a federal income tax in 1913, so the issue
was a timely one in the 1920s. Schumpeter evaluated the effects of a progressive
income tax on the entrepreneurial function:

Any tax on net earnings will tend to shift the balance of choice between “to do or
not to do” a given thing. If a prospective net gain of a million is just sufficient to
over-balance risks and other disutilities, then that prospective million minus a tax
will not be so, and this is as true of a single transaction as it is of series of transac-
tions and of the expansion of an old or the foundation of a new firm. Business
management and enterprise . . . will for its maintenance depend, at least in the
long run, on the actual delivery, in case of success, of the prizes which that scheme
of life holds out, and, therefore, taxes beyond a percentage that greatly varies as to
time and place must blunt the profit motive. (Business Cycles, pp. 291–292)
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Chapter 23 ■ Austrian Economics 583

True to his intellectual training, Schumpeter always kept an eye on the compet-
itive process, that maelstrom of economic activity that is composed of individual
decisions based on reigning economic incentives. He retained the Austrian perspec-
tive on macroeconomics, namely that all aggregates represent collective outcomes
of individual decisions. The causation runs from the individual to the collective,
however, as Menger taught, never the other way around. There may be numerous
institutional forces promoting or discouraging economic growth, but a key one, in
Schumpeter’s judgment, lies in a “do no harm” fiscal policy that includes low and/or
declining rates of taxation. In the vernacular of politics, Schumpeter was an early
“supply-sider.”
Schumpeter’s influence on the theory of economic development has been enor-
mous, even among those economists who reject the theory outright. And among
economists, especially those lacking historical perspective, the term “entrepreneur”
has become virtually synonymous with the name of Schumpeter. As theories of eco-
nomic change go, Schumpeter’s analysis occupies the middle ground between
Alfred Marshall and Max Weber. Marshall’s theory adapted incrementally to shifts
in preference and production functions, the result being a continuous improvement
in moral qualities, tastes, and economic techniques. Its shortcoming was that it did
not explain business cycles, a deficiency that Marshall’s student Keynes set out to
remedy. Marshall’s approach also implied a theory of unilinear progress, which
Schumpeter’s theory denies. Weber’s theory developed its own set of moral impera-
tives and used them to explain rapid social and economic transitions that punctuate
long periods of historical continuity. Borrowing from Weber Schumpeter postulated
the continuous occurrence of innovations and waves of adaptation simply because
entrepreneurs are always present and are a constant force for change.
Ultimately, the appeal of Schumpeter’s theory of economic development
derives from its simplicity and its power, characteristics evident in the Schumpete-
rian phrase: “The carrying out of new combinations we call ‘enterprise’; the individ-
ual whose function it is to carry them out we call ‘entrepreneurs’” (Economic
Development, p. 74). Yet, despite the importance of Schumpeter’s contribution to
economic development, his dynamic approach and his holistic vision of economic
activity have failed to dominate economic analysis. Conventional economics still
works mainly by intellectual specialization and division of labor.

■ COMPETITION AND THE MARKET PROCESS

As a result of the combined influence of many economic theorists, but espe-
cially Cournot and Walras, “competition” took on a meaning in the nineteenth cen-
tury quite apart from the practical but ambiguous sense it was given in classical
economics. Early use of the term meant simply rivalrous behavior (e.g., in Adam
Smith); in other words, two or more parties seeking the same prize, which was usu-
ally economic profits. The subtle but lasting influence of Cournot and Walras was to
change this notion from what may basically be described as a process to what may
be described as a situation. Emphasis turned away from the institutional setting and
the personalities involved and toward the conditions that must be fulfilled in order
to yield an equilibrium result.2 Thus, the notion of “perfect competition” emerged, a
notion that encapsulated the following conditions: (1) perfect knowledge of every

2
This development may have been accelerated, as we hinted in chap. 20, by the advent of “imper-
fect” competition in the works of Chamberlin and Robinson.
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584 Part V ■ Twentieth-Century Paradigms

relevant utility function of both buyers and sellers and of all relevant prices, (2) an
infinitely large number of buyers and sellers, (3) complete and open entry and exit
of all firms, (4) constant expectations, and (5) homogeneous products. When these
conditions operate, the “competitive equilibrium” results—that is, a uniform price
for each good, a “normal” level of profits for each producer, utility maximization for
each consumer, and no further tendency for things to change. The assumptions of
competition are, therefore, nothing else but the conditions necessary to make equi-
librium “determinate.”
The “competitive model” so briefly sketched here has performed yeoman ser-
vice in the evolution of economic theory because it has made it possible to give an
exact account of the course of economic events solely with the aid of scientific gen-
eralizations. In any analytical study, forces whose operations are known must be
separated from those that exhibit no uniform principles. The only satisfactory way
of recognizing and accounting for the influence of the latter in the real world is to
assume them away and observe what happens in their absence. This method of
omission and comparison also offers the best hope that we can gradually extend the
range of phenomena over which we can make generalizations. But it should be
obvious that this technique requires constant awareness of its limitations as well as
its strengths.
It has never been easy to convince people that the way to discover reality is
through unreality—yet that is what the neoclassical model of perfect competition
requires. Modern Austrians offer an alternative that claims to be more realistic
because it attempts to incorporate aspects of the human personality excluded from
the neoclassical, mechanistic model. In particular the Austrian approach seeks to
deal explicitly with individuals’: (1) knowledge about their own tastes and the oppor-
tunities available, (2) interpretations of current events and others’ actions, (3) expec-
tations about future events and behavior, and (4) alertness to new opportunities
previously unrecognized. In the Austrian view the key insight into competition is that
different people know different things. The market is a process whereby scattered
and often contradictory bits of information are assimilated and transmitted to individ-
ual market participants; in Hayek’s phrase, the competitive market process is a dis-
covery procedure. Competition—not in the technical sense of “perfect competition,”
but in the older sense of rivalry—is the engine that drives the market process down
the road to coordination of individual plans (the Austrian conception of equilibrium).
Hayek has never tired of pointing out that if all that needed to be known was
already known, then every market decision would correctly anticipate every other
decision and the market would automatically attain full equilibrium. Instead, the
market is necessary precisely because it is an institutional device for mobilizing
existing knowledge and making it available to market participants who are not
omniscient. Taking the argument one step further, Austrians argue that the compet-
itive market process is needed not only to mobilize existing knowledge but also to
generate awareness of new opportunities. The discoverers of these new opportuni-
ties are the entrepreneurs, who take on a far more crucial role in the Austrian para-
digm than was previously assigned to them by classical or neoclassical economics.
Indeed, in the Austrian framework, the competitive process is by its very nature an
entrepreneurial process.
The standard neoclassical theory employs the concept of “economizing,” or
maximizing utility subject to given tastes and prices, which is inadequate to explain
the search for new opportunities, whether they consist of new products or varia-
tions on existing ones. Likewise, the terms “prices” and “profits” have a more
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Chapter 23 ■ Austrian Economics 585

restricted definition in standard use. Conventional theory assumes that the firm
confronts known and given cost and revenue possibilities; that is, profit maximiza-
tion does not entail discovery of a profit opportunity. Instead, it merely requires cal-
culative action to explain already existing and recognized opportunities.
In the Austrian view, this takes too much for granted. The Austrian approach
views prices as (disequilibrium) exchange ratios representing the incomplete dis-
coveries and current errors made up to the moment by profit-seeking entrepre-
neurs. Thus, market prices offer opportunities for pure profit, and it is up to the
alert entrepreneurs to sniff out these opportunities and act on them. This view of
profit, significantly, has nothing to do with monopoly power. It is merely the reward
for noticing some lack of coordination in the market, and acting on it. As such, it is
a necessary incentive for the discovery of new knowledge, not (as in the standard
theory) a minimal payment to a disembodied economic agent to stand pat.

■ ADVERTISING AND DEMAND DISCOVERY

In light of the attempts by Chamberlin and Robinson to replace or supplement
the notion of perfect competition (see chapter 20), the Austrian approach takes on
additional interest. Among contemporary Austrian economists, Israel Kirzner, for
one, views the Chamberlin–Robinson reformulation as misguided:
The new theories failed to perceive that the characteristic features of the real world
are simply the manifestations of entrepreneurial competition, a process in which
would-be buyers and sellers gropingly seek to discover each other’s supply and
demand curves. The new theories merely fashioned new equilibrium configura-
tions—based, as was the theory of perfect competition—on given and known
demand and supply curves—differing from the earlier theory only in the shapes
assigned to these curves. In the course of attempting to account for such market
phenomena as quality differentiation, advertising, markets in which few producers
were to be found, the new theories were led to conclusions which grossly misinter-
pret the significance of these phenomena. (Competition and Entrepreneurship, p. 29)

The basis for Kirzner’s claim is that the theory of monopolistic competition
rules out the discovery process. There is no awareness of the need for manufactur-
ers and consumers to experiment in order to find those products and variations that
are most wanted. Like the theory it was supposed to supplement, it assumed the
market demand to be given beforehand. A second weakness noted by other writers
besides Austrians is that the theory offers no explanation of how product differenti-
ation can persist in equilibrium, that is, why rival firms cannot duplicate those prod-
uct variations that prove successful.
In particular, Austrian economics has provided fresh insights into advertising,
which proved to be something of an embarrassment to traditional economic theory.
If consumers always have perfect information about the products available, there is
no rational explanation for the persistence of advertising. Indeed, it would seem
wasteful. To Chamberlin and others, advertising was one way of conveying informa-
tion to consumers about a product they knew existed. As such, it would be innocu-
ous, even helpful. But persuasion is another matter. Most economists objected to
persuasive advertising as unabashed hucksterism. Austrian thinking departs sub-
stantially from the conventional view. The Austrians admit that consumers do not
always know what products are available, and even if they do, they are not usually
informed about their properties. Consequently, the seller has a role in capturing the
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586 Part V ■ Twentieth-Century Paradigms

consumer’s attention. But in the Austrian view it doesn’t matter whether advertising
is purely informational, purely persuasive, or some combination of the two. What
matters is that the products are noticed, for then and only then can consumers act
entrepreneurially—that is, exercise their decision-making ability.
In a similar fashion, the Austrian notion of monopoly stands outside the ortho-
dox view. Standard theory traditionally assumes that a monopolist’s demand curve is
known and that his or her ability to raise prices and increase profits depends on the
shape of that curve. It is not always explained how monopolists came to know the
demand curve, why they are sole producers, and why the threat of competition from
other firms does not prevent them from acting as they do. Austrian economists con-
front these questions from the perspective of demand discovery. They maintain that
the presence of monopoly in no way obviates the need for market discovery. Whether
or not a firm is a monopolist, it must discover what its customers want and what they
are willing to pay for it. Therefore, monopolists are subject to the same competitive
market process as other firms. Moreover, monopolists must compete with producers
of new and better products even if they do not face competition from producers of
the same product. Hence it is misleading to characterize monopoly as “the absence
of competition.” Rather, monopoly implies barriers to entry. Kirzner has said:
The existence of rivalrous competition requires not large numbers of buyers and
sellers but simply freedom of entry. Competition places pressure on market partici-
pants to discover where and how better opportunities, as yet unnoticed, might be
offered to the market. The competitive market process occurs because equilibrium
has not yet been attained. This process is thwarted whenever non-market barriers
are imposed blocking entry to potential competitors. (“Perils of Regulation,” p. 9)

One way to gain an appreciation for the operation of the market process is by
reviewing the socialist calculation debate that took place over an extended period of
time between Mises and Hayek on the one hand and Oskar Lange and H. D. Dickin-
son on the other. Mises and Hayek illuminated the enormous difficulties confront-
ing socialist planners trying to emulate the market’s result without an actual market
in operation. Lange and Dickinson, joined later by Abba Lerner and others, main-
tained that efficient allocation is achievable under socialism so long as socialist
managers follow well-prescribed rules in decision making.

■ THE SOCIALIST CALCULATION DEBATE

Mises fired the opening salvo in the socialist calculation debate in 1922 by ques-
tioning whether socialism was possible at all—whether modern industrialized soci-
ety could continue to exist if organized along socialist lines. He attacked the basic
premise of socialist theorists that the economy could be planned and directed effi-
ciently after a socialist state had abolished money, markets, and the price system.
He argued that money prices determined in a market economy were necessary for
rational economic calculation. The price system allows resources to freely flow to
their most highly valued uses; indeed, it directs resources to their highest valued
use. For example, it is technically feasible to construct subway rails out of platinum
rather than steel, but to use platinum would be inefficient in the face of less expen-
sive substitutes. Only the price system, representing the competing bids of all
potential users of platinum, guarantees that such judgments are made. Without the
price system, Mises argued, resources could not be allocated efficiently and the
economy would function at a primitive level.
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Chapter 23 ■ Austrian Economics 587

Socialist economists confronted Mises’s challenge head-on, with some of the

most prominent socialist writers, particularly Oskar Lange and Abba Lerner,
acknowledging that Mises had uncovered an important weakness in the socialist
theory. Lange even half-seriously proposed that in the future socialist common-
wealth a statue be erected to Mises so that no one would forget that prices and mar-
kets are essential under socialism, too. But of course, the socialists launched a
counterattack. Lange started with a tactical retreat. He claimed that socialism
would work if socialist planning were substituted for the market mechanism. In
other words, the state would set prices for goods and factors of production instead
of the market. Managers of state-owned firms would then produce until the mar-
ginal cost of their output equaled the “shadow” price of the good. Resources
required to produce finished goods would be requisitioned in accordance with this
rule, and the state would stand ready to adjust prices in response to any shortages
or surpluses that might result.
As clever as this response appeared on the surface, Mises and Hayek now
responded with an even more devastating critique. The problem with the state “imi-
tating” the market, they argued, is that the ex ante prices established by govern-
ment functionaries could never convey accurate information regarding the true
opportunity costs associated with resource use. The enormous amount of detailed,
specific information required for state-determined prices to match market prices, if
it could be made available to government bureaucrats, would only be forthcoming
at huge transaction costs. In addition, for socialism to approximate market perfor-
mance, individual incentives would have to be structured to ensure that people
within the system would use information and resources efficiently. This could hap-
pen only if property were privately owned, a circumstance rejected by socialism.
At its most fundamental level, the socialist calculation debate was a contest
over theoretical models. Socialist economic theory is based on Walrasian general-
equilibrium models within which the central planning board takes the place of the
Walrasian auctioneer. Lange proposed that a central planning board administer
resource prices and allow consumer goods to be priced in free markets in order to
provide accurate information for factor evaluation. Factor prices would then
respond to market eventualities, and the whole process would, by trial and error,
simulate the Walrasian tâtonnement process. For their part, Mises and Hayek
rejected the Walrasian model as unrealistic and inappropriate. In either its pure
form or its socialist guise it could not capture enough important features of the real
world to make it applicable. In particular, Hayek argued that the information
required by the socialist calculation theory can only be ascertained by a continuous
process of market discovery. The Austrian criticism was essentially the same as that
leveled at the neoclassical model, namely that the proponents of socialism did not
understand the nonparametric function of prices. Somewhere along the way in the
evolution of economic theory, neoclassical economists had forgotten or ignored
Cantillon’s original vision of the market as an arena in which market participants
(i.e., entrepreneurs) nudge prices in the direction of equilibrium by exploiting profit
opportunities offered by disequilibrium prices. This vision has been more consis-
tently grasped and maintained by Austrian economists than by any other group.
Consequently, they attributed the socialists’ myopia to an inappropriate perception
of how “perfect” markets operate.
As usual, Hayek gave the most forceful counterargument to the socialist posi-
tion. In a nutshell, he argued as follows: The information that individuals use to
guide their economic activity is vast, detailed, fragmented, and often idiosyncratic.
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588 Part V ■ Twentieth-Century Paradigms

It is not neatly captured in objective demand and supply functions that are at the
ready command of the central planners, because such information is the subject of
continuous discovery through entrepreneurial action and counteraction. Neoclassi-
cal economics stresses only one kind of knowledge—the “engineering knowledge”
of technical input-output relations. Austrian economics recognizes and emphasizes
the specific knowledge of “time and place,” which leads to the perception of profit
opportunities in advance of the crowd, as well as the kind of knowledge that enables
an individual to conceptualize new methods and new products that may bring large
rewards. Market prices in this framework are not parameters. They are the unique
and timely results of numerous transactions by individuals possessed of these vari-
ous bits and forms of knowledge. In turn these prices serve as signals by which
decentralized knowledge is collected and coordinated into a systematic whole.
The problem that Mises and Hayek were attacking at base was the effects of
different specifications of property rights on individual economic decision making.
This is a wide-ranging issue that does not confine itself to the dichotomy between
socialism and capitalism. It also pervades the issue of economic regulation, which is
a major theme of chapter 24.
Eight decades after the socialist calculation debate began, we may well ask in
retrospect how relevant was the controversy. At the end of the twentieth century
socialism seemed to be in retreat, but in the new millennium, it seems to be resur-
gent. As Mark Twain said of himself—“the rumors of my death have been greatly
exaggerated”—the same might be said of socialism. Despite claims that they have
enlarged the sphere of private market activity and embraced other capitalist
reforms, two of the world’s largest countries, China and Russia, continue to direct
large segments of their economies from the center. And in many underdeveloped
countries, authoritarian leaders continue to cling to the socialist model. No one
knows what the future holds, but history informs us of two sobering facts about
centrally planned economies. First, their economic performance is poor by compar-
ison with capitalist market economies—in some cases, disastrously so. Second, the
private sector in socialist economies, usually existing in the form of illegal under-
ground economies, is typically large and important. These facts offer at least a par-
tial vindication of the Austrian critique of socialism.

■ CONCLUSION
The tradition of economic inquiry begun by Menger continues in the writings of
many contemporary economists who adopt the “Austrian” orientation. In this chap-
ter, we have seen that the Austrian tradition is wide-ranging. It starts with the the-
ory of subjective wants, then builds on that primal insight in a methodologically
consistent fashion to elucidate broader topics such as money, credit, banking, busi-
ness cycles, economic development, and the very nature of competition. The distin-
guishing feature of Austrian macroeconomics is its overriding concern for the
microeconomic foundations of macroeconomic principles. While this same concern
has been expressed with renewed fervor by many conventional economists in the
wake of the perceived failures of Keynesian macroeconomics, many “Austrian”
ideas have been ignored by mainstream economic theory. For example, if contem-
porary monetary economics seems far removed from the concerns of Mises and
Hayek, the reason is that it treats all increases in the quantity of money as being
essentially alike and assumes that relative prices remain unaltered in the wake of
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Chapter 23 ■ Austrian Economics 589

the monetary change. In this way it disregards the question of the transmission
mechanism by which the new money makes its impact felt on the macroeconomy.
In the final analysis, the monetarists and the Austrians are closer together than
the monetarists and the Keynesians. What the monetarists and the Austrians share
is the belief that changes in the quantity of money are the primary cause of aggre-
gate instability. The Austrians, however, have been more sensitive to the ubiquitous
effects of changes in relative prices caused by monetary changes. Understanding
these differences helps to sort out the various policy proposals that are likely to
emanate from each camp. In the face of the Keynesian challenge that “money does
not matter,” the monetarists have counterattacked that “money does matter.”
Though unspoken, Mises’s monetary theory takes the phrase one step further: In
the Austrian view, “money matters all the time!”

REFERENCES
Hayek, F. A. Prices and Production, 2d ed. London: Routledge & Kegan Paul, 1935.
———. The Counter-Revolution of Science: Studies on the Abuse of Reason. Indianapolis:
Liberty Press, 1979.
Jaffé, William. “Menger, Jevons and Walras De-Homogenized,” Economic Inquiry, vol. 14
(December 1976), pp. 511–524.
Kirzner, I. M. Competition and Entrepreneurship. Chicago: The University of Chicago
Press, 1973.
———. “The Perils of Regulation: A Market Process Approach.” Miami: Law and Eco-
nomics Center Occasional Paper, 1978.
Mises, Ludwig von. The Theory of Money and Credit, H. E. Batson (trans.). New York:
The Foundation for Economic Education, 1971 [1912].
———. Human Action: A Treatise on Economics. New Haven: Yale University Press, 1949.
Rothbard, M. N. “The Austrian Theory of Money,” in E. G. Dolan (ed.), The Foundations
of Modern Austrian Economics. Kansas City: Sheed & Ward, 1976.
Salerno, J. T. “The Place of Mises’s Human Action in the Development of Modern Eco-
nomic Thought,” Quarterly Journal of Austrian Economics, vol. 2 (Spring 1999), pp.
35–65.
Schumpeter, J. A. “The Instability of Capitalism,” Economic Journal, vol. 38 (1928), pp.
361–386.
———. The Theory of Economic Development, 2d ed., R. Opie (trans.). Cambridge, MA:
Harvard University Press, 1934.
———. Business Cycles. New York: McGraw-Hill, 1939.
———. Capitalism, Socialism, and Democracy, 3d ed. New York: Harper & Row, 1950.
———. History of Economic Analysis, E. B. Schumpeter (ed.). New York: Oxford Univer-
sity Press, 1954.

NOTES FOR FURTHER READING

For an exposition of the Austrian gestalt, see L. H. White, The Methodology of the
Austrian School (New York: The Center for Libertarian Studies, 1977), and A. H. Shand,
Subjectivist Economics: The New Austrian School (Exeter: Short Run Press, 1980). See
also, E. G. Dolan (ed.), The Foundations of Modern Austrian Economics (Kansas City:
Sheed & Ward, 1976); S. C. Littlechild, The Fallacy of the Mixed Economy (London: Insti-
tute for Economic Affairs, 1978); L. S. Moss (ed.), The Economics of Ludwig von Mises
(Kansas City: Sheed & Ward, 1976); G. P. O’Driscoll, Economics as a Coordination Prob-
lem: The Contributions of Friedrich A. Hayek (Kansas City: Sheed & Ward, 1977); W. D.
Reekie, Industry, Prices and Markets (New York: Wiley, 1979); M. J. Rizzo (ed.), Time,
Ekelund-Hebert 6E.book Page 590 Thursday, August 1, 2013 11:03 AM

590 Part V ■ Twentieth-Century Paradigms

Uncertainty and Disequilibrium: Exploration of Austrian Themes (Lexington, MA: Heath,

1979); and L. M. Spadaro, New Directions in Austrian Economics (Kansas City: Sheed &
Ward, 1978).
Edward Elgar has published several volumes attempting to establish the economic
legacy of famous third-generation Austrians; see, The Legacy of Ludwig Von Mises, Peter
J. Boettke and Peter T. Leeson (eds.) (Cheltenham, UK: Edward Elgar, 2006); The Legacy
of Friedrich A. Hayek, Peter J. Boettke, Andrew Farant, Greg Ransom, and Gilberto Sal-
gado (eds.) (Cheltenham, UK: Edward Elgar, 2000); and The Legacy of Joseph A. Schum-
peter, Horst Hanusch (ed.) (Cheltenham, UK: Edward Elgar, 1999). For particularly cogent
views from notable “insiders,” see Ludwig von Mises, The Historical Setting of the Aus-
trian School (New Rochelle, NY: Arlington House, 1969); L. M. Lachmann, “The Impor-
tance in the History of Ideas of the Austrian School of Economics,” J. H. McCulloch
(trans.), Zeitschrift für Nationalökonomie, vol. 26 (1966), pp. 152–167; and F. A. Hayek,
“Economic Thought: The Austrian School,” International Encyclopedia of the Social Sci-
ences, vol. 4 (1968), pp. 458–462. Earlene Craver, “The Emigration of the Austrian Econo-
mists,” History of Political Economy, vol. 18 (Spring 1986), pp. 1–32, recounts the early
academic careers of third-generation Austrians, especially Mises, Hayek, and Schumpeter.
Mises’s magnum opus, Human Action: A Treatise on Economics (New Haven, CT:
Yale University Press, 1949), is a much-neglected book that still repays careful reading.
Eamon Butler, Ludwig von Mises: Fountainhead of the Modern Microeconomics Revolu-
tion (Brookfield, VT: Gower Publishing, 1988), presents a clear and well-reasoned expo-
sition of the main lines of Mises’s work. Mises’s opening salvo in the socialist calculation
debate has been translated and reprinted in Collectivist Economic Planning, F. A. Hayek
(ed.) (London: Routledge, 1935). See also Ludwig Mises, Socialism: An Economic and
Sociological Analysis, J. Kahane (trans.) (New Haven, CT: Yale University Press, 1951).
Additional appreciations of the problems involved in socialist planning can be found in
G. W. Nutter, “Markets without Property: A Grand Illusion,” in Money, the Market and
the State: Essays in Honor of James Muir Waller, N. A. Beadles and L. A. Drewry, Jr.
(eds.) (Athens: University of Georgia Press, 1968); and in D. T. Armentano, “Resource
Allocation Problems under Socialism,” W. P. Snavely (ed.), Theory of Economic Systems:
Capitalism, Socialism, Corporatism (Columbus, OH: Merrill, 1969).
The socialist side of the debate was put forth most vigorously by Oskar Lange and F.
M. Taylor, On the Economic Theory of Socialism, B. E. Lippincott (ed.) (New York:
McGraw-Hill, 1964); H. D. Dickinson, Economics of Socialism (London: Oxford Univer-
sity Press, 1939); and A. P. Lerner, The Economics of Control (New York: Macmillan,
1944). Peter Murrell, “Did the Theory of Market Socialism Answer the Challenge of Lud-
wig Von Mises? A Reinterpretation of the Socialist Controversy,” History of Political
Economy, vol. 15 (Spring 1983), pp. 92–105, contends that the socialist reply to Mises was
not definitive and that modern economics now has the tools to confront the issues Mises
raised long ago. For more on this debate, see G. K. Chaloupek, “The Austrian Debate on
Economic Calculation in a Socialist Economy,” History of Political Economy, vol. 22 (Win-
ter 1990), pp. 659–675; Don Lavoie, Rivalry and Central Planning: The Socialist Calcula-
tion Debate Reconsidered (New York: Cambridge University Press, 1985); and J. T.
Salerno, “Ludwig von Mises as Social Rationalist,” Review of Austrian Economics, vol. 4
(1990), pp. 26–54. Steven Horwitz, “Monetary Calculation and Mises’s Critique of Plan-
ning,” History of Political Economy, vol. 30 (Fall 1998), pp. 427–450, concluded that the
Austrian position has often been misunderstood—the central issue for Mises was always
how prices emerge in a money-using economy. Mateusz Machaj, “Market Socialism and
the Property Problem: Different Perspective of the Socialist Calculation Debate,” Quar-
terly Journal of Austrian Economics, vol. 10 (Winter 2007), pp. 257–280, presents an
updated summary and appreciation of the socialist calculation debate and a careful con-
sideration of the different arguments advanced by the major contributors.
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Chapter 23 ■ Austrian Economics 591

Regarded as one of the preeminent thinkers of the twentieth century, as much for
his work outside economics as for his work within, Hayek made contributions to the
fields of economics, psychology, political philosophy, and the methodology of the social
sciences. Hayek’s The Constitution of Liberty (Chicago: University of Chicago Press,
1960) has become a classic of its kind; and his three-volume work, Law, Legislation and
Liberty (Chicago: University of Chicago Press, 1973–79) is destined for the same. The
role of psychology in shaping Hayek’s thought is the subject of Nicolò De Vecchi, “The
Place of Gestalt Psychology in the Making of Hayek’s Thought,” History of Political
Economy, vol. 35 (Spring 2003), pp. 135–162. On economics as a coordination problem
and the emergence of spontaneous order, see Müfit Sabooglu, “Hayek and Spontaneous
Orders,” Journal of the History of Economic Thought, vol. 18 (Fall 1996), pp. 347–364.
In the first-ever biography of Hayek, Lanny Ebenstein, Friedrich Hayek: A Biogra-
phy (London: Palgrave Macmillan, 2001), attempted to take the full measure of Hayek’s
accomplishment. A somewhat higher flight has been taken by Bruce Caldwell, Hayek’s
Challenge: An Intellectual Biography of F. A. Hayek (Chicago: University of Chicago
Press, 2004). Caldwell is also general editor of The Collected Works of F. A. Hayek, a
series published by the University of Chicago Press. Hayek on Hayek: An Autobiograph-
ical Dialogue, Stephen Kresge and Leif Weinar (eds.) (Chicago: University of Chicago
Press, 1994), is a complete collection of previously unpublished autobiographical
sketches and a wide selection of interviews.
We will not attempt to give an exhaustive bibliography of Hayek’s writings here, but
see O’Driscoll (op. cit.) for more detail. A significant number of Hayek’s early and later
writings on Austrian themes have been collected and published in three short books:
Prices and Production (London: Routledge, 1935); Individualism and Economic Order
(Chicago: University of Chicago Press, 1948); and New Studies in Philosophy, Politics,
and the History of Ideas (Chicago: University of Chicago Press, 1978). Of general inter-
est, see Bruce Caldwell, “Hayek’s Transformation,” History of Political Economy, vol. 20
(Winter 1988), pp. 513–541; same author, “Why Didn’t Hayek Review Keynes’s General
Theory?” History of Political Economy, vol. 30 (Winter 1998), pp. 545–569. For a reply to
Caldwell’s query, see Susan Howson, “Why Didn’t Hayek Review Keynes’s General The-
ory? A Partial Answer,” History of Political Economy, vol. 33 (Summer 2001), pp. 369–
374. Papers probing the nature of Hayek’s business cycle theory include: G. R. Steele,
“Hayek’s Contribution to Business Cycle Theory: A Modern Assessment,” History of
Political Economy, vol. 24 (Summer 1992), pp. 477–492; Hans-Michael Trautwein,
“Money, Equilibrium, and the Business Cycle: Hayek’s Wicksellian Dichotomy,” History
of Political Economy, vol. 28 (Spring 1996), pp. 27–55; Harald Hagemann and Hans-
Michael Trautwein, “Cantillon and Ricardo Effects: Hayek’s Contributions to Business
Cycle Theory,” The European Journal of the History of Economic Thought, vol. 5 (Sum-
mer 1998), pp. 292–316; J. P. Cochran and F. R. Glahe, “The Keynes–Hayek Debate: Les-
sons for Contemporary Business Cycle Theorists,” History of Political Economy, vol. 26
(Spring 1994), pp. 69–96. Roger W. Garrison, “Overconsumption and Forced Saving in
the Mises–Hayek Theory of the Business Cycle,” History of Political Economy, vol. 36
(Summer 2004), pp. 323–349, attempts to sort out the differences between Mises and
Hayek and reconcile the Austrian theory with contemporary macroeconomics.
Although a significant amount of attention has been devoted to Hayek’s business
cycle theory, much less attention has been lavished on the banking theory underpinning
his business cycle model. For a notable exception, see Lawrence H. White, “Why Didn’t
Hayek Favor Laissez Faire in Banking?” History of Political Economy, vol. 31 (Winter
1999), pp. 753–769; and same author, “Hayek’s Monetary Theory and Policy: A Critical
Reconstruction,” Journal of Money, Credit and Banking, vol. 31 (February 1999), pp.
109–120. J. S. Ferris and J. A. Galbraith, “On Hayek’s Denationalization of Money, Free
Banking and Inflation Targeting.” The European Journal of the History of Economic
Thought, vol. 13 (2006), pp. 213-231, examine Hayek’s proposals for banking reform.
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Various aspects of Hayek’s thought covering subjectivism, methodology, and institu-

tions are treated by: William Butos and Roger Koppl, “The Varieties of Subjectivism:
Keynes and Hayek on Expectations,” History of Political Economy, vol. 29 (Summer
1997), pp. 327–359; K.-H. Paqué, “Pattern Predictions in Economics: Hayek’s Methodol-
ogy of the Social Sciences Revisited,” History of Political Economy, vol. 22 (Summer
1990), pp. 281–294; and P. Garrouste, “Menger and Hayek on Institutions: Continuity and
Discontinuity,” Journal of the History of Economic Thought, vol. 16 (Fall 1994), pp. 270–
291. An even broader array of papers was collected from the first conference of the Asso-
ciation des Historiens de la Tradition Économique Autrichienne and published under the
title, F. A. Hayek as a Political Economist. Economic Analysis and Values, Jack Birner,
Pierre Garrouste, and Thierry Aimar (eds.) (London: Routledge, 2002).
In many respects, Hayek’s The Road to Serfdom (Chicago: The University of Chi-
cago Press, 1944), has never lost its relevance. Ben Jackson, “Freedom, the Common
Good, and the Rule of Law: Lippmann and Hayek on Economic Planning,” Journal of the
History of Ideas, vol. 73 (January 2012), pp. 47–68, weighs Walter Lippmann’s influence
in the 1930s and ’40s on Hayek’s political thought and notes that Lippmann anticipated
Hayek’s later arguments that: Planning would destroy civil and political freedom, certain
legal orders are necessary for the preservation of liberty, and critics of planning should
be able to produce a suitable replacement consistent with the previous principle.
Generalized dissatisfaction with Keynesian fiscal policies in the postwar period has
generated resurgent interest in Schumpeter and his ideas. Two biographies on Schum-
peter and his work are R. L. Allen, Opening Doors: The Life and Work of Joseph Schum-
peter, 2 vols. (New Brunswick, NJ: Transaction Publishers, 1991), and Richard
Swedberg, Schumpeter: A Biography (Princeton, NJ: Princeton University Press, 1991),
which has received more favorable reviews. Also by Swedberg, “Joseph A. Schumpeter
and the Tradition of Economic Sociology,” Journal of Institutional and Theoretical Eco-
nomics, vol. 145 (September 1989), pp. 508–524, traces the influence of Weber and Som-
bart on Schumpeter’s thought. Yuichi Shionoya, “Schumpeter on Schmoller and Weber:
A Methodology of Economic Sociology,” History of Political Economy, vol. 23 (Summer
1990), pp. 193–220, is a complement to Swedberg’s article. Also see Yuichi Shionoya,
Schumpeter and the Idea of Social Science (Cambridge University Press, 1997).
Peter Kesting, “The Interdependence between Economic Analysis and Methodology
in the Work of Joseph A. Schumpeter,” The European Journal of the History of Economic
Thought, vol. 13 (2006), pp. 387–410, examines Schumpeter’s work from a methodologi-
cal perspective, concluding that Schumpeter’s total economic work can be properly
understood only from the point of view of methodology. Agnès Festré and Eric Nasica,
“Schumpeter on Money, Banking and Finance: an Institutionalist Perspective,” The Euro-
pean Journal of the History of Economic Thought, vol. 16 (2009), pp. 325–356, claim that
an institutional analysis of Schumpeter’s theory of money, banking, and finance is natu-
ral given his emphasis on economic sociology in his methodological views.
Schumpeter’s big themes of entrepreneurship and innovation are explored by Nicolò
De Vecchi, Entrepreneurs, Institutions and Economic Change: The Economic Thought of J.
A. Schumpeter (Cheltenham, UK: Edward Elgar, 1995); Enrico Santarelli and Enzo Pesci-
arelli, “The Emergence of a Vision: The Development of Schumpeter’s Theory of Entrepre-
neurship,” History of Political Economy, vol. 22 (Winter 1990), pp. 677–696; and Govidan
Parayil, “Schumpeter on Invention, Innovation and Technological Change,” Journal of the
History of Economic Thought, vol. 13 (Spring 1991), pp. 78–89. Mark W. Frank, “Schum-
peter on Entrepreneurs and Innovation,” Journal of the History of Economic Thought, vol.
20 (December 1998), pp. 505–516, denies the dichotomous nature of Schumpeter’s entre-
preneur. Joseph Alois Schumpeter: Entrepreneurship, Style and Vision, Juergen Backhouse
(ed.) (Dordrecht, Netherlands: Kluwer Publishers, 2003), offers a somewhat broader
sweep; of particular interest in this volume is the chapter by Alexander Ebner, “The Institu-
Ekelund-Hebert 6E.book Page 593 Thursday, August 1, 2013 11:03 AM

Chapter 23 ■ Austrian Economics 593

tional Analysis of Entrepreneurship: Historicist Aspects of Schumpeter’s Development

Theory,” pp. 117–140, which offers a reconstruction of Schumpeter’s concept of entrepre-
neurship in light of the influence of Gustave Schmoller (see chapter 11). Gilles Campag-
nolo and Christel Vivel, “Before Schumpeter: Forerunners of the Theory of the
Entrepreneur in 1900s German Political Economy—Werner Sombart, Friedrich von Wie-
ser,” The European Journal of the History of Economic Thought, vol. 19, (November 2012),
pp. 908–943, question the conceptual connection between Schumpeter, Sombart, and Wie-
ser on entrepreneurship by showing which views these authors shared on the character of
the entrepreneur, the role of the entrepreneurial function in the economic process, and the
evolution of entrepreneurship until the stage of developed capitalism. They conclude that
the entrepreneur is a keystone for building capitalism. Joseph T. Salerno, “The Entrepre-
neur: Real and Imagined.” Quarterly Journal of Austrian Economics, vol. 11 (2008), pp.188–
207, provides an overview of the Austrian approach to the entrepreneur through a textual
analysis of the writings of its key proponents and discusses the differences between the
approaches taken by Mises and Kirzner. Nicolai J. Foss and Peter G. Klein, Organizing
Entrepreneurial Judgment: A New Approach to the Firm (Cambridge: Cambridge Univer-
sity Press, 2012), survey Austrian work on the entrepreneur and the theory of the firm,
with particular emphasis on Knight’s (and Mises’s) work on uncertainty and judgment.
The Misesian tradition has been carried on in America by Murray Rothbard and
Israel Kirzner. See particularly M. N. Rothbard, Man, Economy and State: A Treatise on
Economic Principles (New York: Van Nostrand, 1962). Rothbard is also the author of an
Austrian-centered history of economic thought, An Austrian Perspective on the History of
Economic Thought, 2 vols. (Brookfield, VT: Edward Elgar, 1995). Joseph T. Salerno, “The
Rebirth of Austrian Economics—In Light of Austrian Economics,” Quarterly Journal of
Austrian Economics, vol. 5 (Winter 2002), pp. 111–128, credits Rothbard with the mod-
ern revival of the Austrian School. Kirzner’s work is on conspicuous display in I. M.
Kirzner, Competition and Entrepreneurship (Chicago: The University of Chicago Press,
1973); same author, Perception, Opportunity and Profit (Chicago: The University of Chi-
cago Press, 1979); and again, Discovery and the Capitalist Process (Chicago: The Univer-
sity of Chicago Press, 1985). For a treatment of advertising (a favorite Austrian theme)
that poses a “process” view of competition in contrast to the conventional view, see R. B.
Ekelund, Jr., and D. S. Saurman, Advertising and the Market Process (San Francisco:
Pacific Research Institute for Public Policy, 1988). See also, R. F. Hébert, “Advertising,” in
Peter Boettke (ed.), The Elgar Companion to Austrian Economics, (Aldershot, UK:
Edward Elgar, 1994), pp. 389–393.
Ludwig Lachmann reflects an Austrian influence absorbed from Hayek at the Lon-
don School of Economics; see Lachmann, Capital, Expectations and the Market Process
(Kansas City: Sheed & Ward, 1977); and same author, “From Mises to Shackle: An Essay
on Austrian Economics and the Kaleidic Society,” Journal of Economic Literature, vol. 14
(March 1976), pp. 54–61.
The Ludwig von Mises Institute located in Auburn, Alabama, is a research and edu-
cational center for the Austrian School of economics, following the intellectual tradition
of Ludwig von Mises (1881–1973) and Murray N. Rothbard (1926–1995). It conducts a
variety of teaching and fellowship programs and offers a vast array of publications,
including the Quarterly Journal of Austrian Economics and the Journal of Libertarian
Studies. For representative academic works sponsored by the Mises Institute, see 15
Great Austrian Economists, R. G. Holcombe (ed.) (Auburn, AL: Ludwig von Mises Insti-
tute, 1999); L. H. Rockwell, Jr., Gold Standard: An Austrian Perspective (Lexington, MA:
D. C. Heath, 1985); John V. Denson (ed.), Costs of War: America’s Pyrrhic Victories (New
Brunswick, NJ: Transaction, 1997); same author, Reassessing the Presidency: The Rise of
the Executive State and the Decline of Freedom (Auburn, AL: Ludwig von Mises Insti-
tute, 2001). The Mises Institute web site, http://mises.org, provides open access to the
Ekelund-Hebert 6E.book Page 594 Thursday, August 1, 2013 11:03 AM

594 Part V ■ Twentieth-Century Paradigms

most comprehensive source of materials and publications on the Austrian school, is

linked to classrooms and libraries around the world, and at this writing, attracts more
Internet traffic than any other market-oriented, nonprofit organization.
Some works to consult that are not strictly Austrian but bear closely on the nature of
subjectivism, especially in regard to costs, include A. A. Alchian, Economic Forces at
Work (Indianapolis: Liberty Press, 1977), particularly pp. 273–334; J. M. Buchanan, Cost
and Choice (Chicago: Markham, 1969); and L. S. E. Essays on Costs, J. M. Buchanan and
G. F. Thirlby (eds.) (New York: New York University Press, 1981). For an Austrian per-
spective on some of the topics not treated in this chapter, see F. A. Hayek, Monetary The-
ory and the Trade Cycle (New York: A. M. Kelley, 1975); L. M. Lachmann, Capital and Its
Structure (Kansas City: Sheed & Ward, 1977); R. W. Garrison, Austrian Macroeconomics:
A Diagrammatic Exposition (Menlo Park, CA: Institute for Humane Studies, 1978); J. R.
Hicks, Capital and Time: A Neo-Austrian Theory (Oxford: Clarendon Press, 1973); and
M. N. Rothbard, America’s Great Depression (Kansas City: Sheed & Ward, 1975).
G. L. S. Shackle has written at length on the problem of time and uncertainty, nota-
bly in Uncertainty in Economics (London: Cambridge University Press, 1955), and in
Epistemics and Economics (London: Cambridge University Press, 1972). T. W. Hutchison
and Brian Loasby (a student of Shackle) have sounded related themes, the former in
Knowledge and Ignorance in Economics (Chicago: The University of Chicago Press,
1977) and the latter in Choice, Complexity and Ignorance (London: Cambridge Univer-
sity Press, 1976).
Historical development of the mainstream notion of competition of which the Aus-
trians have been critical is the subject of several papers. See G. J. Stigler, “Perfect Com-
petition, Historically Contemplated,” in Stigler (ed.), Essays in the History of Economics
(Chicago: The University of Chicago Press, 1965); P. J. McNulty, “Economic Theory and
the Meaning of Competition,” Quarterly Journal of Economics, vol. 82 (November 1968),
pp. 639–656; and K. G. Dennis, “Competition” in the History of Economic Thought (New
York: Arno Press, 1977). On the importance and significance of property rights in eco-
nomic theory, see A. A. Alchian, “Some Economics of Property Rights,” in Alchian (ed.),
Economic Forces at Work (Indianapolis: Liberty Press, 1977); and E. G. Furubotn and S.
Pejovich (eds.), The Economics of Property Rights (Cambridge, MA: Ballinger, 1974).
The entrepreneur, who assumes such a central role in the neo-Austrian paradigm,
emerges chameleon-like from a study of past economic thought. Different writers have
conceived the concept and role of this prime economic actor in many different ways, so
much so that in contemporary economics the term is often used indiscriminately, or at
best, ambiguously. An attempt to review the historical record and to distill meaning and
direction for the notion of entrepreneurship is contained in R. F. Hébert and A. N. Link,
The Entrepreneur: Mainstream Views and Radical Critiques, 2d ed. (New York: Praeger,
1988); and, same authors, A History of Entrepreneurship (New York: Routledge, 2009).
Ekelund-Hebert 6E.book Page 595 Thursday, August 1, 2013 11:03 AM

24

The New Political Economy

Public Choice and Regulation

The great classical writers, such as Adam Smith, Jeremy Bentham, and John Stuart
Mill, considered economics to be a social science in the broadest possible sense. Polit-
ical economy, as they called the “new” discipline, emphasized the adjective almost as
much as the noun. In the eighteenth and early nineteenth centuries economics was
an inquiry into human behavior, institutions, policy, and policy formation. As eco-
nomics progressed through the nineteenth and twentieth centuries, however, the
scope of its inquiry gradually narrowed. Indeed, we have now come to the point that
in some graduate institutions in the United States and abroad, economics is seen
more as a branch of applied mathematics than a social science. In the quest to formal-
ize the subject, political and institutional concerns have often been relegated to sec-
ond-class status within economics curricula (despite Veblen’s influence).
But there have always been economists who maintained an interest in the inter-
face between “politics” (political behavior and institutions) and the motives of self-
interested economic actors. For them, “economic” behavior is not limited to pecuni-
ary matters. Why should politicians be regarded as selfless lawgivers, whose actions
are exogenous to the economic happenings in society? Are they not like the rest of
us, self-interested competitors maximizing returns (power, position, votes, etc.)
under certain constraints (reelection, for instance)? The important point is that in
seeking to optimize their own interests, politicians have an impact on the entire eco-
nomic system, for example, through fiscal policy or through the supply of industrial
regulation. The germ of these notions—especially the idea of political action as an
endogenous force—has always been present in economic literature, but in the past
fifty years renewed and intensified interest has been directed toward these issues,
and in the process, economics has been reborn as a political and social science.
The purpose of this chapter is to show how the self-interested economic
motives postulated by classical and neoclassical economists are applied and
extended in contemporary economics. Our focus is on two major contemporary
themes—public choice and the economic approach to regulation. Even a cursory
investigation of these two important and developing areas reveals a fundamental
continuity in economic analysis stretching from Adam Smith to the present. In addi-
tion, such active concerns on the part of prominent modern writers are evidence
that, despite the recent surge of mathematical formalism in the discipline, econom-
ics is not down at the heels as a social science.

595
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596 Part V ■ Twentieth-Century Paradigms

■ PUBLIC CHOICE
The “new” term for political economy goes by the name of public choice. Mod-
ern public choice is a study of the political mechanisms or institutions through
which taxes and expenditures are determined; that is, it is a study of the demand for
and the supply of public goods. Public choice employs the simple analytics of com-
petition to make fact-based statements concerning institutions and events in the
public sector. Although the economics of the private sector has been well developed
over the last two centuries, until recently an analysis of how social goods are sup-
plied and demanded took a back seat to the central concerns of most economists.
Some classical and neoclassical writers, such as Adam Smith, Alfred Marshall,
and A. C. Pigou, always paid attention to public finance. However, the Marshallian–
Pigovian approach to public finance, antedated as we have seen by a cadre of
French engineers, focused on “problem solving” in the provision of specific public
goods. Moreover, its focus was almost exclusively on the tax side of the fiscal equa-
tion. The welfare and efficiency effects of various types of taxes were stock-in-trade
for neoclassical (Marshall–Pigou) analysis, but it never occurred to writers in this
somewhat insular Anglo-Saxon tradition that fiscal decisions were the result of
choice on the part of both demanders and suppliers acting through a process of
political filtration.
Modern research has demonstrated conclusively that intellectual efforts to
place fiscal theory on more broad-based interdependencies were emerging in Ital-
ian and Scandinavian writings in the late nineteenth century. James M. Buchanan,
Nobel laureate and founder-pioneer of modern public-choice theory, investigated
the classical, Italian tradition in public finance (1880–1940) and contrasted it to the
Anglo-Saxon (Marshallian–Pigouvian) model.1 He wrote:
As early as the 1880s, Mazzola, Pantaleoni, Sax, and De Viti De Marco made rudi-
mentary efforts to analyze the public economy within an exchange framework.
Sax and Mazzola discussed the demand side of public goods by identifying collec-
tive as distinct from private wants. Pantaleoni extended the marginal calculus to
apply to the legislator who makes choices for both sides of the budget. De Viti De
Marco explicitly constructed a model in which the consumers and the suppliers-
producers of public goods make up the same community of persons. (“Public
Finance,” p. 384)2

In addition, Swedish economists Knut Wicksell (1851–1926) and Erik Lindahl

(1891–1960) were hard at work developing a holistic approach to the public sector,
with the goal of explaining the determination of a public budget within a political
process rather than treat budgets as the endogenous dictates of a Platonic philoso-
pher-king. Contemporary movements among public-choice theorists to establish the
entire fiscal sector of the economy within a general-equilibrium theory owe much to
the efforts of these Continental economists.
The emergence of Continental contributions to public-sector equilibrium came
as no surprise to Buchanan, because he regarded these developments as a straight-
forward extension of the emergent neoclassical (marginalist) theory of private mar-

1
Buchanan chronicles this tradition in his essay “La scienza delle finanze: The Italian Tradition in
Public Finance” (see references).
2
Buchanan’s essay “Public Finance and Public Choice” (see references) provides a fine introduc-
tion to contemporary public choice and its history, as does Randall G. Holcombe’s “Concepts of
Public Sector Equilibrium” (see references). The spirit of our discussion, as well as some details,
follow these two papers closely.
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Chapter 24 ■ The New Political Economy 597

kets in the 1870s (see chapters 14–17). However, the vexatious problem for the
historian of economics is to explain what Buchanan termed “the long-continued
failure of English-language economists to make comparative extensions of their
basic framework or to acknowledge an interest in the continental efforts” (“Public
Finance,” p. 384). The bridge between these early Continental contributions and the
emergence of modern public-choice theory is a long one that has, in the main,
spanned the Atlantic and reached bedrock in the United States. Contemporary pub-
lic-choice theory is essentially an ongoing American achievement, originating in the
late 1930s and 1940s.3 The content of this achievement is both extensive and
detailed. Voting theory, for example, is an integral and complex part of public
choice. Space constraints in a book such as this prohibit a detailed account of the
entire field. We therefore confine our discussion to some simple concepts and areas
of concern in public-choice theory so readers might grasp an overview of this devel-
oping paradigm in contemporary economics.

Public-Goods Demand and the Median-Voter Model

The theory of public-goods demand is an integral aspect of contemporary pub-
lic-choice theory. It provides a good example of how economic analysis developed
to handle one problem can often be applied to new problems. In this case the theory
of public-goods demand is analogous in most respects to the Mill–Marshall joint-
supply theory applied to the simultaneous production of such items as beef and
hides, mutton and wool, and so on (see chapter 8 for the introduction of the joint-
supply model). Originally articulated by Howard Bowen in 1943, the necessary con-
ditions for allocative efficiency in the provision of a public good were developed by
Paul Samuelson in 1954 in a classic paper entitled “The Pure Theory of Public
Expenditures.” A public good in this context may be distinguished from a private
good insofar as an individual’s consumption of the public good does not reduce all
other individuals’ simultaneous consumption. In the private-good case, if XT is the
total consumption of shoes, then XT = x1 + x2 + . . . + xn, where x1 + x2, etc., is the
sum of all individuals’ consumption of shoes. In the public-goods case, Xp may be
total consumption of, say, national defense, and Xp = x1 = x2 = . . . = xn, where all
individuals consume the same amount of defense. In the latter case, one individual’s
consumption of defense does not detract from another’s, and all consume the same
quantity of defense.
Units of measurement are obviously important. A “unit” of a good is defined as
the minimum quantity of that good required to provide more than one consumer
simultaneously with that particular bundle of services that distinguishes the good in
question from all other goods. Accordingly, a dozen pencils would not be consid-
ered a unit of a public good even though twelve individuals could consume this
good simultaneously. The reason is that one pencil is capable of providing the
unique bundle of services (writing, erasing, etc.) usually associated with the term
“pencil.” A unit of pencils would be a private good because its services are provided
to only a single individual. A Polaris submarine, on the other hand, can be viewed as
a unit of a public good because it provides “safety from nuclear attack” simultane-

3
The early, seminal American contributions were those of Richard A. Musgrave, “The Voluntary
Exchange Theory of Public Economy,” Howard R. Bowen, “The Interpretation of Voting in the
Allocation of Resources,” and Buchanan, “The Pure Theory of Government Finance: A Suggested
Approach,” (all cited in the references). This ongoing tradition in contemporary American eco-
nomics persists at the Center for the Study of Public Choice, founded by Buchanan, and in Public
Choice, a journal devoted to the subject, of which Gordon Tullock is the founding editor.
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598 Part V ■ Twentieth-Century Paradigms

ously to more than one individual. While the provision of “safety from nuclear
attack” as a private good might be possible (individual concrete underground silos,
for example), the cost per individual presumably is less when the service is pro-
vided as a public good.
Some other characteristics of public goods are important though they are not
unique to public goods. For instance, in the public-good case described by Samuel-
son, the marginal cost of supplying additional users would be negligible—some-
times zero—and the exclusion of nonpaying consumers would be impossible. Some
goods in the private sector approximate the above cost conditions (a bus trip for a
particular journey, perhaps). Moreover, it may always be possible to exclude con-
sumers. Even in the case of national
defense it would theoretically be possible
Individual A to remove nonpayers to (nonprotected)
islands in remote areas of the Pacific
Ocean, although such exclusion would be
costly. The conceptual difficulties of defin-
ing a pure public good are many, therefore,
P1
but these matters need not detain us here.
Let us assume that joint-consumption, zero
D1
marginal cost, and nonexcludability condi-
tions apply and turn to the Bowen–Samuel-
O Q* Public good son equilibrium of figure 24-1. (Note that
the details of this case are analogous to
Mill’s model of joint supply for jointly pro-
Individual B
duced private goods [such as steers]
depicted graphically in figure 8-1.)
The two upper quadrants of figure 24-1
depict the demands for a public good (edu-
cation, Polaris submarines, etc.) on the part
P2 of a closed community of two individuals.
These demands are summed vertically in
D2
order to get the total demand for the public
O Q* Public good good shown (with a constant-cost supply
curve) in the lowest quadrant of figure 24-
Total 1. Insofar as consumption by these two
people is noncompeting, the community
F demand curve for a public good can be
S S obtained by vertical summation of individ-
ual demand curves. Individual A’s con-
sumption of nuclear submarines does not
DT
compete with individual B’s. Consumption
is simultaneous and “complementary.”
Most importantly, note that the equilibrium
O Q* Public good described in the public-goods case with
simultaneity of consumption requires (in
exact contrast to the private-goods exam-
Figure 24-1 The total demand for the ple) that the same quantity of the good
public good is the vertical sum of individual (Q*) be consumed by each consumer. Dif-
demands D1 and D2, with each demander ferent prices are required in equilibrium to
consuming Q* quantity of the good. get different individuals with different
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Chapter 24 ■ The New Political Economy 599

demands to hold Q* of the commodity. The equilibrium prices would not be equal
except in the unlikely event that the two individuals’ demands are identical.
Samuelson’s description of the demand for public goods is perfectly abstract
and general, but in fitting the principle to real-world applications several difficulties
emerge. When the good in question is not purely public in Samuelson’s sense, the
optimal size of the consuming group will not be known, and the question that begs
answering is: What quantity should be produced (i.e., what Q*)? In his 1943 paper,
Bowen answered:
It is, of course, no more difficult to obtain information on the cost of producing
social goods than to get data on individual goods; but to estimate marginal rates of
substitution [public-goods demands] presents serious problems, since it requires
the measurement of the preferences for goods which, by their very nature, cannot
be subjected to individual consumer choice. (“Interpretation of Voting,” pp. 32–33)

In other words, some sort of proxy for public-goods demands is required, and
Bowen suggested that under certain conditions, voting (in a democratic setting) is
the closest substitute for consumer choice.4 This insight led to the development of
the median-voter model (actually a whole set of models), which became a major tool
of public-choice theorists in the 1960s and 1970s, owing in large part to the persis-
tent efforts of Kenneth Arrow and Duncan Black. Although the median-voter model
is a central element of public-choice theory, it is a fairly technical subject and a full
discussion of it would take us too far afield from our present purpose.5 Neverthe-
less, the Bowen model and its variants (along with possible complications and prob-
lems) may be presented in simple terms.
Any individual’s demand for public goods will be determined by two things: (1)
the satisfaction he or she expects to receive from various amounts of the good, and
(2) the cost to the individual of alternative amounts of the public good. In order to
look at even a basic model of voting behavior, it is necessary to invoke simplifying
assumptions. First, assume that all members of a community actually vote and
thereby correctly reveal their individual preferences for the social good. Second,
suppose that the total and average cost of the good to the community is known and
that it is divided equally among all citizens. Finally, assume with Bowen “that the
several curves of individual marginal substitution [i.e., the individual demand
curves] are distributed according to the normal law of error” (“Interpretation of Vot-
ing,” p. 34). This simply means that there are a large number of demand curves and
that, for any quantity of the public good provided, there will be demands clustered
symmetrically about a mode. Such a community may be illustrated easily in terms
of figure 24-2 (on the following page), which shows individual demands clustered
about the demand of the median voter. The pro rata tax share (AC/N) is the same for
each voter-consumer.
Now consider provision of some quantity of the public good Q1 in figure 24-2.
Clearly for the same quantity of the good, different demanders would be willing to

4 Bowen was not the first economist, and certainly not the last, to deal with this general problem.
Harold Hotelling broached the issue of the median voter in 1929 (see references).
5
The interested reader should consult two works central to the argument, Kenneth Arrow’s Social
Choice and Individual Values and Duncan Black’s The Theory of Committees and Elections (see
“References” and notes for further reading). These works raised the question of the efficiency and
workability of majority rule through the median voter in registering individual preferences for
social goods. The fascinating intellectual history of the efficiency of voting rules is presented in
Black’s book. The contributions of the Rev. C. L. Dodgson, better known by his pen name, Lewis
Carroll, are particularly interesting (see Black’s Theory, pp. 189–213).
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600 Part V ■ Twentieth-Century Paradigms

Price D7
of public
good D6
D5
D4
D3
D2 Pro rata
share of
public good
cost
D1
AC /N (MC /N)

TD /N (median curve)

O Q1 Q* Q2 Quantity of public good

Figure 24-2 At quantity Q1 of a public good, the median voter values Q at some rate
D4, which is higher than the pro rata tax share. Thus, with majority rule, any Q proposed
above Q1 will win approval and any Q proposed above Q* will fail to carry.

pay different tax shares. Thus, for Q1, those who value the good highly would be
willing to pay D7, those placing little value on the public good would only be willing
to pay D1, and so on. The median voter, however, values Q1 at some rate D4, which is
higher than the pro rata tax share to all taxpayers who receive the public good AC/
N(MC/N). Thus, in, say, a town-meeting process employing majority rule, any Q
proposed above Q1 will win approval; any Q proposed above Q*, such as Q2, will fail
to carry. In this process, the quantity preferred by the median voter, Q*, will always
defeat any other motion.
Under certain circumstances the median-voter process can yield similar results
in other variants of the model, such as voting for marginal increases of a public
good in a voter referendum, or through elected representatives. In the latter case, if
the people are consulted on particular policies and if representatives identify with
specific issues, the results of the process can approximate those of figure 24-2.
Many factors affect voting. Public officials working through certain institutions may
upset the results of Bowen equilibrium by manipulating the agenda or simply by
representing and voting on a large variety of issues. Thus, majority-rule election
processes do not ensure that voter preferences for public goods will be optimized.
However, it does seem to be a practical system for approximating voter preferences.

Lindahl Tax Prices and Wicksellian Public Finance

Distribution of the tax share is a crucial feature in the provision of public goods
because each individual will demand a good both on the basis of its (marginal)
value and on the basis of its cost. The “marginal cost” is simply the share of taxes
that the citizen-consumer pays for his or her portion of the output. A major problem
in public choice, then, is to devise a means for providing an optimal quantity of any
public good such that, for the single quantity produced, some distribution of the tax
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Chapter 24 ■ The New Political Economy 601

burden may be found that equates the marginal valuation of the good to the mar-
ginal tax share for each citizen-consumer. Two early writers on public choice, Erik
Lindahl and Knut Wicksell, were interested in different aspects of this question and
set out on different analytical paths.
Lindahl Equilibrium. In his 1919 contribution entitled “Just Taxation—A Pos-
itive Solution” (part of his book Die Gerechtigkeit der Besteuerung), Lindahl treated
the problem of tax-share determination as one of bilateral exchange in an “isolated”
community with two categories of taxpayers: one “well-to-do” and the other “rela-
tively poor.” He saw the distribution of the tax shares as a problem to be settled by
“a kind of economic exchange,” based on free argument.6 Lindahl wrote: “[In a]
solution in which both parties have equally safeguarded the economic rights to
which they are entitled under the existing property order,” the price of the collective
good “tends to correspond to marginal utility for each interested party” (“Just Taxa-
tion,” pp. 172–173). This means that tax price will equal the affected voter’s (or
group of voters’) marginal valuation of the public good.
The modern adaptation of Lindahl equilibrium is demonstrated in figure 24-3
(which is constructed in the same manner as figure 24-1, except that the two
demand curves and their summation are contained in one graph in figure 24-3).7 In
figure 24-3, DT is the vertically summed demand curve for the public goods, with D1
and D2 being the separate demand curves of the two groups. Lindahl equilibrium

Price DT

D1 (well-to-do
demanders)
F
MC = Supply

D2 (relatively
poor demanders)
T1
A B T3
T2

O Q2 Q* Q1 Q (Public good)

Figure 24-3 Lindahl equilibrium is achieved when well-to-do demanders are charged
a marginal tax rate T1 for Q* and relatively poor consumers are charged a lower tax rate
T2. At a tax rate of T3 the poor will prefer Q2, a less-than-optimal quantity, and the rich
will prefer Q1, a more-than-optimal quantity.

6
He recognized that because this process was filtered through protagonists in a political process the
resultant tax-share distributions would be influenced by the relative power of competing groups,
but he assumed initially that such political “blocs” did not influence the model under free exchange.
7
Figure 24-3 is adapted with modifications from R. G. Holcombe’s “Concepts of Public Sector Equi-
librium,” p. 82.
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602 Part V ■ Twentieth-Century Paradigms

would occur (through voluntary exchange) when for quantity Q*, well-to-do
demanders are charged a marginal tax rate T1 and the relatively poor consumers
are charged a lower tax rate T2. Under this tax system, each group is paying a mar-
ginal cost (T1 and T2, respectively) equal to its marginal valuation of the public
good. Efficiency is achieved in the Bowen–Samuelson sense because a single quan-
tity of the good is produced, Q*, which corresponds to the equation of total demand
DT and marginal cost of production (at point F in figure 24-3).
The establishment of Lindahl prices is not necessary in order to obtain efficiency
in the production of public goods in the Bowen–Samuelson sense. All that is required
for efficiency is that total output of the good be established at point F (producing Q*)
in figure 24-3. In order to understand this fact, consider the imposition of some “aver-
age” tax rate T—one that would be imposed on both groups of demanders and that
would cover the costs of producing Q*. It is easy to see that the well-to-do demanders
would prefer this system and would, if possible, foist it on the poor through a political
process (Lindahl considered this case). Note, however, that at tax rate T3 the poor
would prefer Q2, a less-than-optimal quantity of the public good. If the poor were
politically powerful, they might force society to take a less-than-optimal quantity of
the good.8 In general, however, a system of Lindahl-tax prices would produce
Bowen–Samuelson efficiency—everyone would agree on how much of the public
good should be produced. While a Lindahl system is not the only one capable of pro-
ducing this result, it is the case that a Lindahl model features unanimous agreement
of the taxed parties in voluntary exchange, given differential tax rates. In developing
this feature of his model Lindahl was influenced by his mentor, Knut Wicksell.
Wicksell and Wicksellian Extensions. Swedish economist and reformer Knut
Wicksell was probably the most important early progenitor of contemporary public
choice. In a lengthy essay titled “A New Principle of Just Taxation” (1896), Wicksell
attacked the orthodox approaches to public finance and simultaneously laid the
groundwork for both normative and positive public choice. Wicksell emphasized
the dual nature of the fiscal side of the economy. In his view, normative comments
concerning the welfare effects of alternative tax systems were of no value unless the
expenditure side of the fisc (benefits to taxpayers) was simultaneously considered.
“Most importantly,” as Buchanan pointed out, “Wicksell admonished economists for
their failure to recognize the elementary fact that collective or public-sector deci-
sions emerge from a political process rather than from the mind of some benevolent
despot” (“Public Finance,” p. 385).
Wicksell was chiefly concerned that a fiscal system conform to justice and effi-
ciency. In his view justice and efficiency demanded unanimity among all parties that
participate in public-sector decisions. Wicksell was unequivocal on this matter:
When it comes to benefits which are so hard to express numerically, each person
can ultimately speak only for himself. It is a matter of comparatively little impor-
tance if perchance some individual secures a somewhat greater gain than another
so long as everyone gains and no-one can feel exploited from this very elementary

8 In an ingenious extension of the above problem, Charles M. Tiebout noted in 1956 that people may
“vote with their feet” in choosing where to reside (“A Pure Theory of Local Expenditures”—see ref-
erences). In other words, local communities may be thought of as offering a continuum of public-
service quantities. In terms of figure 24-3, given that both groups of demanders face tax rate T3,
the poor would move to a local community offering quantity Q2 and the well-to-do would seek out
one offering Q1 of public goods. Tiebout’s idea certainly offers a testable hypothesis, but there are
of course other reasons why citizen-consumers are attracted to specific local communities.
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Chapter 24 ■ The New Political Economy 603

point of view. But if justice requires no more, it certainly requires no less. In the
final analysis, unanimity and fully voluntary consent in the making of decisions
provide the only certain and palpable guarantee against injustice in tax distribu-
tion. The whole discussion on tax justice remains suspended in mid-air so long as
these conditions are not satisfied at least approximately. (“New Principle,” p. 90)

According to Wicksell state activity must therefore be of general usefulness;

furthermore, the sacrifice must be weighed against the expected utility of the proj-
ect. Whether individuals favor a project or not depends on a number of variables,
such as their position in the income distribution, relative tastes for private versus
public consumption, and subjective evaluation of the public project. The tax-price
distribution of the costs will determine whether the project would be approved or
not. Some distributions of costs would win majority approval and others would not.
In a slap against “authoritarian” tax allocations, Wicksell argued that alternative
financing and spending proposals should be subject to a public vote of approval. He
argued that it would be possible, theoretically, to find a distribution of the costs that
would produce unanimity. Any other results would provide, in his words, “the sole
possible proof that the state activity under consideration would not provide the
community with utility corresponding to the necessary sacrifice and should hence
be rejected on rational grounds” (“New Principle,” p. 90).
Although no other principle would be “just” in Wicksell’s system, he did recog-
nize that the ideal of unanimity was not to be expected in practical situations. Soci-
ety must therefore confront a set of voting-rule options, none of which are efficient
in Wicksell’s ideal sense. This apparent impasse set the stage for the next advance
in the modern literature on public choice. In The Calculus of Consent (1962), James
Buchanan and Gordon Tullock analyzed less-than-optimal-Wicksellian rules within
a framework of methodological individualism. Within this positive (value-free)
framework, Buchanan and Tullock modeled the calculus of a utility-maximizing,
rational individual as he or she faces the choice of constitutional design. In their
model, a “constitution” is simply a set of rules decided on in advance that deter-
mines the manner in which future action will be conducted.9
The institutions of collective choice in the Buchanan–Tullock conception are
themselves variables. They argue:
The constitutional choice of a rule is taken independently of any single specific
decision or set of decisions and is quite rationally based on a long-term view
embodying many separate time sequences and many separate collective acts dis-
posing of economic resources. “Optimality” in the sense of choosing the single
“best” rule is something wholly distinct from “optimality” in the allocation of
resources within a given time span. (Calculus of Consent, p. 95)

Optimality, or the determination of the “best” decision rule (e.g., majority rule),
takes place in the presence of people’s uncertainty concerning their future prefer-
ences about a series of individual collective acts or proposals to be voted on. Given
such uncertainty about the nature of future preferences, individuals may vote on
criteria unrelated to their respective positions in income distributions. In other
words optimality in the more “dynamic” Buchanan–Tullock framework does not
mean the same thing as in Wicksell’s time-constrained decision model. Inasmuch as

9
Moreover, “Collective action is viewed as the action of individuals when they choose to accomplish
purposes collectively rather than individually, and the government is seen as nothing more than
the set of processes, the machine, which allows such collective action to take place” (Buchanan
and Tullock, Calculus of Consent, p. 13).
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604 Part V ■ Twentieth-Century Paradigms

the choices facing the Wicksellian community are later in time than the constitu-
tional choices analyzed by Buchanan and Tullock, his model requires strict unanim-
ity as a condition for optimality (i.e., “justice”). However, at an earlier point a voting
rule that is nonoptimal from a Wicksellian perspective can be optimal in the face of
future preference uncertainty. Buchanan and Tullock thus provide a theory of con-
stitutions and a design of political institutions that augment the unanimity rule as
the sole criterion for efficiency in the narrow Wicksellian sense. Their analysis,
especially when combined with the norm of “individualism,” has had a large impact
on contemporary research on political behavior and institutions.

Bureaucracy, the Supply Side, and Empirical Public Choice

Demand analysis—the interconnections between voting and the demand for
public goods—has taken center stage in much of the contemporary public-choice
literature. The implicit assumption in this approach is that goods and services
demanded in the public sector are automatically supplied. However, public goods
are supplied by government bureaucracies, which generate incentive mechanisms
that have not often been closely scrutinized. Two major exceptions have been the
work of the Austrian economist Ludwig von Mises (Bureaucracy, 1944) and the
more recent study by Gordon Tullock, The Politics of Bureaucracy (1965). These
books, especially the latter, represent serious attempts to model the process of
bureaucratic output and most particularly the motivations and processes by which
“public-sector supply” takes place.
How do bureaucrats behave? What are their motivations? Is there a discernible
quantity that they optimize in their efforts to supply public goods? These issues and
more were taken up by William A. Niskanen, Jr., in his Bureaucracy and Represen-
tative Government (1971). Reflecting the influence of Tullock, Niskanen views the
bureaucrat as an “endogenous” maximizer in the politico/economic arena, not
unlike the entrepreneurial suppliers of private goods in the economic marketplace.
But one crucial difference stands out. While private entrepreneurs can maximize
profits, government bureaucrats cannot legally do so. Though illegal side payments
are not unknown in the political arena, it is far more reasonable to posit that the
maximand for most bureaucrats is one (or more) of the following: income, prestige,
bureau size and/or power, the bureau’s budget, promises of a lucrative job after
leaving the bureaucracy, and so on. Niskanen assumed that bureaucrats are budget
maximizers, and he modeled government bureaus as individual budget-maximizing
units. Budget maximization enables the individual bureaucrat to increase his or her
salary, change the working environment to his or her liking, or both.
In Niskanen’s analysis, bureaus are “nonprofit organizations which are
financed . . . by a periodic appropriation or grant” (Bureaucracy, p. 15). In essence,
a total budget is transformed into some level of total output, since marginal adjust-
ments are not feasible within the bureaucratic context. One of the (many) implica-
tions of the model is that in their attempt to maximize budget size (and thus the size
of the bureau), suppliers will “eat up” the consumer surplus that results from pub-
lic-goods supply. The sheer growth of bureaucracy is also an obvious implication of
this theory. Integrating the theories of public-goods demand and Niskanen’s notion
of public-goods supply into a “general-equilibrium model” is beset by numerous dif-
ficulties, but Niskanen’s model has stimulated a good deal of research into the “sup-
ply problem,” and it has become an ongoing research concern in the economics of
public choice.
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Chapter 24 ■ The New Political Economy 605

Public-choice theory has yielded a large number of testable implications and

extensions, especially since 1970. Economists have been hard at work expanding
and empirically estimating some of these propositions. A very large literature, some
of which might be called “empirical public choice” has developed.10 The list of con-
tributions to this field is long and pertains to such issues as: (1) What are the eco-
nomics of campaign contributions and how do they affect political competition? (2)
How does self-interest lead to length of political terms in office and to the rules of
succession? (3) How does an independent judiciary affect cartel behavior? (4) How
do economic variables determine entry barriers into politics? (5) How and why are
coalitions formed within legislatures? and (6) Why do state and federal legislatures
contain more lawyers as representatives than any other occupation? A whole
branch of literature has developed on the “political business cycle,” attempting to
explain how self-interested politicians acting under reelection constraints cause
swings in inflation, income, and employment. Some of these interesting contribu-
tions are discussed below, while others are referenced in the notes for further read-
ing at the end of this chapter.
Empirical Support for the Median-Voter Model. Consider the median-voter
model described earlier in this chapter. Assuming there is competition among polit-
ical parties, it has been shown that whichever party appeals most to the interest of
the median voter will be elected. It is not likely that the strongest supporters of a
political party will be rewarded in proportion to their contributions. In order to get
elected, party members must devise tax-and-spend programs that reallocate bene-
fits from their strongest supporters to the median voter. Randall Holcombe has
shown that when tax shares can be offered as part of a political platform, “democ-
racy has a natural bias in favor of electing the political party that has the highest
demand for public sector output” (“Public Choice,” p. 382). He has also studied the
empirical relevance of the Bowen median-voter model (see figure 24-1). Utilizing
data from Michigan tax referenda on educational expenditures in 275 elections in
1973, Holcombe provided empirical support for the assertion that the median-voter
model is consistent with local governmental referenda on educational expenditures
(“Empirical Test,” pp. 272–273).
The Economics of Political Representation. Empirical models in public
choice have concentrated on testing practical questions. For instance, do methods
of paying legislators (as set by a state constitution or by state legislators them-
selves) determine “outside earnings”? A study by Robert McCormick and Robert
Tollison suggests that in higher-paying states, with legislators setting their own sal-
aries, individuals find it less in their own interest to seek outside payments or bribes
(“Legislatures as Unions,” p. 77). In another interesting empirical study, entitled
“Legislators as Taxicabs: On the Value of a Seat in the U.S. House of Representa-
tives,” Mark Crain, Thomas Deaton, and Robert Tollison investigated the question
of why the size of the U.S. House of Representatives has remained constant at 435
(with the minor exception of a temporary expansion after Alaska and Hawaii were
admitted to the Union). The only two constitutional requirements respecting size
are that there be (1) no more than one representative per 30,000 population and (2)
at least one representative from each state. Given these restrictions the House of
Representatives could have held 5,977 members in 1977. Why, then, were there only

10
See “Public Choice: A Survey,” by Dennis C. Mueller, for an annotated discussion of contributions
up to 1975 or so (see references).
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606 Part V ■ Twentieth-Century Paradigms

435? The answer, according to Crain, Deaton, and Tollison, is that legislators are
able to restrict their own numbers, much like the situation where taxicabs are con-
trolled in major cities. The result is that economic rents are earned by the existing
units of supply—at least partially by the legislators themselves. Thus, some “eco-
nomic” answers to “political” questions are provided by the axioms of self-interest,
the ability of legislators to control their own numbers, and the theory of rent seek-
ing (which is discussed in more detail below).
Agency Problems in Politics. Principles of public choice have also been used
to analyze congressional voting and the possibilities that representatives do not
always represent the will of the people who elect them. Indeed, one of the major
issues in public choice deals with problems relating to agents and principals. The
basic problem is how to get the agent to behave in ways that correspond to the
interests of the principal. Anyone who has worked in a firm or owned corporate
stock, for example, should be familiar with this dilemma. Employees may work in
their own interests under certain circumstances and not in the interests of their
employer. Left unsupervised, employees may shirk their tasks and engage in activi-
ties that enhance their own utility rather than that of the employers. Some examples
are: overextending lunch breaks, playing computer games, unauthorized e-mailing,
or creating “overtime” situations to boost one’s pay. Managers may also work
against stockholders’ interests, as in the infamous cases of Enron and Tyco, two
prominent examples of colossal business failures.
Political representation is beset by the same type of problems and opportunistic
behavior that affects businesses. The issue for public-choice scholars is how to get
the agents (legislators and the bureaucracies they oversee) to behave in a manner
intended by the principals (voters) in a representative democracy. Alternatively,
how do representatives respond to election results? In these matters, there are two
theoretical camps. Either the legislator is a perfect agent of the people or he or she
is a “statesman” independent of the constraints of the electorate. Political scientists
have argued that congressional committees use legislative and appointment powers
to control bureaucracies (Weingast, “Congressional-Bureaucratic System”). The
role of ideology in voting by representatives has been studied also by both political
scientists and economists.11
This brief discussion of public choice suggests the richness of the emerging lit-
erature on the subject. But beyond that, the public-choice paradigm has been a fer-
tile source of advances in the theory of economic regulation. Indeed, an endogenous
political process is central to most contemporary theories of economic regulation.

■ THE NEW POLITICAL ECONOMY OF REGULATION

In a distinct and dramatic shift of emphasis from the philosophy of “New Deal
liberalism,” deregulation of some industries became stylish in the United States
among both Democratic and Republican politicians in the 1970s. Historically, regu-
lation of some industries, especially those regarded as natural monopolies (e.g.,
railroads, electric utilities), has been considered in the “public interest.” After the

11
See James Kau and Paul Rubin, “Self-Interest, Ideology and Logrolling in Congressional Voting”;
same authors, Congressmen, Constituents, and Contributors; Joseph Kalt and Mark Zupan, “Cap-
ture and Ideology in the Economic Theory of Politics”; Sam Peltzman, “Economic Interpretation of
Congressional Voting in the Twentieth Century” (all are in the references).
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Chapter 24 ■ The New Political Economy 607

establishment in 1887 of the first large federal regulatory agency (the Interstate
Commerce Commission), economists spent great time and effort trying to devise
better pricing tools to be implemented in the regulatory process.12 A vast literature
developed on such subjects as marginal-cost pricing, price discrimination, and
peak-load pricing, all ostensibly to be of some use in implementing public policy in
the regulated areas of the economy. The whole regulatory process was seen as
stemming directly from market failure and from the consequent necessity of gov-
ernment actions in the interests of the public. While imperfections in the regulatory
process were acknowledged, most economists lined up behind the view that regula-
tion was required due to the presence of “natural monopoly” and, further, that the
process could be perfected by successive approximations in control.
Unfolding intellectual events of the 1960s changed all of this within the eco-
nomics profession and, ultimately, among politicians and the public as well. We
have already discussed one of these developments—the emergence of the public-
choice paradigm with its emphasis on politicians as endogenous actors in economic
processes. It was a logical extension to apply these principles to the regulatory pro-
cess by means of a theory of rent or profit creation by politicians and regulators
(“the government”). The stage was set by two important papers appearing in 1962.
George Stigler and Claire Friedland broke the ice with an essay questioning the
effects of regulation on such variables as rate levels, the degree of price discrimina-
tion, and the rate of return. Their surprising conclusion, based on statistics before
and after electrical-utility regulation, was that regulation was almost totally ineffec-
tive at controlling the quantities it was designed to control. They noted:
The theory of price regulation must, in fact, be based upon the tacit assumption
that in its absence a monopoly has exorbitant power. If it were true that pure
monopoly profits in the absence of regulation would be 10 or 20 percent above the
competitive rate of return, so prices would be on the order of 40 to 80 percent
above long run marginal cost, there might indeed be some possibility of effective
regulation. The electrical utilities do not provide such a possibility. (“What Can
Regulators Regulate?” p. 12)

A second contribution was no less influential in questioning long-held beliefs

about regulation. Harvey Averch and Leland L. Johnson posited a theory about the
firm’s actions when facing a regulated rate of return constraint (“Behavior of the
Firm under Regulatory Constraint”). They concluded that, from society’s point of
view, regulated firms would overinvest in fixed capital under certain conditions.
Although optimal (i.e., profit maximizing) from the regulated firm’s position, too
much capital (relative to labor inputs) could force up the costs of utility services to
society. The empirical relevance of this Averch–Johnson effect is still being debated
by economists and econometricians, but their allegations, along with those of Sti-
gler and Friedland and other writers, helped agitate a general rethinking of the
whole regulatory process. This reassessment was, moreover, strongly influenced by
the economics of politics and rent seeking.

12
An early “Chicago school” economist, Henry Simons, went so far as to suggest that failures in the
regulatory process demanded government ownership of some industries (“A Positive Program for
Laissez Faire”—see references). However, this position is distinct from the modern Chicago view
(deregulation plus competitive franchise bidding for rights to supply in some cases), and it is even
more distant from the views of a majority of contemporary economists.
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608 Part V ■ Twentieth-Century Paradigms

Rents, Politics, and Regulation

Before turning to forms of the contemporary theory of regulation, let us review
what “rent seeking” means. A basic model is presented in figure 24-4.13 For simplic-
ity, assume linear demand and marginal-revenue curves plus a constant average-
and marginal-cost function. Under competitive conditions, Qc represents the quan-
tity produced and Pc represents its price. A monopoly, or a legalized cartel sustained
by a regulatory system, could have the effect of causing a reduction of output to Qm,
and an increase of price to Pm. It is important to be clear about the nature of the
losses. Triangle AFG corresponds to a deadweight loss due to monopoly—one that
was first noticed by the French engineer Jules Dupuit (see chapter 13). Such a loss
is always present whenever price exceeds marginal cost (excise taxes and monop-
oly prices are analogous in this regard).
But what of area PcPmAF? Many economists have claimed these “rents” repre-
sent only a redistribution from consumers to the monopolist. In the context of regu-
latory processes, however, they may be viewed by any given competitor as the value
of gaining the franchise.14 In other words if a single award is given, each individual
competitor will have an incentive to spend an amount, PcPmAF, less an infinitesimal
amount, for the exclusive monopoly-granting franchise. Likewise, assuming that

Price

economic rents
or profits

Pm A
deadweight
loss

F G
Pc LRAC = LRMC

MR D
O Qm Qc Quantity

Figure 24-4 In the regulatory process, individual competitors will be willing to spend
Pc Pm AF less an infinitesimal amount for the exclusive monopoly rights.

13
A “rent-seeking” interpretation of the mercantile age was presented in chap. 3, although a specific
model, such as figure 24-4, was not developed then.
14
These “rent-seeking” arguments originated in the writings of Gordon Tullock (“Welfare Costs of
Tariffs, Monopolies, and Theft”; “Transitional Gains Gap”) and Richard Posner (“Social Costs of
Monopoly and Regulation”); see references.
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Chapter 24 ■ The New Political Economy 609

market shares among firms can be cheaply and efficiently devised, a cartel would
be willing to bid a similar amount for protection from competition. The disposition
and dissipation of these rents could be in lobbying or legal fees. With these princi-
ples in mind, let us return to the political and economic interconnections in the reg-
ulatory process.
The above argument contains a flaw. Legally, of course, politicians and regula-
tors cannot take bribes, although, as stated earlier, sub rosa and illegal side pay-
ments have on occasion been unseemly features of government at all levels.
Payments from business interests may take other forms, of course, and these
motives are the key to the modern theory of regulation. Regulation, like any other
good, such as shoes or beer, is demanded and supplied with underlying motives of
self-interest. In a provocative paper published in 1971 (“The Theory of Economic
Regulation”) George Stigler fleshed out a “capture” theory of regulation based on
self-interested motives of demanders and suppliers. This view, it must be empha-
sized, is only superficially similar to the Marxian notion that “capital” uses the state
and the political apparatus to capture benefits. In the modern theory, capital or
“business” does not always win. Groups of any kind, such as labor, farmers, or con-
sumers, may initiate a regulatory regime or take over an existing one from time to
time. In Stigler’s view regulation benefits politically effective groups. Let us con-
sider this proposition in more detail.
The Capture Theory. In order to understand the capture theory, we must
resolve the issue of who benefits from regulation and who is burdened by it. Regu-
lated firms may benefit from state or federal control to the extent that they receive
direct subsidies of money from governing bodies, protection against rival entry into
their markets, fixed (minimum) prices that guarantee full cost recovery, or other
measures that limit competition. Regulation, however, is almost always a mixed
blessing. Regulated industries (railways, electrical utilities, etc.) or occupations
(barbers, funeral directors, building contractors, etc.) must pay certain fees and
submit to certain rules, regulations, standards of conduct, or other interferences.
These are costly and reduce the net return to the regulated firm, but as long as the
net benefit is positive and lobbying costs are not prohibitive, those who stand to
gain from the regulatory process will logically demand it.
The less obvious question is why would politician-regulators supply regulation?
Stated another way, how do businesses go about demanding regulation in a system
where outright bribes are illegal? Politically effective coalitions (e.g., labor unions,
trade associations, etc.) make their voices heard with votes or campaign contribu-
tions. But why are politicians willing to cater to limited interests at the expense of
the majority of voters/consumers? The logical answer is that certain characteristics
of a democratic political process make it possible for benefits to be concentrated on
small numbers while the costs are “diluted” because they are spread over large
numbers. Stigler noted that in a democratic process decisions must be taken
(through elected representatives) that simultaneously involve all parties—those
very interested in a decision, those somewhat interested, and those uninterested
(“Theory of Economic Regulation,” pp. 10–11). In these circumstances, the larger
damage to majorities (i.e., the “deadweight loss” analyzed above) may meet little
resistance because the total costs are spread over so many people that the cost to
any one person is miniscule.
Information is a good with costs and benefits. Good information makes for bet-
ter decisions, but it takes time and effort to acquire. Because time is a limited
Ekelund-Hebert 6E.book Page 610 Thursday, August 1, 2013 11:03 AM

610 Part V ■ Twentieth-Century Paradigms

resource an individual has no incentive to acquire costly information on issues of no

concern to him or her, yet the individual votes on these issues, ordinarily through a
full-time representative affiliated with a political party. As Stigler argues:
The representative and his party are rewarded for their discovery and fulfillment
of the political desires of their constituency by success in election and the perqui-
sites of office. If the representative could confidently await reelection whenever he
voted against an economic policy that injured the society, he would assuredly do
so. Unfortunately virtue does not always command so high a price. If the represen-
tative denies ten large industries their special subsidies of money or governmental
power, they will dedicate themselves to the election of a more complaisant succes-
sor: the stakes are that important. This does not mean that the representative and
his party must find a coalition of voter interests more durable than the anti-indus-
try side of every industry policy proposal. A representative cannot win or keep
office with the support of the sum of those who are opposed to: oil import quotas,
farm subsidies, airport subsidies, hospital subsidies, unnecessary navy shipyards,
an inequitable public housing program, and rural electrification subsidies. (“The-
ory of Economic Regulation,” p. 11)

Politics and the voting process act as gross filters of individual preferences. Regula-
tions of all kinds are simply the result of interactions of self-interested demanders—
effective coalitions of individuals who stand to gain from regulation—and political
suppliers who must endure periodic reelection constraints.
Does this mean that the “public interest” comes in last in this process? In the
modern approach to regulation, the term “public interest” itself takes on a different
meaning. The public interest is not some abstract legalism; it is rather a summation
of individuals’ interests on any issue. If transactions costs among consumers were
zero, they would most certainly buy out monopolies. In figure 24-4, for example, with
a payment of PcPmAF consumers could buy off the monopolist and gain triangle AFG,
the dead-weight loss. In the imperfect world we inhabit, however, coalition costs are
positive and the state is permitted, within the bounds of democracy, to coerce monop-
olies. As a consequence, economic regulation can reduce the welfare of consumers.
It is important to recognize that regulation does not always support the special
interests of industrial market groups. Consumer or environmental groups may also
form effective coalitions to affect the political process. Preferences of nonmarket
groups may be registered, and different groups may capture the process at different
points in time. Identification of the specific configurations of costs and benefits fac-
ing demanders and politician-suppliers of regulations is an ongoing task engaging
contemporary economists in this field. One of the central problems is to develop a
sound single theory of political decision making within bureaucracies. Research on
such matters is ongoing.
Politics and the Peltzman Model of Regulation. Sam Peltzman (“Toward a
More General Theory of Regulation”) engineered the most powerful extension of
Stigler’s economic theory dealing with the interface between the distribution of eco-
nomic welfare and the political process. In Peltzman’s formulation, consumer wel-
fare is brokered against producer welfare by the political process to produce a
regulatory equilibrium level of price and profit. As with Stigler’s view, politicians
are rewarded with votes, money, and other perquisites—incentives to provide gains
for producers. But there is a trade-off: Gains for producers mean losses for con-
sumer-voters, which in turn mean loss of votes for politicians. Therefore, politicians
play a “balancing” game between the two groups.
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Chapter 24 ■ The New Political Economy 611

Peltzman’s model may be summarized in figure 24-5. Here the politician-regu-

lator’s “indifference” curves (i.e., what Peltzman calls “iso-majority” curves) repre-
sent the political process at work. Each curve traces out combinations of price and
profit that yield the same level of political support. Curves that are higher (ever
more northwesterly), such as I1 versus I0, denote higher levels of political support.
Higher prices (bad for consumers) must be linked with higher profits (good for pro-
ducers), so that the iso-majority curves are positively sloped. In other words, in
order to maintain a given level of political support, votes lost through price
increases must be compensated by increases in profits. The conventional profit hill
(shown in figure 24-5) shows the amount of wealth that is available for redistribu-
tion (from consumers to producers or from producers to consumers). The regulator
seeks to mediate between producers and consumers and establishes political equi-
librium price and profit levels at point E. Note that the regulator does not choose
either the competitive optimum (A) nor the monopoly optimum (F), but rather some
intermediate price-profit pair. This result stems from the fact that there will always
be a trade-off between consumers’ interests and producers’ interests that will have
political implications for the politician-regulator. Because politicians want to maxi-
mize their majorities at election time, there will always be moderation in the kind of
business regulation that they establish and support.
This insightful model—which is actually a theory of government as well as a
theory of regulation—contains multiple insights. The iso-majority functions
depicted in figure 24-5 present a monolithic summary of political preferences and
are determined by a variety of factors. Nevertheless, it is the existence of democrat-
ically determined legislative rules and the self-interest of politicians that explains

Profit

Higher political support

I1
Iso-indifference curve
I0

E Profit hill

Price
A

Figure 24-5 Peltzman’s model shows that regulation results from the interaction
between the profits of the firm (represented by the “profit hill” of businesses) and the
political support of politicians (represented by the iso-indifference curves). This interac-
tion generally results in a regulated price between monopoly price and competitive price.
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612 Part V ■ Twentieth-Century Paradigms

the supply of regulation. Likewise, the profit hills in Peltzman’s model come from
somewhere. Anything that causes these hills to emerge or to change measurably
invites regulation and regulatory change as a consequence. Thus, the advent of
inventions and new technologies, a sudden shift in relative prices due to cartel for-
mation, the aftermath of a hurricane, economic growth or decline, and the like, can
all lead to the establishment of new regulatory regimes. Many empirical implica-
tions, moreover, may be developed from Peltzman’s model. For example, as Mark
Crain and Robert E. McCormick indicate, regulated prices are likely to be lower in
jurisdictions in which regulators are elected rather than appointed (“Regulators as
an Interest Group”). Peltzman’s seminal idea has produced an ongoing and infor-
mative inquiry into the nature of the regulatory process.
Other Modern Approaches to Regulation. Historically the case for economic
regulation has rested squarely on the presence or absence of “natural monopoly”
conditions, that is, a situation in which a firm faces high fixed costs so that its long-
run costs per unit fall over large blocks of output. But the modern view rests on a dif-
ferent premise: It suggests that any effective coalition might secure regulation
through the political process, regardless of the nature of its cost structure. But what if
natural monopoly conditions (i.e., high fixed costs plus declining marginal costs) are
present? Does that mean that regulation by some government agency is inevitable?
In a view derived from Sir Edwin Chadwick’s nineteenth-century assessment of
similar problems (see chapter 10), Harold Demsetz (“Why Regulate Utilities?”)
questioned the necessity of regulating (in traditional fashion) industries having
scale economies in production.15 Demsetz proposed that formal regulation of utili-
ties would be rendered unnecessary where governments could allow “rivalrous
competitors” to bid for the exclusive right to supply the good or service over some
indefinite “contract” period. In such a system, as Demsetz demonstrated, the exis-
tence of natural monopoly does not imply monopoly price and output, as long as
there are an elastic supply of potential bidders and prohibitive collusion costs on the
part of potential suppliers.
Under certain restrictive conditions a “competitive” price and output could be
achieved by employing Demsetz’s idea (see the discussion of Chadwick and figure
10-1 in chapter 10). Critics of this idea have questioned vigorously the concept of
franchise bidding as a substitute for traditional forms of regulation, judging the
franchise-bidding scheme practicably unworkable because of market uncertainty,
information and policing costs, ambiguous investment criteria, and so on. Govern-
ment ownership of certain basic property rights would also be required to make the
scheme work. Since it is probable that Demsetz never intended his scheme to serve
as a full-fledged theory of regulation, it is not easy to weigh the burden of criticism.
There is not much empirical support for the existence of natural monopoly in utili-
ties and other regulated industries, and the “free-market position” on the matter—if
there is a unified position—is that deregulation and the return of competition to
most regulated activities would improve consumer welfare. For a view that con-
trasts Demsetz’s theory to an “Austrian” view of regulation that focuses on risk and
uncertainty, see the box, The Force of Ideas: Schumpeter on Risk, Regulation, and
Market Processes.

15
Actually, the modern rediscovery of the “Chadwick principle” was made three years earlier by
Gordon Tullock, who applied it to political party competition. See Tullock’s “Entry Barriers in Pol-
itics” in the references.
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The Force of Ideas: Schumpeter on Risk, Regulation, and Market Processes

The concern for regulation and the nature and extent of government involvement in mar-
kets is a very old issue, although as we note in this chapter modern writers have taken up the
debate with renewed vigor. As is often the case, it is useful to look back at past writers who
have informed the debate.
Joseph Schumpeter characterized the market function as an intertemporal competitive
process—which implies certain things about the role of government regulation.* According
to Schumpeter, risk is an unavoidable and natural element of market activity. In discussing
problems risk and uncertainty pose to entrepreneurs in a capitalist society Schumpeter said:
Practically any investment entails . . . certain safeguarding activities such as insuring
or hedging. Long-range investing under rapidly changing conditions, especially
under . . . the impact of new commodities and technologies, is like shooting at a tar-
get that is not only indistinct but moving—and moving jerkily at that. Hence it
becomes necessary to resort to such protecting devices as patents or temporary
secrecy of processes or, in some cases, long-period contracts secured in advance.†
But when there are “no facilities for insuring against it,”—such as patents; or enforcement
of patents is inadequate; or market participants do not have the ability to devise long-term
contracts with each other—then risk costs may be recouped (temporarily) by higher prices or
aggressively competitive behavior. In other words, Schumpeter stressed that elements of
competition that may appear to be anticompetitive from a purely static perspective (patents,
etc.) may encourage progress in a more dynamic competitive setting. Expressing a few reser-
vations about the adverse effects of cartels, Schumpeter even characterized a number of
static “monopolistic” practices as “natural” tools of dynamic (long-run) competition.
Schumpeter was also alert to the possibilities of utilizing regulatory procedures to subvert
the welfare effects of the marketplace. Since government is the only permanent source of
monopoly privilege, its regulatory actions should be scrutinized intensively:
The power to exploit at pleasure a given pattern of demand . . . can under the condi-
tions of intact capitalism hardly persist for a period long enough to matter for the
analysis of total output, unless buttressed by public authority. . . . Even railroads and
power and light concerns had first to create the demand for their services and, when
they had done so, to defend their market against competition.‡
This perspective on market processes provides a forceful case for a clear demarcation
between “static” competition and “dynamic” competition. Viewed in a static sense, nongov-
ernmental restrictions on competition are usually considered suboptimal, when in fact they
may help regulate the introduction of new technology that improves economic welfare. Gov-
ernment regulation, on the other hand, is the major source of long-term economic rents asso-
ciated with output reductions and welfare losses. Schumpeter’s insights, combined with the
modern theory of regulation as discussed in this chapter, remind us that the mere existence of
regulation and of intertemporal problems of production and consumption does not consti-
tute proof that the market has failed to work properly.
*For additional discussion of Schumpeter’s ideas see Method Squabbles 5 (chapter 21) and chapter 23.
†
J. S. Schumpeter, Capitalism, Socialism, and Democracy, p. 88.
‡
Capitalism, Socialism, and Democracy, p. 99.
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614 Part V ■ Twentieth-Century Paradigms

■ CONCLUSION
The purpose of this chapter has not been to settle contemporary theoretical dis-
putes in the theory of public choice or regulation. Rather, it has been to demonstrate
that new and ongoing inquiries in political economy have utilized and are utilizing
the simple models of competition and self-interest sponsored so long ago by Adam
Smith. The twist here—and the essential lesson to take from this chapter—is that
self-interest as a basic economic motive does not differ in form whether one is buy-
ing an ice cream cone or running a campaign for city treasurer. The same motives,
in form if not in kind, pervade the activities of all humans. Public-choice theory and
application, linking both taxation and expenditures and including the theory of reg-
ulation, is a valuable means of transforming economic analysis into other realms of
human action. In doing so it is stretching the reaches of the discipline within the
original conception of Adam Smith, a conception of economics as part of a broader
social and political inquiry.

REFERENCES
Arrow, Kenneth. Social Choice and Individual Values. New York: Wiley, 1951.
Averch, Harvey, and Leland L. Johnson. “Behavior of the Firm under Regulatory Con-
straint,” American Economic Review, vol. 52 (December 1962), pp. 1052–1069.
Black, Duncan. The Theory of Committees and Elections. London: Cambridge University
Press, 1958.
Bowen, Howard R. “The Interpretation of Voting in the Allocation of Resources,” Quar-
terly Journal of Economics, vol. 58 (November 1943), pp. 27–48.
Buchanan, J. M. “The Pure Theory of Government Finance: A Suggested Approach,”
Journal of Political Economy, vol. 57 (December 1949), pp. 496–505.
———. “La scienza delle finance: The Italian Tradition in Public Finance,” in Fiscal The-
ory and Political Economy. Chapel Hill: University of North Carolina Press, 1960.
———. “Public Finance and Public Choice,” National Tax Journal, vol. 28 (December
1975), pp. 383–394.
———, and Gordon Tullock. The Calculus of Consent. Ann Arbor: The University of
Michigan Press, 1962.
Crain, W. Mark, Thomas H. Deaton, and Robert D. Tollison. “Legislators as Taxicabs: On
the Value of a Seat in the U.S. House of Representatives,” Economic Inquiry, vol. 15
(April 1977), pp. 298–302.
———, and Robert E. McCormick. “Regulators as an Interest Group,” in James M.
Buchanan and Robert D. Tollison (eds.), The Theory of Public Choice II. Ann Arbor:
University of Michigan Press, 1984, pp. 287–304.
Demsetz, Harold. “Why Regulate Utilities?” Journal of Law & Economics, vol. 11 (April
1968), pp. 55–65.
Holcombe, Randall G. “Public Choice and Public Spending,” National Tax Journal, vol.
31 (December 1978), pp. 373–383.
———. “Concepts of Public Sector Equilibrium,” National Tax Journal, vol. 33 (March
1980), pp. 77–88.
———. “An Empirical Test of the Median Voter Model,” Economic Inquiry, vol. 18 (April
1980), pp. 260–275.
Hotelling, Harold. “Stability in Competition,” Economic Journal, vol. 39 (March 1929),
pp. 41–57.
Kalt, Joseph P., and Mark A. Zupan. “Capture and Ideology in the Economic Theory of
Politics,” American Economic Review, vol. 74 (1984), pp. 279–300.
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Kau, James B., and Paul H. Rubin. “Self-Interest, Ideology and Logrolling in Congressio-
nal Voting,” Journal of Law and Economics, vol. 22 (1979), pp. 365–384.
———. Congressmen, Constituents, and Contributors. Boston: Martinus Nijhoff, 1982.
Lindahl, Erik. “Just Taxation—A Positive Solution,” in Richard Musgrave and A. T. Peacock
(eds.), Classics in the Theory of Public Finance. New York: St. Martin’s, 1958 [1919].
McCormick, Robert E., and Robert D. Tollison. “Legislatures as Unions,” Journal of Polit-
ical Economy, vol. 86 (February 1978), pp. 63–78.
Mises, Ludwig von. Bureaucracy. New Haven, CT: Yale University Press, 1944.
Mueller, Dennis C. “Public Choice: A Survey,” Journal of Economic Literature, vol. 14
(June 1976), pp. 395–433.
Musgrave, Richard A. “The Voluntary Exchange Theory of Public Economy,” Quarterly
Journal of Economics, vol. 53 (February 1938), pp. 213–237.
Niskanen, William A. Bureaucracy and Representative Government. Chicago: Aldine-
Atherton Press, 1971.
Peltzman, Sam. “Toward a More General Theory of Regulation,” The Journal of Law &
Economics, vol. 9 (August 1976), pp. 211–240.
———. “An Economic Interpretation of Congressional Voting in the Twentieth Century,”
American Economic Review, vol. 75 (1985), pp. 656–675.
Posner, Richard A. “The Social Costs of Monopoly and Regulation,” Journal of Political
Economy, vol. 83 (August 1975), pp. 807–827.
Samuelson, Paul A. “The Pure Theory of Public Expenditures,” Review of Economics and
Statistics, vol. 36 (November 1954), pp. 387–389.
Schumpeter, J. A. Capitalism, Socialism, and Democracy. New York: Harper & Row, 1942.
Simons, Henry. “A Positive Program for Laissez-Faire,” in Harry D. Gideonse (ed.), Pub-
lic Policy Pamphlet no. 15. Chicago: The University of Chicago Press, 1934.
Stigler, George J. “The Theory of Economic Regulation,” The Bell Journal of Economics
and Management Science, vol. 2 (Spring 1971), pp. 3–21.
———, and Claire Friedland. “What Can Regulators Regulate? The Case of Electricity,”
Journal of Law & Economics, vol. 5 (October 1962), pp. 1–16.
Tiebout, C. M. “A Pure Theory of Local Expenditures,” Journal of Political Economy, vol.
64 (October 1956), pp. 416–424.
Tullock, Gordon. “Entry Barriers in Politics,” American Economic Review, vol. 55 (May
1965), pp. 458–466.
———. The Politics of Bureaucracy. Washington: Public Affairs Press, 1965.
———. “The Welfare Costs of Tariffs, Monopolies, and Theft,” Western Economic Jour-
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D. Tollison, and Gordon Tullock, Toward a Theory of the Rent-Seeking Society. Col-
lege Station: Texas A & M University Press, 1981.
———. “The Transitional Gains Gap,” The Bell Journal of Economics, vol. 6 (Autumn
1975), pp. 671–678.
Weingast, Barry R. “The Congressional-Bureaucratic System: A Principal Agent Perspec-
tive (with Applications to the SEC),” Public Choice, vol. 44 (1984), pp. 147–191.
Wicksell, Knut. “A New Principle of Just Taxation,” James M. Buchanan (trans.), in Rich-
ard Musgrave and A. T. Peacock (eds.), Classics in the Theory of Public Finance.
New York: St. Martin’s, 1958.

NOTES FOR FURTHER READING

The single best introduction to the literature of public choice is William F. Shughart
II and Laura Razzolini, The Elgar Companion to Public Choice (Cheltenham, UK:
Edward Elgar, 2001). This book contains important papers on such topics as public-
choice methodology, constitutional choice, the economics of government branches, and
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616 Part V ■ Twentieth-Century Paradigms

public choice applied to historical episodes. If one chooses to read into the earlier litera-
ture, translations of the classics are available. In addition to the writings of Lindahl and
Wicksell mentioned in the references to this chapter, Musgrave and Peacock’s important
volume contains a number of international classics in public finance translated into Eng-
lish. For much insight into the development of public finance see the essays of Maffeo
Pantaleoni, Ugo Mazzola, F. Y. Edgeworth, Enrico Barone, and Friedrich von Wieser. A
part of the French (Marshall-style) tradition is developed by R. B. Ekelund, Jr., and Rob-
ert F. Hébert, “French Engineers, Welfare Economics, and Public Finance in the Nine-
teenth Century,” History of Political Economy, vol. 10 (Winter 1978), pp. 636–668.
Contemporary literature on public goods is plentiful. A central question concerns
the “competitive provision” of public goods, that is, whether such goods can be supplied
competitively and whether such equilibriums are “stable.” See J. M. Buchanan, The
Demand and Supply of Public Goods (Chicago: Rand McNally, 1968); J. G. Head, “Public
Goods and Public Policy,” Public Finance, vol. 17, no. 2 (1962), pp. 197–219; and Harold
Demsetz, “The Private Production of Public Goods,” Journal of Law & Economics, vol. 8
(October 1970), pp. 293–306. In addition to the literature on voting cited in the text, two
early papers may be consulted: Duncan Black, “On the Rationale of Group Decision
Making,” Journal of Political Economy, vol. 56 (February 1978), pp. 23–24; and Kenneth
Arrow, “A Difficulty in the Concept of Social Welfare,” Journal of Political Economy, vol.
58 (August 1950), pp. 328–346. Also see T. Nicholas Tideman and Gordon Tullock, “A
New and Superior Process for Making Social Choices,” Journal of Political Economy, vol.
84 (December 1976), pp. 1145–1160.
The “constitutional rules” taken up by Buchanan and Tullock in their extension of
Wicksell’s optimal tax rules are considered in a somewhat different context in John
Rawls, A Theory of Justice (Cambridge, MA: Harvard University Press, 1971). Buchanan’s
reaction to Rawls, in addition to a very sizable contribution to the question, is contained
in his Freedom in Constitutional Contract: Perspectives of a Political Economist (College
Station: Texas A & M University Press, 1977). In addition to Niskanen’s major work on
bureaucracy, see his “The Peculiar Economics of Bureaucracy,” American Economic
Review, vol. 58 (May 1968), pp. 293–305. Emendations and extensions of Niskanen’s
work may be found regularly in the journal Public Choice; see also Bruce L. Benson,
“Why Are Congressional Committees Dominated by ‘High-Demand’ Legislators?—A
Comment on Niskanen’s View of Bureaucrats and Politicians,” Southern Economic Jour-
nal, vol. 48 (July 1981), pp. 68–77.
The literature on “empirical public choice” is wonderfully diverse and varied. On the
economics of internal organization of legislatures, see W. Mark Crain and Robert D. Toll-
ison, “Campaign Expenditures and Political Competition,” Journal of Law & Economics,
vol. 19 (April 1976), pp. 177–188; Arleen Leibowitz and Robert D. Tollison, “A Theory of
Legislative Organization: Making the Most of Your Majority,” Quarterly Journal of Eco-
nomics, vol. 95 (March 1980), pp. 261–267; and W. Mark Crain, “On the Structure and
Stability of Political Markets,” Journal of Political Economy, vol. 85 (August 1977), pp.
829–842. An article by Randall G. Holcombe and Asghar Zardkoohi uses a regression
model to show that grants are determined by political rather than economic variables; see
“The Determinants of Federal Grants,” Southern Economic Journal, vol. 47 (October
1981), pp. 393–399. An excellent contribution to interest-group theory is provided by Rob-
ert E. McCormick and Robert D. Tollison, Politicians, Legislation, and the Economy: An
Inquiry into the Interest-Group Theory of Government (Leiden: Martinus Nijhoff, 1981).
An important aspect of the empirical public-choice literature has been the modeling
of a political business cycle wherein inflation, employment, and disposable income are
manipulated by politicians in attempts to win elections. Edward R. Tufte, Political Con-
trol of the Economy (Princeton, NJ: Princeton University Press, 1978), presents one of
the most interesting and comprehensive studies of the electoral cycle. Also see Bruno S.
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Chapter 24 ■ The New Political Economy 617

Frey and Friedrich Schneider, “On the Modeling of Politico-Economic Interdependence,”

European Journal of Political Research, vol. 3 (December 1975), pp. 339–360; same
authors, “A Politico-Economic Model of the United Kingdom,” Economic Journal, vol. 88
(June 1978), pp. 243–253, which employs ex ante measures of actual popularity rather
than ex post electoral success as the “independent variable”. Richard E. Wagner, “Eco-
nomic Manipulation for Political Profit: Macroeconomic Consequences and Constitu-
tional Limitations,” Kyklos, vol. 30 (1977), pp. 395–410, developed a model meshing
political manipulations and the monetarist conception of the so-called inflation-unem-
ployment trade-off (i.e., the “Phillips curve”). See W. Mark Crain and Robert B. Ekelund,
Jr., “Deficits and Democracy,” Southern Economic Journal, vol. 44 (April 1978), pp. 813–
828, for an empirical study of why deficits are demanded as well as supplied.
Alfred E. Kahn’s two-volume study, Volume I: The Economics of Regulation: Eco-
nomic Principles, and Volume II: Institutional Issues (New York: Wiley, 1971), provide an
excellent summary of the “early” regulation literature and of the institutional structure
of broad areas of regulation in the United States through the 1960s. A good survey of
post-1962 regulatory theories—those discussed in the present chapter—is contained in
the introductory chapters of Bruce M. Owen and Ronald Braeutigam, The Regulatory
Game: Strategic Use of the Administrative Process (Cambridge: Ballinger, 1978). For an
important overview of regulation, in succinct graphical terms, see T. Randolph Beard,
David L. Kaserman, and John W. Mayo, “A Graphical Exposition of the Economic Theory
of Regulation,” Economic Inquiry, Oxford University Press, vol. 41 (October 2003), pp.
592–606.
The general topic of rent seeking and its role in regulation and income distribution
is covered in Toward a Theory of the Rent-Seeking Society, James Buchanan, Robert Toll-
ison, and Gordon Tullock (see references). Empirical papers presenting statistical evi-
dence on rent seeking and regulation have appeared regularly in most academic journals
throughout the 1980s and 1990s, especially in journals such as Journal of Law & Eco-
nomics, Journal of Legal Studies, Journal of Regulatory Economics, and Public Choice. A
minuscule sample of these papers includes: Deborah Hass-Wilson, “The Effect of Com-
mercial Practice Restrictions: The Case of Optometry,” Journal of Law and Economics,
vol. 32 (April 1986), pp. 165–186; Ann P. Bartel and Lacy Glenn Thomas, “Predation
Through Regulation: The Wage and Profit Effects of the Occupational Safety and Health
Administration and the Environmental Protection Agency,” Journal of Law and Econom-
ics, vol. 33 (October 1987), pp. 239–264; and Audrey B. Davidson, Elynor D. Davis, and
Robert B. Ekelund, Jr., “Political Choice and the Child Labor Statute of 1938: Public
Interest or Interest Group Legislation?” Public Choice, vol. 82 (1995), pp. 85–106.
The whole question of deregulation has been under constant examination since it
became policy in the late 1970s. Again, the literature is voluminous. For an important
reason why deregulation has not been a total success, see Robert E. McCormick, William
F. Shughart II, and Robert D. Tollison, “The Disinterest in Deregulation,” American Eco-
nomic Review, vol. 74 (December 1984), pp. 1075–1079. For an example involving dereg-
ulation of the trucking industry, see James M. MacDonald, “Railroad Deregulation,
Innovation, and Competition: Effects of the Staggers Act on Grain Transportation,” Jour-
nal of Law and Economics, vol. 35 (April 1989), pp. 63–96. The matter of rent seeking
and deregulation is developed in a number of theoretical and practical papers: See R. D.
Tollison, “Is the Theory of Rent Seeking Here to Stay?” in C. K. Rowley (ed.), Democracy
and Public Choice (London: Blackwell, 1987), pp. 143–157. Some reasons why effective
cable deregulation has been so difficult to establish may be found in Thomas W. Hazlett,
“The Demand to Regulate Franchise Monopoly: Evidence from CATV Rate Deregulation
in California,” Economic Inquiry, vol. 29 (April 1991), pp. 275–296.
Over the 1970s and 1980s, a veritable revolution in the study of industry structure
emerged, called “contestable markets theory.” The basic argument is simple: When
Ekelund-Hebert 6E.book Page 618 Thursday, August 1, 2013 11:03 AM

618 Part V ■ Twentieth-Century Paradigms

potential competitive rivalry is costless or inexpensive—when entry and exit possibilities

exist in a market—and price and output configurations are “sustainable,” the market
may be characterized as perfectly contestable. The theory of contestable markets may be
used to show that the principal conclusion of the traditional competitive model—that
price equates to marginal and average cost—may occur when numbers of competitors
are as small as two (or even one). In this theory the degree of concentration cannot
reveal anything about competitiveness. Under certain conditions even a “natural”
monopoly can behave as a competitive firm and industry. This theory holds that the
degree of contestability (and not the number of firms) is the benchmark for understand-
ing the competitiveness of markets. See William J. Baumol, John C. Panzar, and Robert
D. Willig, Contestable Markets and the Theory of Industry Structure (New York: Har-
court Brace Jovanovich, 1982). A number of the papers mentioned in these notes (and
others as well) can be found in Robert B. Ekelund, Jr. (ed.), The Foundations of Regula-
tory Economics, 3 vols. (Cheltenham, UK: Edward Elgar, 1998).
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Part VI
BACK TO THE FUTURE
THE TWENTY-FIRST CENTURY

Because the future is unpredictable we can only speculate about the path that eco-
nomic theory and method will take during the twenty-first century. But we may find
some hints in the past. Since the very beginning—including the long prelude to clas-
sical economics that we have labeled “preclassical”—the dominant goal of economic
theory has been to construct a meaningful, scientific explanation of how society
functions. The intellectual children of Adam Smith continue to develop new theo-
ries and methods to better explain economic events, including the master’s original
goal of fathoming the nature and causes of economic growth. It is surprising how
often new concerns keep returning to old ideas. Today, for example, theories of eco-
nomic development often hark back to a central concern of Smith and the English
founders—how the impact of institutions such as religion and government affect the
well-being of entire nations.
The movement to mathematics and econometrics—a combination of statistics
and mathematics used to test and verify theories—is now firmly fixed in economics
and will continue throughout the twenty-first century. In chapter 25 you will learn,
in very basic terms, the nature of this trend and its major tools. As the twenty-first
century spreads out before us, we seek to offer some preliminary assessment of the
actual and potential outcomes that mathematics and econometrics might have for
the discipline. We have seen clearly in earlier portions of this book that this move-
ment is not new. But the underpinnings of mathematics and econometrics have
become so pervasive in professional economic discourse as to cause one to openly
wonder whether economics will become another branch of mathematics.
Another distinct trend that will likely continue is the application of microeco-
nomic theory to a broad array of social problems. In chapter 26 you will learn some-
thing of the past accomplishments of economists working this venue, and perhaps
see opportunities for future research. The chapter focuses on modern developments
in demand/consumption theory, and broaches the critical question of the “rationality”
assumption in economics brought to the fore by contemporary experiments in psy-
chology. In addition the importance of the economics of information, quality differen-
tiation, and advertising and their relation to consumption technology are treated.
Chapter 27 takes you on an excursion into a few of the major applications of
economic theory to matters traditionally relegated to the other social sciences. Here
you will see, at least in preliminary fashion how simple economic theory can inform
matters in sociology (marriage, dating, etc.), religion (demands for religion, the his-
torical evolution of religion, etc.) art, archeology, anthropology and, not least, poli-
tics. These interesting application are the foundation for on-going and interesting
extensions of economics as part of the “everyday business of life.”

619
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620 Part VI ■ Back to the Future

Finally, in chapter 28 you will learn some of the high points of twentieth century
economics through a brief survey of Nobel Prize winners in Economic Science.
These economists and their winning ideas provide a backdrop for an assessment of
the directions of the more distant future. Will core economic theory survive? How
has the “technology” for the introduction of economic ideas changed? Will new het-
erodoxies arise? If so, will there be a schism between political economists (in the
tradition of Adam Smith and general social science) and those who regard econom-
ics as a pure mathematical science? Only time will tell.
Ekelund-Hebert 6E.book Page 621 Thursday, August 1, 2013 11:03 AM

25

Mathematical and
Empirical Economics
A Method Revolution

Possibly the most visible aspect of modern economics is the suffusion of ever-
expanding new mathematical and statistical techniques into every branch of
inquiry. A visit to any university library to investigate the latest in economic
research might turn up titles such as the following: “The Economist as Engineer:
Game Theory, Experimentation and Computational Tools for Design Economics”;
“Recursive Utility and Optimal Growth with Bounded or Unbounded Returns”;
“Arrovian Aggregation in Economic Environments: How Much Should We Know
About Indifference Surfaces?”; or “On the Nonexistence of Universal Information
Structures.” These examples are not fabricated but are actual papers in the leading
journals. Nobel laureate Gerard Debreu (see references) cited the following jour-
nals as playing a major role in the spread of the mathematical technique in econom-
ics: Econometrica (founded in 1933), Review of Economic Studies (1933),
International Economic Review (1960), Journal of Economic Theory (1969), and
Journal of Mathematical Economics (1974). Others such as the Journal of Econo-
metrics (1973) might be added to the list. But these journals, which emphasize the
development of technique, grossly underestimate the number of journals and regu-
larly published papers that use and apply mathematical and empirical techniques in
economics—papers that number in the tens of thousands of pages each year. Basic
economics teaches us that there are costs and benefits to everything. The present
chapter seeks briefly to examine some of the applications of mathematic tools to
economic study and, as the twenty-first century unfolds before us, to provide a pre-
liminary assessment of the actual and potential outcome of this development for
economic science.
Certainly the quest to formalize economic theory and to gauge the power of its
predictions is not new. It was a mission and ongoing concern within the discipline
throughout the twentieth century and even before. Most, if not all graduate or under-
graduate programs in economics require some evidence of proficiency in mathemat-
ics and statistics, or econometrics (a combination of economic theory and statistical
methods). Advanced students of economics would not be able to read papers in aca-
demic journals (such as those listed above and many more) without such profi-
ciency. New mathematical and statistical techniques are rapidly introduced in order
to elaborate new economic theories or new tests of earlier economic theories.

621
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622 Part VI ■ Back to the Future

The enthusiasm for these developments is somewhat mixed. Some critics argue
that the costs of further developments along mathematical/empirical lines heavily
outweigh the potential benefits. Others defend these developments and argue that
economics cannot and will not ever achieve “scientific” status without continuous
cultivation and refinement of technique. Obviously, no definitive prediction of the
outcome of these developments in the twenty-first century is possible. But if part of
the role of the historian of economic thought is to chronicle and assess major devel-
opments in the discipline, the encroaching dominance of technique requires analy-
sis. Specifically, what are the origins of these important developments in method?
How and to what end are mathematics and statistics applied in economics and in
economic theory? What are the gains and losses from such applications? What is the
current state and what is the probable future of mathematical and testing techniques
in the profession and in economic inquiry? Since methods of testing economic the-
ory paralleled or followed the acceptance and development of mathematical and sta-
tistical techniques, we first devote attention to mathematical methods and their long
history in economics.

■ HISTORY AND DEVELOPMENT OF MATHEMATICAL ECONOMICS

From the very beginnings of what we now call economic analysis, economists
have attempted to “display” their ideas in order to improve them and to facilitate
communication. Much early work was framed in a purely literary style, but numeri-
cal and mathematical presentations entered the literature as early as the eighteenth
century. Of a fairly substantial mass of international contributions, we provide only
three examples worthy of mention. In Italy Cesare Beccaria (1712–1769), a scholar
and administrator, established utility as underlying economic behavior in Dei delitti
e delle pene (1764) and in Elementi de economia publica (1771), works he crowned
by applying mathematical methods to economic reasoning. In France, a civil engi-
neer, A. N. Isnard (1749–1803), applied a “general equilibrium”/mathematical
approach to questions of exchange, production, capital, interest, and foreign trade
in Traité des richesses (1781). While Ricardo and Malthus were developing a literary
approach to classical economics, a British scholar William Whewell (1799–1866)
wrote between 1829 and 1831 a Mathematical Exposition of Some Doctrines of
Political Economy, a book that applied mathematical analysis to Ricardian econom-
ics and to capital and input substitution.1 These and many other amazing contribu-
tions were natural developments, since economics not only deals with “tendencies”
but also with the numerical calculation of social phenomena.2 The kind of deduc-
tion from which economic theory proceeds clearly invites and encourages research-
ers to employ mathematics.
Many early advances in the mathematical approach to economic theory did not,
fortunately or unfortunately for the history of economics, establish a pattern of
acceptability. Augustin Cournot (1801–1877), as we learned in chapter 13, was the
real founder of mathematical economics. One could hardly improve, even today, on

1 These writers are but a small sample. A fuller idea of the achievements of economic innovators
with a “technical” bent may be found in chap. 13. Also see the excellent treatment by Theocharis,
Early Developments in Mathematical Economics (see references).
2
For example, in the seventeenth century, Sir William Petty developed what he called “Political
Arithmetick” to describe a primitive national income account system (see chap. 4). A few decades
later, Charles Davenant, building on earlier work by Gregory King, estimated a demand curve (see
John Creedy, “On the King–Davenant ‘Law’ of Demand,” in the references).
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Chapter 25 ■ Mathematical and Empirical Economics 623

Cournot’s understanding of the role and advantages of using mathematics in eco-

nomics. The employment of mathematics, in Cournot’s embryonic understanding,
was not different from the use of words or graphical representations of economic
theory. Cournot claimed that Ricardo had only disguised his algebra under “numer-
ical calculations of tedious length” (Researches, p. 4). But Cournot knew full well
that numerical calculations were not the only or even the major benefits of the use
of mathematics. He valued mathematics as a methodological tool, declaring:
I have said that most authors who have devoted themselves to political economy
seem also to have had a wrong idea of the nature of the applications of mathemati-
cal analysis to the theory of wealth. They imagined that the use of symbols and for-
mulas could only lead to numerical calculations, and as it was clearly perceived
that the subject was not suited to such a numerical determination of values by
means of a theory alone, the conclusion was drawn that the mathematical appara-
tus, if not liable to lead to erroneous results, was at least idle and pedantic. But
those skilled in mathematical analysis know that its object is not simply to calcu-
late numbers, but that it is also employed to find the relations between magnitudes
which cannot be expressed in numbers and between functions whose law is not
capable of algebraic expression. (Researches, pp. 2–3)

Good data have always been hard to come by, and very often are costly to gen-
erate. This is no less true in our own day as it was in Cournot’s. Nevertheless,
Cournot appreciated the value of mathematics to facilitate economic intuition about
how certain economic values (e.g., price and quantity) were related to each other
and to other magnitudes. In his own words, mathematical symbols are able to “facil-
itate the exposition of problems, to rend it [sic] more concise, to open the way to
more extended developments, and to avoid the digressions of vague argumentation”
(Researches, p. 4). Since the functions developed by Cournot were in finite com-
modity and price spaces, he effectively used Euclidian geometry (i.e., graphs) to
illustrate economic theory alongside algebraic formulations.

■ COMMON MATHEMATICAL TOOLS USED IN ECONOMICS

In principle, then, literary, graphical, and mathematical expressions of economic
theory do not differ in any fundamental respect. But there are costs and benefits to
the use of each means of expression. By way of analogy, consider the use of com-
puter software. Software provides a means to process information; it gets us from
“input” to “output.” Each software package, whether for word processing or data
processing, permits us to transfer inputs to output, and each software package does
it differently. Of course, it takes time to learn any given software package, but once
learned, the tool may be used again and again for any task that may be adapted to it.
One of the tasks of the economic theorist is to reason deductively from postu-
lates (assumptions about economic behavior) to conclusions about the way the
world works—or how some particular facet of it (markets for nurses, for example)
functions. Just as there are different types of computer software that provide a
means to record and disseminate words and thoughts, there are different ways to
get from postulates to conclusions in expressing economic theory. Each kind of soft-
ware has advantages and disadvantages, just as each mode of economic expression
has pluses and minuses.
A purely verbal argument is readily intelligible to the largest audience, but as
Cournot recognized, literary exposition has some definite limitations. Literary
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624 Part VI ■ Back to the Future

exposition can lead to digressions and ambiguities. Where elaborate reasoning is

required, graphical and mathematical expositions offer more precision. Graphs of
economic relations and theories provide a very useful picture and help the econo-
mist grasp and extend complex relations. Geometry has taken and still takes econo-
mists far as a mode of expressing economic ideas. But graphs also have limits.
When problems extend beyond two dimensions (e.g., a demand relation involving
changes in prices, quantities, and income), graphs become cumbersome, and their
usefulness declines. Moreover, graphs are limited to three dimensions, so they are
inappropriate to problems involving more than three dimensions. Mathematics and
geometry were used by neoclassical writers such as Jevons (chapter 15) and their
forerunners (chapter 13) to explicate simple theories of consumer behavior, but as
economists began to tackle larger problems (e.g., Walrasian general equilibrium;
see chapter 17), new modes of expression (“software”) became necessary, and
mathematics became a vital tool of the economic theorist. The benefits that mathe-
matics brings to economics are at least threefold: (1) mathematics makes assump-
tions and premises explicit, thereby eliminating “hidden” biases of theory; (2) it
makes the presentation of economic theory more concise and more precise; and (3)
it allows the economist to deal more readily with economic problems of more than
two dimensions. It was inevitable, therefore, that mathematical theorems of many
kinds, some of them exceedingly complex, would become part and parcel of the
economist’s “software.” We cannot treat this subject exhaustively, but we will iden-
tify some major, elementary tools here, and we will introduce others (at least intui-
tively) later in the chapter.

Calculus
Arithmetic and algebra have always been of great value to the economist, but as
economics progressed the most useful tools have proven to be differential and inte-
gral calculus. We saw previously (chapters 13–17) that early econo-engineers such
as Dupuit, Ellet, and Lardner, and later economists such as Jevons, Marshall, and
Walras, employed calculus in their contributions. It is of the very nature of eco-
nomic study to examine magnitudes—quantities supplied and demanded, popula-
tion, wages, profits, etc.—and whether such magnitudes rise or fall. Purely
qualitative economic models deal with direction—up or down. Thus, a hypothesis
that states that an increase in demand (supply remaining constant) increases both
equilibrium price and quantity makes a qualitative statement about the direction of
price and quantity. But the issue of how much price and quantity will change in
response to a change in demand is a quantitative question (the answer to which
includes the qualitative). Differential calculus, which essentially deals with rates of
change, is thus the natural tool for the economist to employ in constructing and dis-
cussing economic theories, and integral calculus sums these rates of change in
order to arrive at total calculations—total population, total quantity demanded or
supplied, or total profits.
Consider an example from personal finance. Suppose you are a greenhouse
enthusiast and plan to cultivate orchids, eventually for profit. As you add rarer and
rarer orchids to your collection, your total expenses rise. The rate of change in your
expenditures between, say the 121st and 122nd orchid, is found by taking the
“derivative” or “differential” of the total cost curve between these two points. This
derivative constitutes your marginal cost of adding that extra orchid and it is also, in
geometric terms, the tangent to your total cost function. But you may be interested
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Chapter 25 ■ Mathematical and Empirical Economics 625

in another question. What is the total cost of your collection between the 200th and
300th orchid? To find this sum you simply add up, or “integrate,” the rates of change
in expenditures between the 200th and 300th orchids. This simple example suggests
how both the differential and integral calculus might be used with either hypotheti-
cal or actual data. We might, for example, be interested in federal expenditures on
infrastructure throughout the twentieth century. If we have the data, a total expen-
ditures curve could be constructed and the slope at any point in time found by tak-
ing the derivative of the total expenditures curve. By contrast, we could find the
total expenditure on infrastructure between 2008 and 2012 by integrating or finding
the area under the total expenditures curve between these two points in time.
Because economic decisions are usually made at the margin, economists are
often not as interested in total quantities as they are in marginal quantities. In the
theory of the firm, for example, the businessperson is interested in the marginal
cost and marginal revenue of this or that action. Differential calculus is uniquely
suited to provide such answers. An excellent example is the theory of consumer
behavior. The consumer, with a given set of preferences for all goods and services,
faces a certain set of prices and is constrained by his or her income. The mathemat-
ical procedure that describes the consumer’s solution to the problem of utility max-
imization in these circumstances is called constrained optimization, which is a
straightforward application of differential calculus. Another example is given by
Cournot’s theory of profit maximization (see figure 13-1 and related discussion in
chapter 13). Cournot specified the solution as requiring the rates of change of the
firm’s revenue (i.e., marginal revenue) and costs (i.e., marginal costs) to be equal.
Marginal revenue and marginal cost are determined by taking the first derivative of
the total revenue and total cost functions, respectively, thus providing another illus-
tration of the straightforward application of differential calculus.
Integral calculus finds ready application to basic economic problems, especially
in the fields of industrial organization and public finance. The decision whether to
provide a new bridge or public park should be informed by, among other things, a
calculation and comparison of the economic costs and benefits. A common means
of calculating benefits is the computation of consumer surplus (see chapters 13 and
16), by determining the maximum price consumers would be willing to pay for the
good or service rather than go without it. The mathematical measure of this aggre-
gate “benefit” is the integral or “summing up” of the benefits of all individuals under
the demand curve for the good in question. Once the demand curve is estimated and
the costs of the project are calculated, integral calculus provides the economist with
a ready-made tool for making an actual calculation and comparison.

Linear Systems and Algebra

Algebra, whether basic or advanced, provides the economist with a wealth of
tools or “software” by which to express economic theory. This is especially so when
the economist is faced with the task of estimating general-equilibrium (Walrasian)
relations and interrelations. A branch of algebra called matrix algebra has proved
especially useful in dealing with large numbers of equations and variables that sum-
marize or approximate those in a real-world economy.
The combination of linear and matrix algebra provides an estimation procedure
that depicts production or consumption (or other) relations as being linear, or as
being reducible to, or approximated by, linear relations. The advantage of this pro-
cedure is that huge systems of equations can be calculated rapidly by computer to
uncover complicated relations in an economic system. A possible disadvantage to
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626 Part VI ■ Back to the Future

using linear relations is that, even as approximations, they may not capture accu-
rately the features of actual production or consumption relations. However, this
valuable technique forms the basis for economy-wide models that predict overall
economic growth as well as growth in particular economic sectors. A single such
model may contain inaccuracies, but fortunately most advanced economies are
modeled in a number of ways, giving a better overall prediction of growth and other
factors over time. The usefulness of such predictive tools is well established.

■ COURNOT’S HEIRS: APPLICATIONS OF MATHEMATICS

TO ECONOMIC IDEAS
Calculus and algebra are two general mathematical tools that have proved use-
ful to the economist. Depending on the nature of the problem, economists have
adapted as well many other varieties of mathematical “software” of varying com-
plexity. Calculus, however, has been the tool of choice from the beginning for the
simple reason that “small changes” lie at the heart of so many economic problems.
The early intellectual descendants of Cournot applied calculus to economic prob-
lems in quite ingenious ways. Francis Ysidro Edgeworth (1845–1926), a neoclassical
contemporary of Jevons, Marshall, and Walras, was perhaps the premier Anglo-
Saxon economist of his era in adapting mathematics to the social sciences (Mathe-
matical Psychics). (He dealt with complex, sophisticated, and somewhat obscure
problems, which may account for his relative neglect by contemporaries: He
applied calculus and other mathematical tools to issues such as monopoly, price dis-
crimination, index numbers, and taxation (see notes for further reading). His long
co-editorship of the Economic Journal, a duty he shared with John Maynard
Keynes, may have had a major impact on the direction of economic method. His
admirers all agree, however, that he was without peer in his understanding of
(active and reactive) duopoly behavior among competitors and for his invention of
the “core” theory of a contracting exchange economy.3
Alfred Marshall, although an enthusiastic and capable mathematician, largely
eschewed the application of formal mathematics in his academic writings. Mar-
shall’s aim was to portray economics as a tool of social change in a way easily
understandable by the businessperson and to the intelligent layperson (see chapter
16). He wished his ideas to be accessible to the widest possible audience and saw
mathematics as a device that would retard this goal. Yet, while Marshall was reluc-
tant to employ mathematics, his students and successors have taken his (and Léon
Walras’s) ideas to new heights of mathematical sophistication. In 1934, John R.
Hicks (1904–1989) and R. G. D. Allen (1906–1983), in a joint mathematical tour de
force, recast Marshallian value theory in terms of calculus. Hicks (subsequently
awarded a Nobel Prize in Economics in 1972) later expanded this “new” neoclassi-
cal microeconomics in 1939 (Value and Capital) to include dynamic and monetary
considerations. His rigorous mathematical presentation of key components of eco-
nomic theory eventually became a standard for modern practice.
Paul A. Samuelson (1915–2009), an American economist who won the Nobel
Prize in 1970, has also been an important force for mathematical rigor in economic
theory. In his Foundations of Economic Analysis (1947), a work stemming from his
Harvard doctoral dissertation of six years earlier, Samuelson transformed the style

3
See Peter Newman’s biography of Edgeworth in The New Palgrave: A Dictionary of Economics
(listed in the references) for a fuller discussion of Edgeworth as a mathematical economist.
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Chapter 25 ■ Mathematical and Empirical Economics 627

of economic analysis from predominantly verbal-graphical exposition to systematic

and thorough mathematical treatment. In the Foundations and in many other
works, Samuelson applied mathematics to general economic theory and to specific
elements of that theory, including the theory of consumer behavior, growth and cap-
ital theory, welfare economics, and international trade theory. As leaders in the eco-
nomics profession, Hicks and Samuelson gave legitimacy to mathematical and
empirical economics. Moreover, they set the trend that has carried forward into the
twenty-first century and shows no signs of abatement.

Linear Mathematical Relations

As suggested above, linear algebra and its elaborations provide an important
mathematical tool that finds ready application in economic theory. Numerous early
attempts to apply algebra, often in conjunction with calculus, highlight the develop-
ment of economic theory in the nineteenth century. It might be recalled that Fried-
rich von Wieser in his book Natural Value (1884) introduced a simple system of
input-to-value equations in order to determine the productive contribution of each
input (chapter 13). His simple, linear equations (for various industry inputs and val-
ues) yield a simultaneous algebraic solution. Elaborations on this theme abound in
twentieth- and twenty-first century economics.
Linear Programming. One of the most important applications of linear tech-
niques has come through the development of linear programming by mathemati-
cians John von Neumann and George Dantzig in the late 1940s and by economists
Robert Dorfman, Paul Samuelson, and Robert Solow in 1958 (see notes for further
reading). While linear (and certain forms of nonlinear) programming have been
brought to increasingly useful and elaborate states of development, the fundamen-
tal idea is basically uncomplicated. Linear programming models represent optimiz-
ing behavior as the choice of processes or activities under some set of linear
constraints. Dantzig first applied this tool to logistical planning and to the optimal
deployment of military forces, but the tool has many other applications in econom-
ics and business, especially in choosing least-cost production techniques.
For illustrative purposes, consider a standard problem in microeconomic the-
ory—profit maximization by the firm.4 Suppose a sporting goods firm produces ten-
nis rackets and barbell sets and that each production requires three machines: types
A, B, and C. Arbitrarily we might identify these three types as cutting machines,
lathes, and finishing machines. Given the number of machines the firm owns, there
is obviously some maximum utilization of that machine to produce (either or both)
tennis rackets and barbell sets. Units of these goods require definite numbers of
hours of machine use—these are the physical requirements—and, naturally, the
firm owns a limited number of each machine. Once these facts are all known, the
profit-maximizing firm must choose to produce tennis rackets and barbell sets
(called the firm’s choice variables) within some constraint set by the number of
machines the firm owns. The firm is also constrained by the number of machine
hours required to produce each of its goods. In other words, the firm is going to be
limited by what economists call a feasible region of production—combinations of
machine hours that will actually produce tennis rackets and barbell sets.
What solution will the firm choose—i.e., how many barbell sets and tennis rack-
ets (or possibly all or one or the other) will the firm actually produce? That choice

4
The example provided here is adapted from Charles Maurice and Charles Smithson, Managerial
Economics, chap. 7 (see references).
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628 Part VI ■ Back to the Future

will depend on the relative profitability of those two items. In general the firm is
said to maximize profits subject to physical constraints and availability of
machines. Linear iso-profit curves—curves showing profit levels for alternative
combinations of the two goods—may be calculated and an exact output of the two
goods may be ascertained therefrom. (Naturally there cannot be negative quantities
of either good produced.)
This simple example illustrates some fundamental principles of linear program-
ming, but it is only one of many problems that can be treated and solved by linear
programming methods. The technique is useful in any case involving constrained
choice. It has been used repeatedly in problems of cost minimization for given out-
put levels, in the selection of production techniques in industry and agriculture, and
in the minimization of transport costs, but it is applicable also to problems involving
consumer behavior. It can provide solutions, for example, to the problem of allocat-
ing one’s work or leisure in order to maximize one’s income or satisfaction.
Macroeconomic Applications: Input-Output Analysis. Linear programming
is actually an offshoot of a broader mathematical technique called input-output
analysis, which was invented by 1973 Nobel laureate Wassily Leontief (1906–1999),
an American economist who emigrated from Russia. Input-output analysis is a
mathematical technique that emphasizes the general interdependence of inputs and
outputs of whole economies, regions, or, indeed, even the entire world. Leontief,
who joined the Harvard faculty in 1932, published the first input-output tables for
the United States during World War II. His early tables described the American
experience between 1919 and 1929 (“Input-Output Analysis”; The Structure of the
American Economy).
Input-output analysis contains both inductive and deductive components. It
draws inductively on actual data and actual interdependencies of all of the various
sectors of the economy. These interdependencies, however, are analyzed within
mathematical models that facilitate computations and analyses of the effects of
exogenous changes such as changes in the composition of final demand or input
supplies—the deductive component of input-output investigations. Input-output
analysis may also be contrasted with the highly aggregative Keynesian theory (chap-
ter 21), insofar as actual tables are usually based on disaggregated economic data.
As an introduction to this important branch of mathematical analysis, consider
an elementary input-output table with only three sectors in a simple economy.
Actual input-output tables may contain hundreds of sectors and subsectors describ-
ing real-world economies. Ours is represented in table 25-1 and kept simple for
illustration. This simple economy contains three interrelated sectors: a food-and-
raw-materials sector, a manufacturing sector, and a household sector. Like all input-
output tables, table 25-1 is composed of rows and columns arranged in the form of
what is called an input-output matrix. (A 3×3 matrix contains three rows and three
columns; a 75×75 matrix contains seventy-five rows and an equal number of col-
umns.) Each row and its corresponding column represent one particular sector of
the economy, e.g., automobiles, toasters, avocados, and so on. In the simple case
described in table 25-1, the agricultural (food-and-raw-materials) sector has pro-
duced 1,000 bushels of corn, which are delivered in the various amounts to the sec-
tors listed in the column headings. Two hundred bushels have been retained in the
agricultural sector (for replenishment of seed), 100 bushels have been delivered to
the manufacturing sector, and 400 bushels have been delivered to the household
(final demand) sector. Other sectors, not shown in the table, receive the balance, so
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Chapter 25 ■ Mathematical and Empirical Economics 629

Table 25-1 A Three-Sector Input-Output Matrix*

Sector Agriculture Manufacturing Household Total
Food and Raw Materials 200 100 400 1,000 bu. corn
Manufacturing 100 150 25 300 tons plastics
Household 250 200 — 450 work-years
*The production requirements of the various sectors of an economy are summarized in rows and columns.

the row does not add up to the total produced. Entries may also be zero for some
column sectors since some sectors may deliver nothing to other sectors of the econ-
omy. Like the agricultural sector, the manufacturing sector delivers output to other
sectors. The manufacturing sector is represented in table 24-1 by a producer of plas-
tics. Thus, we see that manufacturing delivers 100 tons of plastic to the agricultural
sector, supplies 25 tons to the household sector, and retains 150 tons for its own use.
Each column may be interpreted as displaying the requirements for production in
the sector represented. The agriculture column in table 25-1 tells us that the produc-
tion of 1 bushel of corn requires 1/5 (200/1,000), or 0.20, of a bushel of corn; 1/10
(100/1,000), or 0.10, ton of plastics; and 1/4 (250/1,000), or 0.25, person-year of
labor. The production of 1 ton of plastics (reading down column 2) requires 1/3 (100/
300), or 0.33, person-year of labor.
While this example may seem artificial, its purpose is to show how the technical
coefficients of production are built up and arranged in mathematical form. Once the
technical coefficients (a fancy term for the production requirements for any good or
service) are known, and once final (actual) output is known, equations relating
inputs to outputs may be developed. These equations, which can be manipulated
through the use of matrix algebra, then provide critical information on intersectoral
changes in input and production requirements that would emerge, say, if final
demand for corn or plastics were to change. The general interdependence of any
economic system means that a change in demand in one sector will and must affect
many other sectors in the economy. In any real-world economy these interdepen-
dent intersectoral changes will have an enormous impact on resource utilization in
certain sectors, including employment in specific sectors.5
Successes and Failures of Linear Models. Input-output analysis is a useful
tool for estimating changes in intersectoral production requirements that emerge
from changes in final demands. One early use of Leontief’s model, for example, was
to predict the extent of steel shortages during World War II. The impact on total pro-
duction due to technological change in one sector may be estimated by means of the
device. Input-output analysis is thus both a descriptive tool that permits the model-
ing of an economy from actual data and an analytical tool that permits the estima-
tion of intersectoral shortages or surpluses under the assumption of a specific
change in final demand or technology. While the technique itself is politically neu-
tral, it obviously lends itself readily to problems of socialist planning and economic
development. Be that as it may, Marxist economists did not uncritically accept the
technique. Indeed, the Soviet Union’s use of computer-driven techniques to deter-
mine target outputs and so-called shadow prices for goods did not protect it against

5
The reader may wish to reexamine Quesnay’s Tableau économique (see chapter 4) in order to
appreciate it as a primitive input-output model.
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630 Part VI ■ Back to the Future

failure due, in large part, to issues raised by Austrian economists in the socialist cal-
culation debate (see chapter 23). Miscalculations and bureaucratic opportunism
(i.e., cheating and fraud) riddled the system, resulting in chronic waiting lines for
all manner of goods, including food. Scarcity of food and waiting in long lines to
purchase it were not the least important reasons for the final breakup of the Soviet
Union in 1991.
The use of linear models in microeconomics and macroeconomics, as exempli-
fied by linear programming and input-out analysis, has been enhanced in a positive
manner by the invention and development of the computer. Greater and greater
computing capacity—roughly doubling every two years—and the increased speed of
calculations have allowed the development of highly sophisticated econometric
forecasting models of the economy (famously at the St. Louis Federal Reserve Bank
and at MIT). Input-output matrices may now be manipulated and analyzed with
hundreds of sectors, thanks to advanced computer technology. In addition, the con-
cepts of linear programming and input-output theory have helped bridge the chasm
between the highly aggregative kind of Keynesian macroeconomic theory so popu-
lar in the precomputer age and the microeconomic principles of general-equilib-
rium theory.
Despite rapid advances in technology, however, predictive accuracy has been
illusive because the fundamental elements of the economy or most “systems”
become more complex through time. Hence theories devised to capture more com-
plex reality become more complex as well—even as computer capabilities are ever
increasing. We should be continually mindful that no matter how sophisticated
computers become, the quality of “output” (predictions of GDP, employment, infla-
tion, sectoral input requirements, and so on) depends on the quality of the “input”
(data derived from varied and sometimes dubious sources). Moreover, no matter
how quantitative economics becomes, it remains a social science that involves
human, and therefore not strictly predictable, behavior. Actual production and con-
sumption relations may not be strictly reducible to linear functions. In other words,
economies or diseconomies may exist in production and consumption patterns in
the real world. But these problems do not negate the usefulness of contemporary
mathematical techniques. In most cases, some estimation technique is far better
than none at all, and estimates can usually be improved over time by better eco-
nomic theory and intuition, aided by ever-improving methods of calculation. Prop-
erly used, linear algebra is a powerful tool that can enlighten and enliven
contemporary economic research.

Game Theory
One of the most interesting and important tools of modern economic analysis is
the technique called “game theory.” Unless huge numbers of competitors act or
react in exchange markets of all kinds, some form of mutual interdependence
develops. Because we all find ourselves in situations of mutual interdependence
every day, the basic problems of competitive games should be familiar to everyone.
Anyone who has ever played games of any sort—tennis, soccer, bridge—will imme-
diately recognize the problem. Our actions are interdependent when playing games
because the actions of one player affect other players’ behavior. Moreover, our own
behavior is conditioned by what we expect other players’ reactions to our own
behavior to be. Do we go the extra mile in performing our job in expectation that
the boss will give us a raise? That depends on how we expect our boss to react to
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Chapter 25 ■ Mathematical and Empirical Economics 631

increased productivity. And think of your weekly tennis match with your friend
Sam. Respectful of your powerful serve, Sam has learned to stand well behind the
baseline when receiving it. This position allows him to return an increasingly high
percentage of your serves. Noticing this, you decide to surprise him with a shallow
slicing serve. If you serve this way consistently, Sam will likely change his behavior.
Sam’s actions and yours are clearly interdependent—and recognized to be so. Game
theory is a branch of economics that merely formalizes the effects on alternative
strategies of mutual interdependence.
The Origins of Game Theory. Cournot (see chapter 13) originated an early
form of game theory in the nineteenth century by analyzing the nature of competi-
tion between two mineral water sellers. Each competitor’s behavior was condi-
tioned on conjectures about how the other seller of mineral water would behave in
reaction to the first competitor’s actions. Facing demand for a homogeneous prod-
uct (mineral water), sellers A and B adjust the quantities they sell assuming that the
other will keep quantity constant no matter how much experience he has to the con-
trary. Each knows the total demand curve for mineral water and each maximizes his
own profits under the quantity-constant assumption. As a result (see chapter 13 for
a graphical representation) the competitors arrive at an equally shared, combined
output equal to [n/(n + 1) (i.e., the monopoly quantity)]. Cournot’s model employs a
(naive) conjectural variable about a rival’s quantity of sales. But in other contexts a
conjectural variable could be almost anything—how your boss reacts to your pro-
ductivity by the amount she pays you, or how Sam reacts to your tennis serve.
The game-theoretic aspects of Cournot’s model were fully appreciated early on.
The French mathematician, Joseph Bertrand (see notes for further reading) argued
in 1883 that Cournot’s model would yield different results if it was adapted to
include a conjecture about price rather than quantity. In effect Bertrand changed
the behavior of each rival to reflect a different conjecture. The new conjecture is: I
assume that my competitor will hold price rather than quantity constant (no matter
what I do in reaction). It can be demonstrated that such a conjecture would lead to
competitive output (where price equals average cost).
A decade after Bertrand offered up his modification, Francis Ysidro Edgeworth
added a different perspective to Cournot’s original model. He assumed that the
duopolist in fact conjectured about price, but that each competitor had an output
limitation, so that neither seller could sell all the output that would be demanded
under competitive conditions. In this case, equilibrium is unattainable. Because
Edgeworth’s model anticipates some of the problems that pertain to game theory, it
is instructive to consider it in more detail. Let us suppose, as Edgeworth did, that
duopolists share a market for mineral water such that each faces a demand curve
for half the daily market for water. Figure 25-1 on the following page replicates
Edgeworth’s figure (“Pure Theory of Monopoly,” pp. 118–121). RC is the demand
curve for duopolist A and RC is the demand curve for duopolist B. There is a catch,
however. A’s output limitation is quantity OB and B’s output limitation is OB.
Assuming they both start at profit-maximizing price levels, they will share the mar-
ket equally selling OA and OA respectively.
Edgeworth asked the question, “What would you do if you were either seller of
mineral water?” In order to maximize profits you would lower your price down to Q
in figure 25-1 and sell quantity OB or OB. In this instance Edgeworth’s conjecture
relates to price: Each competitor thinks the other will hold price constant. By lower-
ing price you take some business away from your competitor. If the output limita-
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632 Part VI ■ Back to the Future

R
Figure 25-1 Edgeworth’s duopolists,
each under an output constraint (OB and
OB of mineral water), reduce price from OP,
P stealing sales from each other. After price
reductions, however, it is in each seller’s
Q interest at some point to raise price in order
to maximize profit. No equilibrium is stable,
however, and price oscillates between OP
C‫׳‬ B‫׳‬ A‫׳‬ O A B C and OQ.

tion is such that the whole market cannot be supplied, your rival is free to set a price
to “fill out” the market. He would do so in this instance by raising price back to the
profit-maximizing level (OP). As Edgeworth put it, the price-raising competitor
“need not fear the competition of his rival, since that rival has already done his
worst by putting his whole supply on the market. The best that the rival can now do
in his own interest is to follow the example set him and raise his price to [OP]”
(“Pure Theory,” p. 120) and the whole process begins again! Thus, when the condi-
tions of a duopoly game match those specified by Edgeworth, continuous oscilla-
tions in price result and equilibrium is not possible.
Edgeworth’s model, like Cournot’s, was a prelude to future developments.
Early models like these, however suggestive, were fairly simplistic concerning the
kinds of conjectures that competitors routinely make. In many competitive situa-
tions, for example, we expect individuals to eventually realize that collusion is bet-
ter than competition. Moreover, the early theorists did not establish sets of
alternative “payoffs” of one kind or another from particular combinations of actions
by competitors. This next step forward is attributed to a mathematician, A. W.
Tucker, whose exposition of the “prisoner’s dilemma” reached to the core of the
modern approach to game theory.
A Prisoner’s Dilemma. Consider the following “dilemma.” Suppose Bonnie
and Clyde—infamous bank robbers of the 1930s who were gunned down for their
crimes—return to life to rob banks again. Further suppose that they are caught in
the act of robbing a bank but that the FBI only has hard evidence to convict them of
some lesser crime. In an attempt to improve their evidence, the FBI sequesters the
two prisoners separately and tries to get confessions from them in the following
manner. In isolation each prisoner is informed that (1) if he/she confesses, the con-
fessor goes free and the other person gets a big penalty (25 years); (2) if neither
confesses, both will receive the light penalty that accompanies the lesser crime (5
years); (3) if both confess, both will receive a severe penalty but of less severity than
if only one confesses (15 years). Given the payoffs and the uncertainty, the expected
solution is that Bonnie and Clyde both confess to bank robbing.
Economists use a “payoff” matrix like that shown in figure 25-2 to tease out the
solution to this problem. The potential prison term for Bonnie is shown on the left
side of each individual block, or quadrant, and the potential time served for Clyde is
shown on the right side. The police will try to get Bonnie and Clyde to testify against
each other. If Clyde confesses, but Bonnie does not confess, Bonnie gets 25 years in
the big house and Clyde goes free. Similarly, if Bonnie confesses to the greater
crime and Clyde holds out, Bonnie goes free and Clyde gets 25 years. If both refuse
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Chapter 25 ■ Mathematical and Empirical Economics 633

to confess, they each get 5 years but if both confess, they each serve 15 years. What
is the most likely outcome of this strategy “game” between Bonnie and Clyde? The
result depends on the assumptions (conjectural variations) that each makes about
the other’s behavior. We may reasonably presume (1) that both Bonnie and Clyde
want to minimize their time in jail and (2) that neither is concerned about the cost
of their decision on the other. Given these two presumptions, the outcome of the
game is that both “players” confess.
Look at figure 25-2 and consider the potential years served. What is Bonnie’s
best strategy? If Clyde confesses, Bonnie gets 15 years if she also confesses; but she
gets 25 years if she doesn’t. Therefore, Bonnie’s best choice is to confess if Clyde
confesses. If Clyde does not confess, Bonnie goes free if she confesses and gets 5
years if she doesn’t confess. In this instance Bonnie’s best choice is to confess if
Clyde does not confess. In other words, Bonnie’s best strategy is to confess, no mat-
ter what Clyde does. The sequester means that Bonnie cannot know Clyde’s deci-
sion, and can in no way influence his decision, so a confession is the only way for
Bonnie to ensure a lesser jail term for herself. You should verify that figure 25-2
shows the same is true for Clyde; his best choice is to confess regardless what Bon-
nie does. Note, however, that if the two could communicate, and if each could hold
the other to his/her word, the best choice for both Bonnie and Clyde would be to not
confess. In the terminology of game theory, there is a dominant strategy: Each
player has the same best choice, no matter what strategy the other player chooses.
In the game represented by figure 25-2, the dominant strategy is to confess.
Economic Games. It does not take a leap of imagination to visualize how this
kind of “game” can be generalized to other issues, encompassing, for example,
actions of love, war, and business. The formal idea of applying Cournot’s duopoly

Does not Clyde Does

confess confess

5 years Goes Free

Does not Bonnie's Clyde's Bonnie's Clyde's

confess Term Term Term Term

5 years 25 years

Bonnie
Figure 25-2
If Bonnie and 15 years
25 years
Clyde want to
minimize their Bonnie's Clyde's Bonnie's Clyde's
Does
jail time, the pris- confess Term Term Term Term
oner’s dilemma
leads both of Goes Free 15 years
them to confess.
Each receives a
15-year term.
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634 Part VI ■ Back to the Future

theory to such stratagems was developed in tandem by John von Neumann, a math-
ematician, and Oskar Morgenstern, an economist, who set forth the principles
involved in The Theory of Games and Economic Behavior (1944). Economic strata-
gems that fit this model riddle the conduct of firms, for example, particularly when
the products involved are close substitutes. Should Burger King introduce a new
low-cal burger, increase advertising, or establish a promotional contest? It depends
on how McDonald’s or Wendy’s will react. Different strategies yield different net
profit results in this regard.
Consider yet another example spawned by the prisoner’s dilemma. From time to
time auto manufacturers increase the warranty period applied to new cars. Warran-
ties are a method of making new cars more attractive to buyers, but they are costly
to institute because they increase production costs, which lowers profits. What com-
pels automakers to resort to this measure to increase sales? Game theory helps
explain the self-interests involved. Figure 25-3 is a payoff matrix that presents a
hypothetical situation in which two auto manufacturers, Toyota and General Motors,
are trying to maximize profits. The numbers in the grids represent profits in millions
of dollars. Toyota and General Motors could maximize joint profits in grid A where
neither manufacturer provides extended warranties. In this instance industry profits
total $120 million dollars (GM earns $55 million; Toyota earns $65 million). Simi-
larly, total profits are $100 million in grids B and C and $90 million in grid D. Acting
independently, however, both General Motors and Toyota could make higher profits.
General Motors would maximize profits in grid B ($70 million) by providing
new warranty protection when its competitor does not. Consider the company’s
options. Regardless of Toyota’s behavior, GM’s profits are higher when it offers

Does not provide GM Does provide

extended warranty extended warranty

55 70
Figure 25-3
Does

A B
not Automakers are
provide depicted in a
extended “game” to maxi-
warranty mize profits.
While they will
65 30 earn lower total
Toyota profit ($90 mil-
30 40 lion) from doing
so, game theory
Does
predicts that
provide
extended
warranty C D individual deci-
sions on the part
of both firms to
maximize their
profit will lead to
70 50 the introduction
of warranties.
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Chapter 25 ■ Mathematical and Empirical Economics 635

extended warranties. If GM offers a warranty and Toyota does not, its profit is $70
million. If it offers a warranty and Toyota does too, GM’s profit drops to $40 million.
However, if GM elects not to offer the warranty and Toyota does, GM’s profit falls to
$30 million. Toyota’s management, assessing the possibilities, will reach the same
conclusion, namely that it will always be better off by offering the warranty. Inde-
pendent decisions to maximize profits by each firm will lead to the introduction of
warranties. This means that the sum of profits between the two firms will be lower
($90 million) than it would have been if each firm did not offer warranties ($120
million). In other words, they are “prisoners” of a game.
While such behavior may benefit auto consumers at the expense of General
Motors’ and Toyota’s stockholders, the problem for stockholders could be avoided if
the manufacturers were allowed to communicate and to reach grid A in figure 25-3.
Communication in this case, as in the case of the prisoner’s dilemma, would pro-
duce a different solution, but such collusion is usually prohibited by antitrust laws.
Complexities of Economic Games. In the simple illustration of figure 25-3, the
game between General Motors and Toyota has a stable outcome, an equilibrium solu-
tion. In this simple case, the participants minimize their opponents’ maximum—what
von Neumann and Morgenstern called a minimax solution. More complex games—
those with more players and multiple strategies—may not result in stable equilibria.
Indeed, modern mathematical developments in game theory must deal with numer-
ous complexities, some of which are illustrated in the following three paragraphs.
Strategy outcomes depend on prospects for collusion and the time frame
involved. Clearly, Bonnie and Clyde or GM and Toyota would be better off with a
collusive agreement. As shown in figure 25-3, a move to grid A would make both
GM and Toyota better off than they would be under the case where both provide the
extended warranty (grid D). Collusion is problematic, however. Information costs
may be high, or legal prohibitions may exist. Time is also an important consider-
ation. The two games represented above are one-shot games; in each case, each
party has just one chance to make the best decision. If these games were played
repeatedly, perhaps both parties in each game would eventually decide to do what’s
best for both. In other words, the element of time is bound to the prospects for collu-
sion. Tacit collusive solutions—or outcomes without specific, formal agreement—
exist when, over an indefinite period of time, firms recognize that their own inter-
ests will best be served by maximizing joint or combined profits (or other payoffs).
In the latter case, however, antitrust laws may be able to punish or prevent collusion.
Collusive agreements, whether formal or informal, will always tend to collapse
when the number of players increases, for two reasons. The first reason is that cheat-
ing is more likely as the number of players increases. The second is that the costs of
any group decision-making process rise as the number of decision makers increases.
When products are homogeneous (e.g., eggs), collusion is easier to organize because
there is less need for advertising and other means of product differentiation. However,
in cases where firms offer a range of products and services, sometimes only slightly
differentiated (e.g., burger franchises, auto manufacturers, banking), competitive
strategies to increase market shares and profits are not only possible but extremely
probable. In such cases game-theoretic solutions are more difficult to achieve.
Even in a two-player game, the type of conjectures that one makes about the
other is of critical importance to the solution. When the time horizon facing two
rivals is finite—that is, when the game has a known end point—the outcome is
shaped by the principle of backward induction. Backward induction results from an
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636 Part VI ■ Back to the Future

incentive to cheat in the final period of the game. Suppose the Toyota and GM game
concerning warranties (figure 25-3) is expected to last three periods. If the two
firms have somehow arrived at the collusive solution (grid A) for two periods, it
would be in either GM’s or Toyota’s best interest to cheat in the third and final
period. Why? To do so would mean bigger profits for the cheater—but only if the
other does not cheat. If you think your rival will cheat in the third period, then you
have an incentive to get there first—to cheat in the second period. If you think your
rival will cheat in the second period, then you will cheat in the first period. The col-
lusive, or joint profit-maximizing, solution tends to break down when the end
period of the game is known. Each player has an incentive to cheat before the joint
profit-maximizing solution has a chance to get off the ground, rendering the out-
come in such a case identical to the outcome of a one-shot game.

Experimental Economics, Mathematics, and Game Theory

The foregoing paragraphs describe some of the problems we might expect in
the “real world” when game theory is applied to markets. In essence, there are an
infinite number of games that might be played depending on the circumstances in
particular markets. The analyst of game-theoretic behavior must be able to know or
control an enormous amount of information in order to model competition effec-
tively in particular markets. With the advent of global competition (i.e., “players”
from around the world), the collection of such information—much of it by nature
kept secret—is virtually impossible.
Despite the complexity presented by many actual situations, simple game-theo-
retic models provide many insights into the problems of small-numbers competition.
Moreover, the game-theoretic approach has inspired new directions in economic
analysis. Experimental economics is nothing less than the working out of game-theo-
retic principles in a “laboratory” setting. Models testing the kind of competitive situa-
tions discussed with respect to figures 25-2 and 25-3 have been replicated
experimentally. Vernon Smith, Nobel laureate in 2002, and Charles Plott have been
pioneers in the development of such models, using both human and animal subjects.
Economists John Kagel and Raymond Battalio have used laboratory rats to verify
fundamental principles of microeconomic theory (see notes for further reading and
the final chapter in this book). Other economists have met laboratory success with
monkeys and birds as “economic” actors who respond to work/reward payoffs. Many
simple experiments of this kind lead to competitive equilibria, but more complicated
experiments are likely to yield multiple equilibria or “indeterminate” outcomes.6
Even though game theory is still in a developmental stage, some economists believe it
forms, or will eventually form, the foundation for modern microeconomics, replacing
neoclassical economics in part or in toto. (This claim is evaluated in the box, Method
Squabbles 7: Modern Neoclassical Economics: Is It Simply a Math “Problem”?)
It must be freely admitted that the issues raised by mathematical models and
experimental testing are exceedingly complex, and this complexity often inhibits
determinate solutions. When complications such as imperfect information between
traders or the presence of third-party bargainers are introduced, solutions become

6
F. Y. Edgeworth recognized that the mathematical conditions of exchange in any exchange-based
economy form a “core” principle on which economic theory rests. Edgeworth advanced the notion
of an individual preference function, or “indifference curve.” Underlying the preference function
are the individual’s calculations regarding the number and kind of trades that will maximize his or
her utility. At least implicitly, Edgeworth anticipated the kind of multiple equilibria that sometimes
emerges from game theory.
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Method Squabbles 7: Modern Neoclassical Economics:

Is It Simply a Math “Problem”?
Even if they vehemently deny it, some economists increasingly behave as if economics is
just another “math problem.” An undergraduate degree in mathematics is not only suggested
but in essence is required for admission to many university graduate economics programs.
Students are routinely taught the elements of game and set theory as a foundation for micro-
economic theory. Dissertations are increasingly written on new techniques, eschewing real
world “problem analysis” altogether. These techniques, moreover, are most often not adapt-
able to any form of testing beyond mere “suggestions” of applicability.
At the opposite extreme are those who seek refuge in a total retreat from formalism. These
economists might thereby embrace various forms of “evolutionary economics”; join attacks
on the assumptions of “classic” neoclassicism; substitute a variety of imperfect-knowledge
assumptions; dismiss the “rationality” postulate; and denounce utilitarianism. Some on this
side hold that economics must, in effect, become a science of “change” and not a science of
“constrained maximization” motivated by utility and profit calculations.
A middle ground probably offers a more defensible position. To the extent that the activi-
ties of any methodological camp yield testable propositions or otherwise improve insights
into the economic process, these developments are of great, and sometimes enormous, value
for understanding economic behavior and processes. But as new means of “discovery” (i.e.,
gaining knowledge of the economic world) there is yet no single technique or set of tech-
niques equal to the neoclassical method—a method that emphasizes how unfettered mar-
kets increase or improve social welfare.
Sympathy for the view that neoclassical economics is too simplistic in its representation of
constrained maximization as the modus operandi of individual choice does not obviate the
fact that neoclassical economics is actually a method for discovery.* Problems are no less
thorny today than they were in Alfred Marshall’s day. At present, a “piecemeal” approach to
problems in which variables are examined one at a time is the only fruitful method for obtain-
ing answers. Indeed, most contemporary mathematical techniques use this method in one
form or another. Among other things, this method of reasoning became a foundation for the
development of modern probabilistic econometrics. One would not think of answering a
question such as, “Do new gun laws reduce crime?” or “Would a new state excise tax on hotels
reduce tourism?” without invoking the neoclassical method of analysis and verification. All
sciences, however inexact the methods of testing, need an organizing principle and, for better
or worse, the neoclassical paradigm provides that foundation for economics.
Neoclassical economics has survived even as it has been amended by reductions in the
level of abstraction, by econometric advances, and by other important discoveries generated
by Nobel laureates such as George Akerlof, Gary Becker, James Buchanan, Jr., Ronald Coase,
Milton Friedman, Friedrich von Hayek, Michael Spence, George Stigler, and William Vickrey, as
well as by lesser mortals. Mathematical formalism and advanced general-equilibrium theoriz-
ing, on the one hand, and “deconstructions” of economic theory, on the other, have not
changed the central nature of what economists do when they seek answers to practical prob-
lems. Contrary to those who would proclaim that neoclassical economics is dead, it is quite
alive and not even “smelling funny.”
*Present dissatisfaction with the state of contemporary economics has led in some quarters to the view
that the science has become a mere “grab bag” of ideas. See, for example, David Colander, “The Death of
Neoclassical Economics” (references). However, we maintain that the organizing principles implied in the
term “neoclassical” remain cogent and meaningful, if for no other reason than that this is the form in
which economics is taught to undergraduates and that the practice retains force in the conduct of eco-
nomic research.
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638 Part VI ■ Back to the Future

indeterminant. Some of the most complex and elaborate tools of mathematics have
been applied to these issues. Tools such as game theory, set theory, and measure
theory, which call into play fixed-point theorems and other forms of advanced math-
ematics, have all been used to analyze technical questions raised by Edgeworth’s
theory of contracting. Indeed, several Nobel prizes have been awarded for contribu-
tions related to this issue, such as those received by Kenneth J. Arrow in 1972 and
Gerard Debreu in 1983.
As old and new mathematical tools have influenced the current direction of
technical economic theory, so have mathematics and statistics established a new
area in contemporary economic inquiry. The high-minded aim of the inquiry is
nothing less than to make economics “scientific,” in the same way that the physical
sciences are so regarded. This has induced more and more economists to emulate
the successful techniques of the physical sciences. In other words, more and more
emphasis has been placed on “testing” the validity of economic hypotheses.

■ EMPIRICISM IN ECONOMICS: TESTING ECONOMIC THEORY

Much empirical economics today involves econometrics, the examination of
data with the use of mathematical and statistical techniques to see how well it “fits”
economic theory. Done properly, econometrics has the power to “verify” economic
theory within certain degrees of confidence. Its object is both to explain and to pre-
dict economic behavior within the context of an accepted theory. Within the limits
of statistical inference and probability, econometrics attempts to test economic the-
ory using historical data and to forecast economic events utilizing a combination of
economic theory and economic data.

Descriptive Statistics and Economic Theory

Attempts to enliven economic theory with real-world facts—often called “descrip-
tive statistics”—is centuries old. An interesting early example involves the efforts of
the political arithmeticians of the late seventeenth and early eighteenth centuries to
come to grips with quantitative data concerning national output, the balance of trade,
consumer demand, and a variety of other subjects. One of the earliest and best-known
illustrations of empirical economics comes from research on consumer demand con-
ducted by Gregory King (1648–1712) and Charles Davenant (1656–1714). King, called
by Nobel laureate Richard Stone “the first great economic statistician,” established
the empirical foundations of the inverse relationship between price and quantity pur-
chased. This “law,” which was refined considerably by Charles Davenant, appeared in
Davenant’s mercantilist treatise of 1699, An Essay upon the Probable Methods of
Making a People Gainers in the Balance of Trade. Davenant’s version of the demand
law, which we now refer to as the “King–Davenant law of demand,” is as follows:

We take it, that a defect in the harvest may raise the price of corn in the following
proportions:

Defect Above the common rate

1 tenth Raises 3 tenths
2 tenths the 8 tenths
3 tenths Price 1.6 tenths
4 tenths 2.8 tenths
5 tenths 4.5 tenths
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Chapter 25 ■ Mathematical and Empirical Economics 639

So that when corn rises to treble the common rate, it may be presumed that we
want above 1/3 of the common produce; and if we should want 5/10, or half the
common produce, the price would rise to near five times the common rate. (Politi-
cal and Commercial Works, pp. 224–225)

King’s actual statement of the demand relation was considerably less sophisticated
than Davenant’s, but it is clear that both writers drew on observations of actual
price and quantity behavior. Although this early attempt at estimating a statistical
demand curve was naive and quite obviously simplistic, it nevertheless demon-
strates the desire to establish economic theory on firm empirical foundations.
During the nineteenth century the field of descriptive statistics made great
strides. Besides applications of statistical theory to such problems as population
and public health, the technological revolution in transportation provided a back-
drop for statistical investigations of a purely economic type. Early railway engineers
from Europe and America attempted to identify cost data in order to assess the
costs and benefits of existing railroads and proposed rail systems. The American
engineer Charles Ellet (see chapters 13 and 18) was a pioneer in this regard. In con-
tributions published between 1840 and 1844 (see notes for further reading), Ellet
attempted to determine a “predictive” total cost function for a “typical” American
railroad. He did this by collecting data and building up the constants in an equation
for rail costs involving various components of railway expenses.
William Stanley Jevons (see chapter 15) also advanced the subject of descrip-
tive statistics in his famous essays of the 1860s on commercial fluctuations and on
price series. Jevons improved the notion of index numbers and the nature of sam-
pling techniques. But as Stephen M. Stigler has remarked in his assessment of
Edgeworth, “Jevons’s lack of use and development of probability-based statistical
methods in his empirical work was typical of even the best efforts before the 1880s”
(“Francis Ysidro Edgeworth, Statistician,” p. 288).

Getting (Tentative) Answers:

The Method of Neoclassical Theory and Empiricism
An array of methods for analyzing economic problems exists today. It cannot be
said, therefore, that there is one model or method for analyzing economic issues and
problems. But it can be said that there is a dominant method for analyzing problems
and testing for results. For want of a better description, the dominant method of eco-
nomic investigation today is one that integrates neoclassical economic theory with
modern statistical analysis.7 Neoclassical economics, which we traced to French
economists Cournot and Dupuit (chapter 13) and others (chapter 18), was raised to
new prominence by Alfred Marshall (chapter 16). Often the individual tools that Mar-
shall developed are allowed to overshadow the analytical method he propounded.
That method is one in which economic “tendencies” are discovered by examining one
element of a problem at a time while holding all others constant. Marshall’s method-
ology is one in which not all factors are specified (nor can they be) within a theory,
and where some of the unspecified factors may measurably alter predicted results.
Marshall regarded economic science as a procedure for scientific discovery. He
maintained that it is the business of science to collect, arrange, and analyze facts.

7
Economists are divided on what to call this dominant method and on the method itself. Sutton
calls it the “standard paradigm” (Marshall’s Tendencies), while others would like to proclaim the
death of neoclassical economics in the wake of other methods of discovery (game theory, simula-
tion, experimental economics, and so on). See references and notes for further reading.
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640 Part VI ■ Back to the Future

We draw inferences from facts and improve theories in the process. But Marshall
did not think that economics could be a science such as physics or chemistry where
controlled experiments are possible. Rather, while certain methods of these “hard”
sciences could be useful in economics, he believed economic science was more like
meteorology, which involved a much “looser” form of testing and prediction. Mar-
shall cited the study of ocean tides as akin to the study of economics. John Stuart
Mill and others also favored this analogy, and Dupuit used it to explain the nature of
economic science as early as 1860 (see chapter 18). The reason for the vicissitudes
of tides, Dupuit explained, is because there are regular actions that scientists know
how to calculate and others that still elude them, despite the best efforts of science.
There may always be variables outside the research paradigm that could upset the
behavior of regular (scientific) forces.
Seeing economic science this way encouraged the development of modern
methods of econometrics to determine, probabilistically, which factors do and
which do not alter results. The dominant empirical method of discovery today
remains that which combines economic and statistical investigation of variables
using the method established by Dupuit, Marshall, and many other neoclassicists.
The statistical technique favored for this kind of study is regression analysis.

Regression Analysis
Suppose we observe two quantities moving in particular ways. Let’s say that
you own a hamburger stand and that you observe that as you raise the price (X) of
your hamburgers, the quantity you sell (Y) rises. Are you justified in concluding that
the demand for your hamburgers is upward sloping? The simple answer is no. On
the basis of incentives and self-interest, this result would violate common sense and
is not what economists expect. But there are other reasons to deny this illogical con-
clusion. There are many factors besides price that affect the quantity taken of your
hamburgers. We know that X and Y are related in some way. But does a change in X
cause a change in Y or does a change in Y cause a change in X? Or does some other
factor cause or affect both X and Y? (Z might equal income of potential customers
around your hamburger joint). There are a huge number of possible changes that
might explain your observation. Suppose a new business paying high wages has
recently moved into your area. That could shift the demand curve for your product
to the right, so that what you are observing might be rightward equilibrium move-
ments along your supply curve. This possibility illustrates the so-called identifica-
tion problem in empirical studies—the identification of cause and effect. The supply
and demand for any good may be altered by numerous factors. But simply because
we observe two variables moving together (correlation is the statistical term), the
observation does not imply that one causes the other. Correlation, in other words,
does not imply causation.
Most behavioral issues are explained by multiple causes, and the “real-world”
data collected by the economist or analyst do not easily give up truths concerning
cause and effect. This is precisely why economists favor regression analysis.
Regression analysis is an econometric tool commonly used to gauge a relationship
between a dependent variable and one or more independent variables. If you
wished, for example, to study the effect of advertising expenditures on the levels of
concentration in some industry or set of industries you might set up the following
symbolic relationship:
Ci = B0 + B1Ai + ei (i = 1,...,n)
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Chapter 25 ■ Mathematical and Empirical Economics 641

where Ci is a measure of industrial concentration in some (ith) industry, B0 is a con-

stant, Ai is a measure of advertising intensity in the ith industry, and ei is a catchall
(error) term designed to capture discrepancies in the posited relationship. In this
equation, C is the dependent variable (it is posited to depend on the independent
variables), and advertising intensity is the independent variable—the one (or ones)
theorized to determine the values of or the dependent variable, Ci. The B values,
such as B1, which measures the strength of the marginal effect of advertising inten-
sity on industrial concentration in this simple example, are estimated from available
data. While B values may be estimated in a number of ways, the most common esti-
mation procedure is called “the method of least squares.”
Simple regression means that the regression equation contains only one inde-
pendent variable, as shown in the above expression. In effect, our equation seeks to
determine the impact of a one-unit change in advertising intensity on industry con-
centration, which, of course, could be positive or negative. The impact is measured
by a regression coefficient (B), which is a number that contains two pieces of infor-
mation. In addition to indicating whether the proposed relationship is positive or
negative, it indicates how the dependent variable would change when the indepen-
dent variable (advertising intensity in our example) changes by one unit. This num-
ber, it must always be remembered, is only an estimate of the theorized cause-and-
effect relation. The researcher employing this technique can never be entirely cer-
tain that the coefficient reflects the true relationship. He or she can be confident
only that the estimate is correct within certain (probabilistic) intervals (i.e., a 5 per-
cent confidence interval means that the technique will yield the correct answer 95
percent of the time).
Other important issues often raise more complex statistical questions. Recon-
sider the simple relationship between concentration and advertising. If our theory is
that advertising intensity causes concentration, can we be sure that a positive and
significant B1 coefficient is conclusive evidence of that result? Might it not be the
case that industries that are more profitable can afford to advertise more, or that
more profitable industries are more concentrated? Insofar as other variables may
affect industrial concentration besides the one posited in a simple regression,
econometricians most often test such theories with multiple regression techniques.
Multiple regression includes more than one explanatory (independent) variable and
is usually of the following general form:
Yi = B0 + B1 X1i + B2 X2i +  Bk Xki + ei ( where i = 1, , n )

This equation describes n observations and the relation between some dependent
variable, Y, and k independent variables. Returning to our advertising-industrial
concentration example, for example, we might express concentration in some
industry as a function of (or relating to) advertising intensity, the profitability of the
industry, and the amount of product differentiation associated with the industry,
together with other factors. A multiple regression technique would allow the experi-
enced investigator to give a reliable judgment of the impact of the various factors
affecting industry concentration—within specified limits of confidence. Contempo-
rary theoretical econometrics is concerned chiefly with the development of more
powerful tools so that complex equations such as these can be better fitted to the
data. As indicated above, however, regression techniques are incapable of providing
conclusive proof of selected hypotheses. We can never be 100 percent sure that an
estimator captures true relationships. Nevertheless, econometrics can develop sta-
tistical techniques that add confidence to estimates. All manner of problems, social
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642 Part VI ■ Back to the Future

and economic, are routinely investigated in this manner. Does the death penalty
deter murder? More generally, do increased expenditures on law enforcement deter
crime? Do more liberal divorce laws increase the incidence of divorce? Does a liber-
alized tax deduction for charitable giving increase such giving? Econometric test-
ing, within limits, provides some answers to these and many more interesting
questions in economics and social science (see notes for further reading).

The Quest for Knowledge: Modern Econometrics

The search for improved techniques has been a vital part of the development of
econometrics. Late in the nineteenth century and early in the twentieth century, cer-
tain key economists distinguished themselves in this respect. In Britain, G. U. Yule
(1813–1886) pioneered economic and social science applications of statistics,
whereas in the United States, Henry L. Moore (1869–1958) championed empirical
methods in his studies of business cycles and agricultural production (see notes for
further reading). Moore was particularly influential in fostering a zeal for econo-
metric studies among a number of important students, particularly Henry Schulz
(1893–1938), whose Theory and Measurement of Demand (1938) became an early
twentieth-century classic.
A natural inquiry for those interested in measurement involved the aggregative
aspects of the economy, especially as the ascendance of Keynesian economics in the
post–World War II period spurred interest in developing measurements for the
national income accounts, inflation, and employment. Many pioneers of measured
sector performance in the economy went on to win the Nobel Prize in Economics
after it was inaugurated in 1969. Names such as Simon Kuznets (winner in 1971),
Wassily Leontief (1973), James Meade (1977), and Sir Richard Stone (1984) have all
been heralded for work in measuring performance in key sectors of the economy.
Thus, it was the quest for knowledge about the overall economy that was a primary
impetus for econometric research. While the empirical nature of economic theory
and the quest to measure the macroeconomy was the subject of accelerated attention
in the late nineteenth and early twentieth centuries, the formal recognition of econo-
metric research as a distinctive field of economics may be traced to the year 1933.
In 1933 a distinguished international coterie of scholars founded the Economet-
ric Society and its journal, Econometrica, which is dedicated to the pursuit of empir-
ical economics. Harold Hotelling (1895–1973), a prominent American economist
and statistician, and Ragnar Frisch (1895–1973), a Norwegian economist and subse-
quent Nobel Prize winner (1969), were among the founders.8 The society and its
journal have supported research for more than three-quarters of a century on the
theory and method of testing economic ideas. On occasion, inadequate methods
have been attacked (e.g., Frisch presented devastating early critiques of measure-
ment errors). At the same time, new and superior testing tools have been generated
(e.g., the development of probabilistic rationalizations of regression analysis and
the use of probabilities to develop maximum-likelihood estimation methods). These
developments continue to the present day, not only in the first wave of the econo-
metric journals, but also in a number of later journals devoted to the subject that
have appeared in the wake of Econometrica’s success.
8
Hotelling and Frisch were critically important to early efforts, but there were many other pio-
neers. A survey of Nobel Prize winners in Economic Science includes many of these names as well
as an indication of the international flavor of econometric and measurement inquiry. The latter
would include Jan Tinbergen (cowinner in 1969), Leonid Kantorovich and Tjalling Koopmans
(cowinners in 1975), Robert Solow (1987), Trygve Haavelmo (1989), and Harry Markowitz (1990).
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Chapter 25 ■ Mathematical and Empirical Economics 643

■ CONCLUSION
No abbreviated survey of mathematical and empirical techniques could possi-
bly do justice to the full range of their use in modern economics. The reader is
invited to pick up almost any current economics journal to savor the flavor of quan-
titative economics today. Virtually no area of modern microeconomic or macroeco-
nomic theory has remained untouched by mathematical and empirical methods.
Mathematical and econometric tools have permeated the microeconomic subfields
of labor, public finance, and antitrust and government regulation, to name a few.
Macroeconomic model building and forecasting of national income, inflation, and
employment would be inconceivable without such tools.
Historians of economic thought are in a unique position to address critical
questions related to these ongoing developments. A meaningful evaluation must
rest on the advantages (benefits) and deficiencies (costs) of this development as it
relates to some conception of progress in economics. Is the purpose of formulating
analytical tools to make economics “scientific” or is it merely to create a means to
help us answer important economic and social questions? The chief argument for
continued mathematic formalization of economics is that the discipline cannot
become truly scientific until it attains the rigor and completeness of science—in
other words, until its fundamental propositions have been tested and proven. The-
ory without verification or potential verification is of limited usefulness. Facts with-
out theory are meaningless.
Some economists have strong reservations concerning this view. Critics argue
that the nature of social science, of which economics is a part, makes exact formula-
tion and verification impossible. Many of the central problems of contemporary
econometrics relate to inexact or incomplete formalizations of economic theory and
to various insufficiencies in sample data and in the random errors inherent to the
measurement of variables. Modern econometric techniques are, generally speaking,
most appropriate when data samples are large; yet in many instances, large-sample
data do not exist. Thus, the quantities and qualities of economic data are often
insufficient to the task. In contrast to conditions in the physical and natural sci-
ences, the collection of most economic data is not predetermined or predesigned to
fit tests of economic theory. Indeed, most economic data are collected by govern-
ment agencies for far less specific purposes, often for purely political reasons.
While inadequate theory and poor data are not sufficient reasons in themselves to
reject quantitative method, some critics argue that the design costs and the collec-
tion costs necessary to secure high-quality data are prohibitive.
Numerous critics, especially neo-Austrian and institutional economists, argue
that the attempt to make economics a science through mathematical formalization
and empirical verification is illusory. In the opinion of these critics, the fruits of
decades-long intellectual investment in mathematical and statistical techniques
have been small, if not negative. According to this argument, these futile attempts at
rendering economics scientific have engendered widespread distrust of the eco-
nomic pronouncements of policy makers and an almost total breakdown in commu-
nication between “mainstream” economists and other social scientists. Even worse,
mathematics and calculation in the hands of those equipped with tools but with few
or no creative ideas about problems or policies can lead economists away from the
basic truths about markets and market functioning. The march to socialism, so the
argument goes, is likely to be led by “calculators” who have no practical under-
standing of how real-world markets function. In this view, mathematics inevitably
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644 Part VI ■ Back to the Future

diverts attention away from the basic truths of the economic process, as developed
by its founders.
There is some growing awareness of the dangers of technical pursuits as substi-
tutes for the study of economics, a subject we will return to in the final chapter of
this book. Some skepticism is undoubtedly healthy, and yet the complete or sub-
stantial abandonment of formalization and aggressive testing would be as much a
mistake as its uncritical acceptance. Of all people, economists must avoid this pitfall
because they, more than other scientists, deal with quantities at the margin. An
appreciation of the limits to mathematics and econometric technique fosters an
understanding of their correct and useful place in economic science. So long as
these limits are understood, the value of mathematics and econometrics in formu-
lating and testing economic ideas is very great.

REFERENCES
Colander, David. “The Death of Neoclassical Economics,” Journal of the History of Eco-
nomic Thought, vol. 22 (June 2000), pp. 127–143.
Cournot, Augustin. Researches into the Mathematical Principles of the Theory of Wealth,
N. T. Bacon (trans.). New York: A. M. Kelley, 1960 [1838].
Creedy, John. “On the King–Davenant ‘Law’ of Demand,” Scottish Journal of Political
Economy, vol. 33 (July 1986), pp. 193–212.
Davenant, Charles. The Political and Commercial Works of That Celebrated Writer
Charles D’Avenant, Relating to the Trade and Revenue of England, collected and
revised by Sir Charles Whitworth in five volumes, vol. 2. London: Farnborough
Gregg, 1967.
Debreu, Gerard. “Mathematical Economics,” in John Eatwell, Murray Milgate, and Peter
Newman (eds.), The New Palgrave: A Dictionary of Economics, vol. 3. London: Mac-
millan, 1987, pp. 399–404.
Edgeworth, F. Y. Mathematical Psychics: An Essay on the Application of Mathematics to
the Moral Sciences. London: Kegan Paul, 1881.
———. “The Pure Theory of Monopoly,” Papers Relating to Political Economy, 3 vols.
London: Macmillan, 1925.
Hicks, J. R. Value and Capital. Oxford: Oxford University Press, 1939.
———, and R. G. D. Allen. “A Reconsideration of the Theory of Value,” Economica, vol. 1
(February, May 1934), pp. 52–76, 196–219.
Leontief, Wassily. The Structure of the American Economy: 1919–1929. Oxford: Oxford
University Press, 1941.
———. “Input-Output Analysis,” in John Eatwell, Murray Milgate, and Peter Newman
(eds.), The New Palgrave: A Dictionary of Economics, vol. 2. London: Macmillan,
1987, pp. 860–864.
Maurice, Charles, and Charles Smithson. Managerial Economics, 3d ed. New York:
McGraw-Hill, 1988.
Newman, Peter. “Francis Ysidro Edgeworth,” in John Eatwell, Murray Milgate, and Peter
Newman (eds.), The New Palgrave: A Dictionary of Economics, vol. 2. London: Mac-
millan, 1987, pp. 84–98.
Samuelson, P. A. Foundations of Economic Analysis. Cambridge, MA: Harvard University
Press, 1947.
Stigler, Stephen M. “Francis Ysidro Edgeworth, Statistician,” Journal of the Royal Statis-
tical Society, ser. A, vol. 141 (1978), pp. 287–322.
Sutton, John. Marshall’s Tendencies: What Can Economists Know? Cambridge, MA: MIT
Press, 2000.
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Chapter 25 ■ Mathematical and Empirical Economics 645

Theocharis, Reghinos D. Early Developments in Mathematical Economics, 2d. ed. Phila-

delphia: Porcupine Press, 1983.
Von Neumann, John, and Oskar Morgenstern. Theory of Games and Economic Behavior.
Princeton, NJ: Princeton University Press, 1944.

NOTES FOR FURTHER READING

Any introduction to the vast literature of economics containing formalized mathe-
matics and econometrics must begin with a grasp of certain essentials. Although several
basic texts contain excellent treatments of mathematical economics, the following two
are especially noteworthy and useful to upper-division or first-year graduate students:
Alpha Chiang, Fundamental Methods of Mathematical Economics (New York: McGraw-
Hill, 1967); and Akira Takayama, Mathematical Economics (Cambridge: Cambridge Uni-
versity Press, 1985). Those interested in basic calculus applied to consumer demand
should master the mathematical appendix to Hicks’s Value and Capital (see references).
Similarly, those seeking an introduction to econometrics along with knowledge of basic
statistics, should consult G. S. Maddala, Introduction to Econometrics (New York: Mac-
millan, 1988); and Domodar Gujarati, Basic Econometrics, 2d ed. (New York: McGraw-
Hill, 1988). Another very useful reference is William H. Greene’s Econometric Analysis,
7th ed. (Upper Saddle River, NJ: Prentice-Hall, 2012).
Early works in mathematical economics and descriptive statistics (the handmaiden
of modern econometric techniques) tended to be isolated contributions until the late
nineteenth and early twentieth centuries. The most cited example of an early empirical
statement of demand is the King–Davenant law of demand, but both the priorities of the
two writers and the quality of their statements have been debated. Two papers deal with
these issues: John Creedy, “On the King–Davenant ‘Law’ of Demand” (see references);
and A. M. Endres, “The King–Davenant ‘Law’ in Classical Economics,” History of Politi-
cal Economy, vol. 19 (Winter 1987), pp. 621–638. See also A. M. Endres, “The Functions
of Numerical Data in the Writings of Graunt, Petty, and Davenant,” History of Political
Economy, vol. 17 (Summer 1985), pp. 245–264.
The splendid work of Cournot is graced not only by his contributions to mathemati-
cal economics, but also by a treatise on probabilities. Reghinos D. Theocharis provides
excellent coverage of mathematical economics in its infancy (see references and Theo-
charis, The Development of Mathematical Economics: From Cournot to Jevons [London:
Macmillan, 1993]). Those interested in early attempts by engineers to measure cost func-
tions should examine Charles Ellet, “Cost of Transportation on Railways,” Journal of the
Franklin Institute of the State of Pennsylvania (September, December 1842; November
1843); and R. B. Ekelund, Jr., “Economic Empiricism in the Writing of Early Railway
Engineers,” Explorations in Economic History, vol. 9 (Winter 1971), pp. 179–196.
W. S. Jevons, Investigations in Currency and Finance, H. S. Foxwell (ed.) (London:
Macmillan, 1884), provides a starting point for the “middle” period of mathematico-statis-
tical writings in economics. But pride of place should go to F. Y. Edgeworth. In addition to
his Mathematical Psychics (see references), Edgeworth produced an enormous literature,
largely published in the Economic Journal, devoted to the application of mathematical
tools to index numbers, theories of taxation, the theory of monopoly and price discrimi-
nation, and theories of economic welfare. Many, but not all, of these papers are contained
in Edgeworth, Papers Relating to Political Economy (see references). The birth of modern
statistics in the writings of Galton, Pearson, and Edgeworth is detailed by S. M. Stigler,
The History of Statistics: The Measurement of Uncertainty before 1900 (Cambridge, MA:
Harvard University Press, 1986), who takes his readers on a journey strewn with multiple
attempts to obtain improved measurement in fields as diverse as astronomy, psychology,
heredity, and the social sciences. Stigler’s book reads like a well-crafted mystery story, in
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646 Part VI ■ Back to the Future

which the author demonstrates how the development of modern tools of correlation and
regression analysis, which required sound analyses of probability and measurements of
uncertainty, were remarkably slow in flowering. The key figures in the drama, as Stigler
shows, were Francis Galton, Karl Pearson and, most importantly, Edgeworth.
Edgeworth’s theory of the “core” exchange conditions in an economy and its impor-
tance in modern economic theory are set forth in lucid fashion by Peter Newman in The
New Palgrave (see references), and on a more technical plane in The Theory of
Exchange (Englewood Cliffs, NJ: Prentice-Hall, 1965). Also see John Creedy, Edgeworth
and the Development of Neoclassical Economics (Oxford: Basil Blackwell, 1986). Alberto
Baccini, “Edgeworth on the Foundations of Ethics and Probability,” The European Jour-
nal of the History of Economic Thought, vol. 14 (2007), pp. 79–96, argues that Edge-
worth’s utilitarianism and his probability theory share a common theme: the search for
an encompassing epistemological basis for the social sciences.
Henry L. Moore, the American pioneer in statistics and econometrics, made several
important contributions, e.g., “The Statistical Complement of Pure Economics,” Quar-
terly Journal of Economics, vol. 23 (November 1908), pp. 1–33; Generating Economic
Cycles (New York: Macmillan, 1923); and same author, Synthetic Economics (New York:
Macmillan, 1929). See George J. Stigler, “Henry L. Moore and Statistical Economics,” in
Essays in the History of Economics (Chicago: University of Chicago Press, 1965), for
more details on Moore’s place in the history of mathematical economics. Jeff Biddle,
“Statistical Economics, 1900–1950,” History of Political Economy, vol. 31 (Winter 1999),
pp. 607–651, conveys a sense of the “standard practice” in statistical economics and how
it changed in the first half of the twentieth century.
The foundations for the mathematics of linear programming were established by the
great mathematician John von Neumann in the 1920s and 1930s and brought to fruition
by George B. Danzig in his work entitled Programming in a Linear Structure (Washing-
ton, DC: U.S.A.F. 1948). Salim Rashid, “John von Neumann and Scientific Method,” Jour-
nal of the History of Ideas, vol. 68 (July 2007), pp. 501–527, argues that in regard to the
relation between mathematics and economics von Neumann eventually settled on a
pragmatic (engineering) approach, where math is justified by its applications. Robert
Dorfman, Paul Samuelson, and Robert Solow, Linear Programming and Economic Anal-
ysis (New York: McGraw-Hill, 1958), show how linear programming can be applied to
economic analysis. An excellent basic introduction to the subject of linear programming
may be found in Christopher Thomas and Charles Maurice, Managerial Economics
(New York: McGraw-Hill, 2004).
Olav Bjerkholt and Ariane Dupont, “Ragnar Frisch’s Conception of Econometrics,”
History of Political Economy, vol. 42 (Spring 2010), pp. 21–73, draw on largely unknown
documents to elaborate Frisch’s scientific views, how he aimed at modeling economics
on physics by transferring methodological principles, and on the methods he proposed
for economics, such as his axiomatization approach, his structural modeling approach
(which became a cornerstone for macroeconomics), his refined explication of concepts
such as static/dynamic, micro/macro, and equilibrium, and his concern with the probabi-
listic nature of the real economic world. See also, same authors, “Ragnar Frisch and the
Probability Approach,” in Marcel Boumans, Ariane Dupont-Kieffer, and Duo Qin (eds.),
Histories on Econometrics, Annual Supplement to volume 43, History of Political Econ-
omy (Durham, NC: Duke University Press, 2011), which contains thirteen essays dealing
with the history of econometrics.
Prior to his book-length contribution to input-output analysis mentioned in this
chapter, Wassily Leontief published the elements of his famous idea in an article entitled
“Quantitative Input-Output Relations in the Economic System of the United States,”
Review of Economics and Statistics, vol. 18 (August 1936), pp. 105–125. This complicated
topic was made more comprehensible by William H. Miernyk, The Elements of Input-
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Chapter 25 ■ Mathematical and Empirical Economics 647

Output Analysis (New York: Random House, 1965). Miernyk not only clearly develops
the analytical principle involved but also shows how to apply it in regional, interregional,
and international contexts, concluding his discussion with a lucid review of the mathe-
matics required by the technique (e.g., matrices and determinants). Chious-shuang Yan,
Introduction to Input-Output Economics (New York: Holt, Rinehart and Winston, 1969),
is another useful source on the subject.
Cournot’s duopoly model was the genesis of game theory, but others helped to refine
his idea. For those who read French, see Joseph L. F. Bertrand, “Théorie mathématique
de la richesse sociale par Léon Walras; Recherches sur les principes mathématiques de la
théorie des richesses par Augustin Cournot,” Journal des savants (Septembre 1883), pp.
499–508. Besides the modern classic work by von Neumann and Morgenstern, Martin
Shubik, in Game Theory in the Social Sciences, Concepts and Solutions (Cambridge, MA:
MIT Press, 1982), and same author, A Game Theoretic Approach to Political Economy
(Cambridge, MA: MIT Press, 1984), outlines the many applications of game theory,
actual and potential. The important field of experimental economics got a boost when
Vernon L. Smith won the 2002 Nobel Prize in Economics “for having established labora-
tory experiments as a tool in empirical economic analysis, especially in the study of alter-
native market mechanisms.” (He shared the prize with Daniel Kahneman of Princeton
University). The interested reader may wish to dig into the literature produced by Smith
on experiments relating to auctions, electricity pricing, public goods provisions, and a
plethora of issues. For a sample, see Vernon L. Smith. “An Experimental Study of Com-
petitive Market Behavior,” Journal of Political Economy, vol. 70 (April 1962), pp. 111–137;
same author, “Experiments with a Decentralized Mechanism for Public Good Decisions,”
American Economic Review, vol. 70 (September 1980), pp. 584–599; Bargaining and Mar-
ket Behavior, Vernon L. Smith (ed.) (Cambridge, UK: Cambridge University Press, 2000).
Some of the more arresting laboratory economic “experiments” have been con-
ducted by the late Professor Raymond C. Battalio, Professor John Kagel, and others. In
addition to more “conventional” experiments, they employed rats and pigeons to test
economic theories. Parts of their fascinating results may be found in the following
papers: R. C. Battalio and John Kagel, “Demand Curves for Animal Consumers,” Quar-
terly Journal of Economics, vol. 66 (February 1981); “Commodity Choice Behavior with
Pigeons as Subjects,” Journal of Political Economy, vol. 89 (February 1981); “Consump-
tion-Leisure Trade-offs of Animal Workers,” American Economic Review, vol. 71 (Febru-
ary 1981); same authors, with D. MacDonald, “Animal Choices Over Uncertain
Outcomes: Some Initial Experimental Results,” American Economic Review, vol. 75
(September 1985). Also see John B. Van Huyck, Raymond C. Battalio, and Richard O.
Beil, “Tacit Coordination Games, Strategic Uncertainty, and Coordination Failure,”
American Economic Review, vol. 80 (March 1990), pp. 234–248; and, same authors,
“Strategic Uncertainty, Equilibrium Selection, and Coordination Failure in Average
Opinion Games,” Quarterly Journal of Economics, vol. 106 (August 1991), pp. 885–911.
Readers who wish to learn more about a particular mathematical technique or about
the application of mathematics to a particular area of economic theory might profitably
consult The New Palgrave: A Dictionary of Economics (see references). In general, the
entries provide readable, nontechnical introductions to particular subject areas written by
specialists (and sometimes by the pioneers themselves). Another excellent basic source
on such matters is William Baumol, Economic Theory and Operations Analysis, 4th ed.
(Englewood Cliffs, NJ: Prentice-Hall, 1977). Baumol’s chapter-length treatments of such
subjects as game theory and linear programming, not to mention his succinct statements
of the mathematical concepts used in developing them, are masterpieces of clarity and
brevity. Those in search of shorthand definitions of terms and concepts used in mathemat-
ical economics should consult W. A. Skrapek, B. M. Korkie, and T. E. Daniel, Mathemati-
cal Dictionary for Economics and Business Administration (Boston: Allyn & Bacon, 1976).
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26

Changing the Boundaries

of Microeconomics
Demand, Consumption, and “Rationality”

Microeconomics in the static-equilibrium traditions established by Marshall and

Walras has enjoyed and still enjoys great prestige in modern economic theory. But
as we saw in chapter 24, economists have ventured beyond the standard neoclassi-
cal theory of competition into such “new” realms as the nature of market disequilib-
rium, the development of modern public-choice theory, and the reevaluation of the
theories of regulation and industrial organization. Many of the new analytical twists
can be ascribed to what might be termed a “Chicago” school of thought, led over the
past three decades mainly by economists George Stigler (1911–1991) and Gary
Becker (b. 1930), who have systematically rehabilitated most of the standard Mar-
shallian premises.
Marshall, it might be recalled, made many important simplifying assumptions
regarding markets. Specifically, he abstracted from quality differences in products,
costly consumer information, the costs of time forgone in consuming and producing
goods, and the locations of sellers and buyers. The novelty of much contemporary
microeconomic theory consists of (1) providing a formal analysis of how market
outcomes change when we relax these and other simplifying assumptions about
consumers and firms and (2) applying these new tools to interesting and novel
questions that were previously thought to be beyond the purview of economists
(e.g., crime, drug use, family relations, and so on).
Additionally, whole new fields of inquiry have evolved to challenge the very fun-
damentals of economics. Finding the traditional assumptions wanting, contemporary
economic theorists engage in “prospect theory,” “happiness theory,” neuroeconom-
ics, and experimental economics—fields that attempt to integrate psychology with
economic choice. Whether these new areas, which have been graced by Nobel prizes,
will revolutionize the science is an open question, however.
This chapter reviews a small sample of these new developments in economic
theory. These intellectual “novelties” serve as examples of how past ideas continu-
ally shape present and future ideas. On closer examination, many novel tools are
found to be refinements of earlier principles discovered in the classical and neoclas-
sical periods. For example, the new theory of household production pioneered by
Gary Becker rests on the principles of utility maximization established by Jevons,

648
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Chapter 26 ■ Changing the Boundaries of Microeconomics 649

Menger, and Walras. Further extensions of earlier theories of costs and benefits have
resulted in economic theories of marriage, child rearing, and crime. Like other sci-
entists, economists build the present and the future on the contributions of the past.

■ MODERN CONSUMPTION TECHNOLOGY

Traditional neoclassical microeconomics imposes a distinct cleavage between pro-
ducers and consumers, whereas contemporary microeconomics treats the cleavage as
an oversimplification of the process by which goods are purchased and consumed.

The Household as a Factory

Gary Becker established a trend in microeconomics by treating the household
as analogous to a small factory—one that “combines capital goods, raw materials
and labour to clean, feed, procreate and otherwise produce useful commodities”
(“Theory of the Allocation of Time,” p. 496). In this surprisingly broad approach, an
individual consumer becomes part of both household production and consumption.
One of the most important insights of this approach recognizes that the production
and consumption of goods (children are sometimes regarded as consumer goods in
Becker’s model) take time. Time is an opportunity cost that must be calculated
along with the market price of any good or activity in making economic decisions.
Earlier economists (e.g., Senior, Böhm-Bawerk, Marshall) also understood the
nature of time as both a resource and a constraint, but their concepts were some-
times vague, and they never fully integrated them into mainstream economic theory
the way that Becker does.
Figure 26-1 gives a schematic view of the combination of market goods and
time necessary to produce ultimate goods or services (“commodities”). Just as it
takes inputs of human resources, capital, and time to bring children to adulthood,
the production and consumption of any ultimate good or service may be viewed as
combining inputs to consume an output. If we identify an ultimate good consumed
by an individual, such as “healthful behavior,” we see that the production of such a
good requires the combination of numerous “market goods” (those purchased
directly by consumers in the marketplace) and time inputs. Athletic equipment,
health foods of all sorts, medical services, and time spent in doing exercises and in
consuming health-related
goods are all inputs in a
process that yields the Goods Production in the Household
ultimate good. The indi-
vidual or the household
transforms these inputs Market Goods
Time
into outputs through a A, B, C, . . . N
production function.
Ultimate consump-
tion is therefore a func-
tion of both market
goods and time inputs. Ultimate Consumption Goods
Since it takes time to see
a play, read a book, or
consume a meal, the full Figure 26-1 The household as a miniature factory
price of these activities combines market goods and time to produce ultimate
must include the oppor- consumption goods.
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650 Part VI ■ Back to the Future

tunity cost of using time to engage in these consumption activities. The measure-
ment of this opportunity cost can be approximated by the market wage of the
individual under consideration. Assume, for example, that an individual who can
make $10 an hour in market work is choosing between a restaurant meal that takes
an hour and a fast-food meal that takes fifteen minutes. Assume further that the
money cost of both meals is $6. While both meals require the same money outlay,
the full price of consumption differs between the two alternatives. The full price of
the fast-food meal is $8.50 ($6 plus $2.50 in forgone income) versus $16 for the res-
taurant meal ($6 plus $10 in forgone income). The determining factor in the indi-
vidual’s final decision will be the amount of utility each meal produces per (full-
cost) dollar of expenditure.
This approach has the benefit of highlighting the full costs of household pro-
duction, which are usually obscured from view. The value of household produc-
tion—producing and raising children, performing household chores and
maintenance activities, etc.—may also be expressed in terms of opportunity costs.
Also, when the cost of time is placed on an equal footing with the cost of market
goods, new insights into the traditional choice between work and leisure (now a
choice between market work, leisure, and household production) and new views of
the consumption patterns of households in terms of both quantity and quality are
made possible.
The implications of the new consumer theory are expressed in several ways. As
earnings from market work rise (with equal reductions in other income), the oppor-
tunity cost of in-home production increases, and we expect to see more goods and
less time used in household production. In general, the development and wide-
spread use of time-reducing appliances may be explained partly by this phenome-
non. Greater use of child-care services, outside contracting for household services,
and the emergence of condominiums and other low-maintenance housing (and
lawn care) arrangements are all related to wage and earnings increases over time.
Another implication of this new theory of consumer behavior involves patterns
of consumption. As family incomes rise, family members tend to substitute goods-
intensive commodities and activities for time-intensive ones. In effect, economic
growth generates a bias against time-intensive production and consumption within
the household. The development of time-saving devices and products is, in some
measure, a reflection of the increased opportunity cost of time-intensive consump-
tions. The decline of time-intensive gourmet cooking and the substitution of high-
quality frozen foods and take-out meals, all suitable for time-saving microwave
cooking, are manifestations of the effect that Becker emphasizes.
Many modern inventions are successful because they permit substitutions that
allow people to economize by reallocating time-intensive consumptions. The
growth of airline travel, portable computers, smart phones, digital video recorders,
and audio books provide everyday examples. In other words, not only do house-
holds combine market goods and time inputs as raw materials (e.g., a piano, printed
music, and piano lessons) to produce ultimate goods (e.g., music appreciation), but
the proportions in which they are combined change over time as market wage rates
and incomes change.1

1
The assumption of taste stability is examined within the framework of a household production
function by George Stigler and Gary Becker in their paper “De Gustibus Non Est Disputandum”
(see references). In addition, Stigler and Becker give form to their concept by investigating the
implications of taste stability for “addictions,” custom and tradition, advertising, fashions, and fads.
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Chapter 26 ■ Changing the Boundaries of Microeconomics 651

The Economics of Information

The modern theory of consumption technology has let another genie out the bot-
tle. In a Marshallian world, consumers are assumed to be immediately aware, at zero
cost, of any price differences in a given market for a given product. By buying low
and selling high, they will drive market price to a single, uniform value. One price for
a product will prevail when a perfectly competitive market is in equilibrium.
In 1961 George J. Stigler enlarged and developed the argument that information
is an economic good that is costly to produce and obtain (“Economics of Informa-
tion”). For example, when gas stations provide information by posting prices they
must pay for the construction of the signs, including raw materials and labor. Further-
more, consumers must spend valuable time (and other resources) looking for, and
comparing, the prices that are posted. Since information concerning prices is costly
to produce and obtain in most markets, transaction prices will be “dispersed” (more
than one price) for the same commodity even when the market is in equilibrium.
A Simple Information Model. Figure 26-2 provides a framework for under-
standing the economics of information. The marginal cost to the consumer of
searching for a lower price for some particular good or service is represented by
MC in figure 26-2. Since additional search time is typically more costly at the mar-
gin, MC rises over time. If you are in the market for a used car, for example, the
marginal cost of your search can be thought of as the costs associated with visiting
and negotiating with one or more used-car dealers. The level of the MC curve will
naturally vary across goods. It will be low, for example, when shopping for appli-
ances on the Internet, but it will be high when searching for a new home.

Marginal costs
and benefits of
search
MC

E0

E1

MB0

MB1

O S1 S0 Search time

Figure 26-2 The provision of information reduces optimal search time spent acquir-
ing goods and services. Advertising is an example of such information provision.
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652 Part VI ■ Back to the Future

The marginal benefit curve (MB0) depicts the marginal benefit to the consumer
of searching for a lower price. As a consumer checks the prices of more and more
sellers, the prospect of finding a lower price from the next seller declines, therefore
MB0 declines as search time increases. The marginal benefit of additional search
time also varies across markets. For example, additional search time will be
rewarded at a higher level if the purchase involves a high-ticket item (e.g., houses,
central air-conditioning/heating systems, boats, or automobiles) than it will for low-
ticket items (e.g., toothpicks, lipstick, or chewing gum). Generally, the smaller the
share of a consumer’s budget represented by any single expenditure, the less the
benefit of additional search time; that is, the location of the MB0 curve in figure 26-
2 will be further to the southwest.
The consumer will search until the marginal cost (MC) of search time equals
the marginal benefit (MB0) of search time. This coincides with the point of optimal
or efficient search time, shown by point E0 in figure 26-2. At levels of marginal cost
and benefit to the left of point E0 (ignore point E1 and curve MB1 for the moment),
the extra benefits of more search time exceed the extra costs. To the right of point
E0, the marginal costs of search time exceed the marginal benefits. Point E0 repre-
sents the correct or equilibrium amount of search time for a given consumer for
some particular good or service. Consumers employ such optimal search proce-
dures in their shopping behavior, not so much in the rigid fashion of the diagram,
but in an intuitive, instinctive manner. Since point E will not be the same for all con-
sumers for all products or services, the fact that information about prices is costly to
produce and to obtain means that in most markets there will be a dispersion of final
transaction prices and not a single price for a product at all locations.2 Again, as
stressed in earlier examples, this line of reasoning recognizes time as part of the full
cost of consuming goods and services.
A New Role for Advertising. Strong attachment to the competitive model that
assumes homogeneous products and perfect information leads to overt criticism of
advertising as wasteful and/or unnecessary. In contrast, the new economics of
search time provides a rational explanation for the existence of advertising. In this
new approach advertising is a low-cost means of producing information. We have
seen that gathering information is costly in terms of time forgone and that time has
an implicit value. In the simplest of terms, advertising saves the consumer time in
his or her effort to acquire information about prices or qualities of products.
Consider an example in which a consumer starts without any knowledge what-
soever about prices for a desired product. Each additional hour of search time
requires that the individual sacrifice utility in the form of time forgone. Hence, the
marginal cost of the search rises, as shown along curve MC in figure 26-2. The
curve MB0 represents the marginal benefit to search time (i.e., information gained),
assuming that the consumer knows nothing about existing prices. Optimal search
time is therefore S0 for this consumer.
By comparison, consider a situation in which a consumer starts with some (but
not complete) knowledge of prices, obtained, for example, through newspaper
advertising. In this case additional search time will probably not yield price differen-
2
Common sense and personal experience support the idea of search costs. The following experi-
ment may be conducted in any community. Collect the prices for a single product of a particular
quality such as a specific brand and size of aspirin or toothpaste at six or seven different stores.
An array of prices will likely be observed across locations, which is a result consistent with Sti-
gler’s thesis. Real-cost differences to consumers may therefore provide a plausible explanation for
different money prices of a particular good or service.
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Chapter 26 ■ Changing the Boundaries of Microeconomics 653

tials as large as that obtained in the previous case in which the consumer started
with a zero knowledge base. Therefore, the additional benefit to any given amount
of search time (in terms of finding price reductions) is less in the case where the con-
sumer starts with some price information. Marginal benefits to search time in this
second case may be depicted as MB1, reflecting the fact that for any given amount of
search time, additional benefits to search time are less if consumers have some
information ahead of time. We can conclude therefore that the existence of advertis-
ing reduces the amount of time consumers spend in searching for lower prices. If
consumers spend less time searching for lower prices, they necessarily have more
time left to devote to other, more desirable activities such as earning income from
market work, producing goods at home, or partaking in leisure activities.
There are, in effect, two sacrifices involved in consuming most goods: (1) the
money price of the good and (2) the value of time forgone in search and other trans-
action costs. Together these elements constitute the full price of any good or ser-
vice. In the informed modern view, advertising economizes on search time and
therefore lowers the full price of goods and services.

Issues Concerning the Quality of Goods and Services

Modern microeconomics examines information, how it affects consumer
demand, and its links to advertising and search time in highly creative ways. One
innovation classifies goods according to how they affect the generation and
retrieval of information. Phillip Nelson (see references) distinguishes between
search goods and experience goods. Search goods are those whose characteristics
are readily determined before purchase, while experience goods are those whose
characteristics are primarily determined after purchase. In general, consumers
demand less information for search goods, such as gasoline at gas stations, fast
food, or toothpaste. Such goods are typically purchased frequently, and the con-
sumer usually has good information about their qualities. Experience goods, on the
other hand, are often purchased infrequently and tend to be of higher value. We
expect more information to be demanded and supplied for experience goods than
for search goods.
Think of it this way. Would you demand more information about a box of break-
fast cereal or about a new refrigerator? In the case of the cereal we pretty much
know what to expect regarding product quality before we buy. But in the case of the
refrigerator we will typically learn its quality dimensions only after we buy and use
it—which sometimes can be a long time after purchase. Consequently, sellers of
refrigerators have incentives to provide something extra in order to enhance sales.
They must provide information about the quality of the product as well. Advertising
is one way of providing the requisite information that consumers demand in an effort
to reduce search costs for experience goods. Highly personal sales efforts and vari-
ous forms of quality assurance may also characterize the sale of experience goods.
There are yet other types of goods whose quality cannot be discerned even after
purchase. These are called credence goods. Some examples are: services of psychol-
ogists, psychiatrists, fortune-tellers, palm-readers, or organized churches. In partic-
ular, credence goods are those for which consumers face high costs in deciding the
right amount to buy, determining the quality of what has been purchased, or some
combination of the two. As explained by the developers of this idea, Michael Darby
and Edi Karni (“Free Competition”), we expect a higher degree of fraud in the sale
of credence goods because it is difficult to substantiate claims of quality. Fraud is
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654 Part VI ■ Back to the Future

achieved in large part by selling a lower-quality product or service than the con-
sumer believes he or she is buying, with the actual quality impossible or very costly
to discover or verify. Many different religions promise widely varying qualities of an
afterlife, but how are we to determine these qualities of the ultimate product and
how much of it to “purchase”?
While most goods are predominately of one type or another (search, experi-
ence, or credence), it is the case that some goods may contain elements of each
characteristic. Moreover, the dissection of goods and services by type leads us to
particular inferences about the provision of information. The placement and type of
advertising, for example, is typically determined by the dominant characteristic.
Under normal circumstances we do not expect Steinway & Sons to advertise their
pianos for sale in Sports Illustrated; but we do expect Nike to advertise their shoes
there. Our expectations about the kind and quality of information in ads—whether
in magazines, in newspapers, on TV, on the Internet, or even on billboards—will
depend on the type of good for which we typically search. We will expect a higher
proportion of quality information (i.e., years in business, seller reputation, licenses
and certifications) for credence goods (e.g., pest control services) than for search
goods (e.g., outdoor barbecue cookers). Other things equal, moreover, typical buyer
characteristics, such as age and gender, are often considered by sellers and will
determine the amount and kind of advertising in which sellers engage.3
Naturally, when the likelihood of fraud increases, we can expect institutions
and exchange arrangements to emerge that promise to reduce the threat. Consum-
ers can often quickly discover intrinsic and subjective qualities of credence goods
by repeat purchases, or by reliance on third-party quality assessments (e.g., J. D.
Power & Associates, Consumer Reports, customer reviews). Sellers may resort to
“money-back guarantees,” warranties, and service contracts to assuage doubts
about product quality. For a fee, automobile assessment shops will give independent
quality assessments of used cars. Licensing of doctors, dentists, opticians, hospitals,
and many other service providers are yet another means of quality assurance. These
market and institutional arrangements help provide information to consumers that
may prevent or reduce fraud. In sum, the quality of goods and services has become
a major focus of contemporary economic analysis.

Innovations in Demand Theory

Standard Marshallian demand theory assumes that consumers purchase goods
and services that are desired for the direct utility that they convey, an approach that
has been modified by more recent developments. Thus, the household is now por-
trayed as purchasing combinations of market goods and time to produce more ulti-
mate and desirable commodities. A separate, but related, new development in
modern demand theory emphasizes the attributes of goods and services rather than
the good or service itself. This new perspective holds that consumers do not
demand market goods for their direct utility but for the utility derived from certain
combinations of utility-producing characteristics. This feature of demand is repre-
sented in figure 26-3, where a single market good (A) produces multiple character-
istics or joint dimensions (a, b, c, . . . , n characteristics).
The demand for characteristics is a fact of everyday experience. Many goods are
capable of satisfying utility on the basis of several different dimensions. For exam-

3
Some empirical evidence exists on advertising intensities and qualities associated with the distinc-
tion of search, experience, and credence goods (see notes for further reading).
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Chapter 26 ■ Changing the Boundaries of Microeconomics 655

Market Good A

Characteristic a Characteristic b Characteristic c

Figure 26-3 Modern demand theory emphasizes that individuals do not demand
market goods per se, but the characteristics and attributes provided by market goods.

ple, individuals purchase automobiles for prestige and status, not merely for trans-
portation. A Porsche produces these characteristics in different proportions than a
small economy car, which, in turn, produces characteristics in different proportions
than a Cadillac or Lincoln. The point, commonly attributed to Kelvin Lancaster
(1924–1999), is that consumers actually demand jointly produced characteristics
rather than products or services themselves (“New Approach to Consumer The-
ory”). This new approach has some clear advantages over the traditional Marshal-
lian analysis of demand. For example, it provides a basis for examining goods that
are obviously related but that cannot be compared easily (or at all) in standard the-
ory. Motorcycles, bicycles, subways, buses, taxis, railroads, airlines, and walking
shoes all provide one or more of the characteristics of automobiles, and yet standard
theory provides no meaningful way to compare them.
Lancaster’s approach to consumer behavior, along with Becker’s innovations
discussed earlier, serve to remind economists that the purchase of market goods is
merely an intermediate step to the satisfaction of some more ultimate want. The
demand for market goods is therefore a derived demand—the demand for an auto-
mobile or a subway token is derived from a demand for certain utility-creating attri-
butes (e.g., transportation and other things) provided by the good or service. It must
be remembered that quality itself is one of those attributes. This enlarged focus on
goods as bundles of characteristics, where the characteristics are numerous and
variable, sheds light on the sometimes sudden emergence (and rapid disappear-
ance) of market goods in the consumption bundles of individuals or households.
In sum, new developments relating to consumer behavior, including nuances of
the kind discussed here, dot the landscape of modern literature in microeconomics.
As with most new economic ideas, these, too, have been robed in the formal dress of
mathematical models, and the result has been to expose the limitations of the new
developments as well as their relevance to real-world situations. On balance, how-
ever, the modern theory of consumer behavior has widened the boundaries of
microeconomic theory.

■ NEWER THEORIES OF THE FIRM

Broadly speaking, the economic function of a firm is to combine economic
resources in order to produce goods and services demanded by consumers. Stan-
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656 Part VI ■ Back to the Future

dard theory tells us firms that succeed in meeting these demands efficiently survive
and prosper while those that do not incur losses and fail. In traditional economic
theory, cost curves based on resource productivity are combined with demand and
other revenue curves to make models of firms categorized by market structure (i.e.,
competitive, monopolistic, or variations thereof), as seen in chapter 20, for example.
This sort of analysis describes firms and their behavior, but it does not answer a
more fundamental question: Why do firms exist at all?
All advanced economies are based on the division of labor. In a market econ-
omy the division of labor is vented in an incredible array of activities based on the
different skills and talents of individuals. But what mechanism or mechanisms
ensure that such consumables as food, clothing, and airline travel are produced
when and where they are wanted? The answer is found in the concept of economic
coordination. In order to explain why firms exist, market coordination must be dis-
tinguished from firm coordination. Market coordination exists when the price sys-
tem directly provides signals (through supply and demand) that guide production
and consumption. Firm coordination exists when the division of labor is carried on
and directed by managers. Market coordination is by nature decentralized, whereas
firm coordination is by nature centralized. Firm coordination is therefore not unlike
central planning in a socialist economy. Within the firm, resources are not bought
and sold but are transferred through managerial directives.
In the language of economics, a firm is a voluntary institution characterized by
free contract. Employees agree voluntarily to follow the dictates of managers, but
these “commands” are but a figure of speech. Successful managers must mimic the
price system by transferring and allocating resources in an efficient manner, given
the prices of equivalent resources “outside” the firm. But if market and firm coordi-
nation are so similar, why are firms necessary at all? Why do some automobile man-
ufacturers purchase tires for their cars rather than make their own? Why do some
firms purchase advertising and travel services from outside agencies (i.e., other
firms) rather than produce them within the firm? Why is market coordination used
for some resource inputs and firm coordination used for others? Contemporary
microeconomics seeks to provide satisfactory answers to such questions.

Why Firms? The Coasian Perspective

In a classic paper published in 1937 entitled “The Nature of the Firm,” Nobel
laureate Ronald Coase (b. 1910) proposed a simple and elegant answer to the ques-
tion: Why are firms necessary? He argued that firms emerge and exist as a least-cost
means of economic coordination. Economic coordination is a two-sided coin. There
are costs to using market coordination. The hiring of inputs (e.g., temporary labor)
typically involves transaction costs, search costs, and negotiation costs. If contracts
are used, they must be negotiated as well as policed. The other side of the coin is that
market coordination provides certain benefits. For example, it may enable a firm to
act more nimbly and flexibly by hiring labor for one day at a time. When firms hire
“temps” they are using market coordination rather than firm coordination.
At some point, however, market coordination may give way to firm coordina-
tion. Entrepreneurs begin to use firm coordination when a comparison of the costs
and benefits between alternative forms of coordination indicates positive benefits to
coordination within rather than without. It may pay to organize clerical tasks within
the firm by hiring a worker on a regular, longer-term basis rather than on a part-
time basis. A firm therefore emerges as a conglomeration of resources that are
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Chapter 26 ■ Changing the Boundaries of Microeconomics 657

gathered together under the centralized (quasi-socialistic) direction of a manager

because it is cheaper than organizing and directing resources through overt (out-
side) market mechanisms.
The next compelling question is: When do firms stop growing in size? Coase
argued that firms face a limit to growth in the form of rising marginal costs of organi-
zation and direction. When the net benefits derived from internal organization and
direction fall below the net benefits of organizing tasks through market contracts, the
firm stops growing and again resorts to market coordination. Economic reality rarely
presents us with an either/or situation, however. Many firms use both forms of
resource coordination simultaneously. Market coordination may be more efficient for
some specialized tasks, e.g., a “temp” to type rarely needed legal documents, whereas
frequent and repetitive tasks may be accomplished at lower cost by a full-time
worker with a wide array of office skills. As a practical matter, therefore, each task
within the firm may be examined from the standpoint of whether the net benefits
derived from inside coordination exceed those derived from outside coordination.

Team Production and Shirking in the Firm

Coase’s innovative theory of the firm has spawned a number of theoretical
extensions. One of the more promising off-shoots of the theory has been the “team
production” view of how activities are organized within firms. Most of the activities
of firms, including the production of goods and services, involve team effort—and a
team, like a chain, is only as strong as its weakest link. How, then, can the firm pre-
vent its team members from shirking or engaging in unproductive behavior? One
answer has been given by Armen Alchian and Harold Demsetz, who maintain that
the manager acts as a team monitor to ensure efficiency in those instances where
several individuals or groups must work together to accomplish a task (“Produc-
tion, Information Costs and Economic Organization”).
Specialization, as Adam Smith recognized long ago, leads to increased productiv-
ity. But people have an incentive to shirk if no one polices their behavior. At the same
time workers stand to benefit from being monitored because their returns are, to a
large degree, adversely affected by the shirking behavior of other members of the
team. These circumstances explain the emergence of a manager as someone given
the responsibility to reward superior performance and to discipline those who shirk.
In the absence of team production, individual producers are disciplined by the
actions of rivals, that is, by market competition. A worker can shirk, but he or she
bears the full costs of such behavior by receiving lower earnings. In such circum-
stances, an internal monitor is not necessary. Firms that employ monitors obviously
face increased costs over those that do not, so it is only when the benefits of
increased productivity to team production outweigh the costs of monitoring the team
that team production replaces individual production. In the evolutionary scheme of
things, when teams can produce goods and services at a lower cost than individuals
can, firms emerge and prosper. The Alchian–Demsetz view therefore regards a firm
as the logical consequence of positive net benefits that derive from team production
even in the face of the higher costs of monitoring team performance.
This concept of manager-as-monitor-of-team-production raises some rather
obvious questions. For instance, who will monitor the manager? Doesn’t the man-
ager also have an incentive to shirk? The institutional composition of the firm pro-
vides answers to these questions, particularly in what it reveals about the pattern of
incentives, both positive and negative, given to managers. On the one hand, manag-
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658 Part VI ■ Back to the Future

ers are disciplined by the market. If they perform poorly, monitor-managers will be
fired and competing managers will be installed by owners or stockholders. On the
other hand, managers can be rewarded as residual claimants who share in the prof-
its or rewards of team production. Managers thus have both negative and positive
incentives to be efficient monitors of team production.
Interest in the economics of information as a central part of the newer micro-
economics has raised a number of provocative issues related to the quality of prod-
ucts as well. The central question concerns the determination of product quality and
the kind of information buyers and sellers have before the purchase of products. If
sellers possess information that buyers do not have regarding product quality, they
may have incentives to sell substandard products or services. This rather obvious
observation has generated various approaches to the issue of product quality.

Entrepreneurship Redux
Resurgent issues involving the nature of the firm and product quality raised
anew questions about the essence and vitality of entrepreneurship. On the one hand
Lancaster’s characteristics-based demand theory is strongly evocative of Dupuit’s
treatment of demand in an earlier era (see chapter 13). Both writers opened up
broad opportunities for the entrepreneur to be creative in the “formation/manipula-
tion” of products in attempts to form effective profit strategies. On the other hand,
Coase’s view of the firm offers an explanation for vertical integration. Entrepre-
neurs in a Coasian firm are tasked with maintaining administrative arrangements
that supplant the market mechanism. They are merely required to calculate admin-
istrative versus market costs and adjust their organizations accordingly in line with
the profit motive. They do not face uncertainty, nor is their function to be proactive;
it is to be reactive. The chief merit of Coase’s theory is the illumination of transac-
tion costs and how they affect the nature of the firm. Its implications for entrepre-
neurship are limited.
On this point a contrast between Coase and Knight (see chapter 20) on the the-
ory of the firm is instructive. Coase’s theory focused on the execution of economic
activity rather than its conception and planning. Knight emphasized conception and
planning, stressing how the presence of uncertainty induces major changes in the
organon of economic theory. “With uncertainty present,” Knight wrote, “doing
things, the actual execution of activity, becomes in a real sense a secondary part of
life: the primary problem or function is deciding what to do and how to do it” (Risk,
p. 268; emphasis added). Knight recognized that producers take the responsibility
of forecasting consumers’ wants, but he insisted that “the work of forecasting and at
the same time a large part of the technological direction and control of production
are still further concentrated upon a very narrow class of the producers, and we
meet with a new economic functionary, the entrepreneur” (p. 268).
Knight traced major changes in the basic form of business organization to the
rise of the entrepreneur class. Internal organization of a business cannot be
entrusted to chance or to purely mechanical formulas in the face of uncertainty.
Entrepreneurs are required to make discretionary decisions. Firms are compelled to
recognize the disparity among individuals regarding intellect, judgment, and ven-
turesomeness. The successful business must establish an organizational structure
to promote successful decision making. It does so, according to Knight, by encour-
aging the confident and venturesome to assume the risk that the doubtful and timid
wish to avoid. In a phrase, entrepreneurs “insure” the latter group by guaranteeing
them a specified income in return for a share of the enterprise’s outcome.
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Chapter 26 ■ Changing the Boundaries of Microeconomics 659

In sum, the Knightian firm exists because the real world cannot meet all the
conditions for competitive equilibrium dictated by economic theory. Knight held
that the price system is effective in allocating resources among alternative uses but
that it does not establish the pattern of alternative uses, which is established by
entrepreneurs. Thus, the essence of entrepreneurship is judgment, born of uncer-
tainty. “Any degree of effective exercise of judgment, or making decisions,” Knight
wrote, “is in a free society coupled with a corresponding degree of uncertainty-bear-
ing, of taking the responsibility for those decisions” (Risk, p. 271). This responsibil-
ity is expressed in the collateral guarantees of fixed remuneration given to resource
suppliers by the entrepreneur.
Knight’s theory of entrepreneurship is the logical extension of Cantillon’s early
and rich insight into how markets work, but it is also a logical antecedent to Coase’s
theory. The opportunity for transactions to take place must exist before the cost of
such transactions can be used to explain the nature of the firm. Coase’s analysis
takes for granted the primary question of what to produce. Insofar as it emphasizes
calculation rather than judgment, it provides no meaningful way to distinguish the
entrepreneur from other hired inputs. In other words, Coase worked within the con-
fines of standard, neoclassical price theory. He adopted the static, general-equilib-
rium method of analysis, which abstracts from time and uncertainty. As a theory of
the firm, his analysis is imaginative and insightful. As a theory of the entrepreneur,
however, it is limited in scope and substance.
To explain the anomaly of why firms exist in a regime of perfect competition
Knight pushed economic analysis outside the standard neoclassical paradigm. In
place of the perfect foresight hypothesized in static, general-equilibrium models, he
substituted entrepreneurial judgment. He made uncertainty the cornerstone of his
theory, and he adopted Cantillon’s concept of uncertainty (refined to distinguish
between insurable and uninsurable risks). This practice places uncertainty at the
point of final consumer goods and services. One can almost hear the echo of Cantil-
lon in the following passage:
[T]he main uncertainty which affects the entrepreneur is that connected with the
sale price of his product. His position in the price system is typically that of a pur-
chaser of productive services at present prices to convert into finished goods for
sale at the prices prevailing when the operation is finished. There is no uncertainty
as to the prices of the things he buys. He bears the technological uncertainty as to
the amount of physical product he will secure, but the probable error in calcula-
tions of this sort is generally not large; the gamble is in the price factor in relation
to the product. (Risk, pp. 317–318)

Thus, for Knight (as compared to Coase), output price uncertainty accounts for
the unique nature of the firm. Transaction costs do not enter the picture at this stage
of inquiry, because they are secondary to the originative acts of (1) deciding what
goods are to be produced and (2) establishing the appropriate administrative orga-
nization to do so. Whereas Coase took markets for granted, Knight wished to under-
stand the dynamic problem of how markets are created. He believed the creation of
markets is an entrepreneurial function. Prices allocate resources, but they don’t cre-
ate markets—entrepreneurs do. From Knight’s perspective, therefore, the price sys-
tem could never be viewed as a complete substitute for the entrepreneur.
What mattered most to Coase was finding the reason why the price mechanism
should be superseded, and he could not discover this reason in Knight’s treatment
of the firm. Coase’s perceptive analysis of transaction costs eventually spawned a
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660 Part VI ■ Back to the Future

new literature that embellished the idea of the entrepreneur as contractor.4 Thanks
to him, the transactions-cost literature has flowered in contemporary microeco-
nomic theory. Nevertheless, his criticisms of Knight were mostly misplaced because
he did not understand the genuine nature of Knight’s inquiry.
Like Schumpeter, Knight was interested in explaining the nature of economic
progress in a market system, the chief components of which are firms and entre-
preneurs. By firm he meant a basic form of business organization in which the
entrepreneur takes direction, control, and responsibility. Contracting alone does
not capture the full role of the entrepreneur for Knight because “in the world as it is
the interests affected by contracts are never all represented in the agreements”
(Risk, p. 353). In Knight’s view, entrepreneurs are more than contractors. They are
specialists at bearing uncertainty, and while the contract is one way to reduce
uncertainty, some uncertainty can never be eliminated. For Knight, therefore, the
size of firms depends, among other things, on the available supply of entrepreneur-
ial qualities.

Markets, Information, and “Lemons”

Ever since the pathbreaking work of Friedrich Hayek (see chapter 23), econo-
mists have become acutely aware that markets are mechanisms for generating and
disseminating information. It follows that economic markets work best when there
is an unimpeded flow of accurate, reliable information between potential buyers
and sellers. Within the informational framework of the market, price is a “signal”
that conveys important information about quality, and about the relationship
between wants on the one hand and available supplies on the other. But how reli-
able is this signal? Information can be asymmetric: Sellers may have more or better
information than buyers, or vice versa. One of the more interesting extensions of
modern microeconomics attempts to grapple with this important problem.
A good example of what we mean is provided by the automobile market.5 It is
difficult for an automobile buyer to obtain complete information before making a
purchase. A new car may be dependable and trouble-free, or it may turn out to need
repairs continually. Cars in the latter category are known as “lemons.” Unfortu-
nately, the customer usually does not know beforehand whether or not a car is a
lemon. Under such circumstances, the reputation of the seller becomes a basis for
customers to make decisions about which automobiles to purchase.
Consider the used-car market, where the potential for “lemons” is particularly
great. Among other things, used-car buyers demand previously owned automobiles
on the basis of their price and on the probability that they will provide reliable
transportation (i.e., not be a “lemon”). If the initial price of used cars does not clear
the market, the resulting “signal” is that an imbalance exists between quantity sup-
plied and quantity demanded. In the absence of informational barriers, the price
would readily adjust to accommodate the demand to the supply, or vice versa. This
normal process may be short-circuited, however, if buyers have inadequate infor-
mation. Suppose that price is “too high” (i.e., quantity supplied exceeds quantity
demanded). Sellers’ attempts to eliminate the surplus by lowering price may not

4
The classic reference to the “nexus of contracts” theory of the firm is Armen A. Alchian and Har-
old Demsetz; see also, Michael Jensen and William Meckling, Paul Rubin, Benjamin Klein and
Keith Leffler, all cited in the references. More recently, Yoram Barzel (see references) has used
this approach to explore the moral hazard aspects of entrepreneurship. In a more fundamental
historical sense, the idea of the entrepreneur as contractor harks back to Bentham.
5
See George Akerlof, “Market for ‘Lemons’” (references).
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Chapter 26 ■ Changing the Boundaries of Microeconomics 661

succeed because customers may perceive that the cars offered for sale at a lower
price are more likely to be “lemons.” This may lead to aggressive “discounting” at
the wholesale level, so that the average used car sells below its normally depreci-
ated value. But discounting has a potentially adverse side effect in that below-nor-
mal prices of used cars may discourage owners of higher-quality used cars from
selling, thereby reducing the number of potential welfare-enhancing trades that
take place between willing buyers and sellers.
The problem of asymmetric information is particularly resistant in certain mar-
kets. In such cases, circumstances emerge over time, which serve to mitigate the
“lemons” problem. Thus, the reputation of the seller becomes an important criterion
for the prospective purchaser. Auto dealers with good reputations for honoring
promises through warranties or guarantees gain an advantage over unreliable, fly-
by-night firms. Airlines with better safety records gain customers over those with
weak safety records, and so forth. Markets may be imperfect, therefore, but they
remain vibrant and, left to themselves, are usually capable of generating compen-
sating features that promote overall welfare between market participants.

■ NONTRADITIONAL APPROACHES:
PROSPECT THEORY, HAPPINESS THEORY, AND NEUROSCIENCE
New approaches to human behavior that challenge fundamental principles of
economics—specifically the utility-maximization approach to consumer demand
and valuation—have been growing over the last three decades through the efforts
of psychologists. While traditional economic theory clings to its standard assump-
tions of rational behavior, self-interest, and stable preference (utility) functions,
Daniel Kahneman and Amos Tversky have attempted a revision of utility theory
(“prospect theory”) that some economists feel may someday form the basis of a
“new economics.” Spawned from this revision of utility theory is another new
approach, “happiness theory”—that is, discovering what makes people happy.
Foundational to these theories is neuroscience, which has tentacles in social and
behavioral sciences. We briefly touch neuroscientific techniques that assert human
behavior is not always rational.

Prospect Theory
The new approach to utility, demand, and value is outlined in Kahneman and
Tversky’s famous paper, “Prospect Theory: An Analysis of Decision under Risk”
(2000 [1979]). The fruit of their efforts culminated in Kahneman winning the Nobel
Prize in Economics in 2002. Tversky died in 1996, but Kahneman continues to
develop their joint line of reasoning. He argues that people are limited in their
choices by the information available at a given moment; they sometimes depart
from the economist’s view of rationality, and their behavior is never as consistent
and logical as economists assume it to be. People can be generous. They can place
the happiness or welfare of others (wife, husband, partner, poor and/or downtrod-
den people) into their “utility function.” They may engage in “conspicuous con-
sumption,” as Veblen claimed, deriving utility from keeping up with, or outspending,
their peers. The psychologists also argue that over time tastes are unstable. Prefer-
ences change, maybe even frequently, upsetting one of the standard assumptions of
traditional economic theory.
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662 Part VI ■ Back to the Future

Kahneman and Tversky set out to examine how individuals make choices in
their world, as opposed to the world of the economists.6 According to Kahneman:
If you prefer an apple to a banana, then you also prefer a 10% chance to win an
apple to a 10% chance to win a banana. The apple and the banana stand for any
objects of choice (including gambles) and the 10% chance stands for any probabil-
ity. Economists adopted expected utility theory in a dual role: as a logic that pre-
scribes how decisions should be made, and as a description of how Econs make
choices. Amos [Tverskky] and I were psychologists, however, and we set out to
understand how Humans actually make risky choices without assuming anything
about their rationality. (Thinking Fast and Slow, pp. 270–271)

The Kahneman–Tversky approach seeks to develop a utility theory more firmly

rooted in psychology than allowed by the earlier Bernoulli-based theory that under-
girds economics.7 Whereas the economist assumes that individuals start with a ref-
erence point when evaluating decisions or probabilities, prospect theory assumes
that individuals must first identify outcomes that they believe are equivalent, such
as the probability of getting two more apples to the probability of losing two less
bananas. But it should be obvious that whatever one’s reference point will depend
on how one values apples and bananas and how many apples and bananas the indi-
vidual possesses when asked. In other words, behavior and decisions cannot be
assumed, they must be analyzed given some reference point—which, in general,
will be different for different individuals. If two individuals who each earn $100,000
a year are each given a $25,000 raise, the psychological valuation of the raise is
likely to be different for each of them. The psychological value of the raise may well
depend on how comparable workers are compensated or on the consumption pat-
terns of one’s peer group (Veblen again).
Prospect theory may be explicated within the simple framework of a coin toss.
Suppose the gamble is that you win $150 if the coin comes up heads, but you lose
$100 if it comes up tails. Would you take the bet? Kahneman and Tversky recognize
that you have a different reference point if your wealth is $30,000 than if it is $5 mil-
lion, yet the expected value of the gamble is the same. They observed that many
individuals would not take the bet, because “for most people the fear of losing $100
is more intense than the hope of gaining $150.” They concluded that “losses loom
larger than gains and that people are loss averse” (Kahneman, Thinking, p. 284).
Loss aversion is a central tenet of prospect theory. The other key principles are:
Acts of evaluation are relative to a neutral reference point, and changes in wealth
are subject to diminishing sensitivity (e.g., the subjective difference between $900
and $1,000 is much smaller than the difference between $100 and $200).8 These
three principles come into play in figure 26-4, which shows the psychological values
of gains and losses in Kahneman’s theoretical framework. In this figure, psycholog-
ical satisfaction (value) is represented on the vertical axis and outcomes or dollar

6 In order to draw distinctions between two types of decision makers Kahneman and Tversky use
terminology invented by Richard Thaler, who dubbed the two types “Econs” and “Humans.”
Econs are those who behave as economists assume, Humans decide on the basis of “prospects.”
(see references).
7
Daniel Bernoulli (1700–1782), was a Swiss mathematician and physicist, whose invention of the
St. Petersburg Paradox provided the basis for the economic theories of risk aversion, risk pre-
mium and utility. The St. Petersburg paradox is a classical situation where a naive decision crite-
rion (which takes only the expected value into account) would recommend a course of action that
no (real) rational person would be willing to take.
8
This principle is somewhat different from the principle of the diminishing marginal utility of money.
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Chapter 26 ■ Changing the Boundaries of Microeconomics 663

amounts on the horizontal axis. The neutral reference point is at the intersection of
the vertical and horizontal axes. The S-shape of the curve represents diminishing
sensitivity to gains and losses. Kahneman points out that the two curves that form
the S around the reference point are not symmetrical due to loss aversion—the
slope of the function changes abruptly at the reference point showing that the
response to losses is stronger than the response to corresponding gains (Thinking,
pp. 282–283).
Figure 26-4 shows that from a neutral reference point the positive psychological
value of a $100 gain (NE quadrant) is less than the negative psychological value of a
$100 loss (SW quadrant), or that a person fears the resulting loss to a greater extent
than he or she welcomes the resulting gain. By inference, this person would not take
a bet with the fifty-fifty prospect of winning $150 or losing $100. Not all individuals
are necessarily loss averse with this gamble. Each individual is required to establish
some benchmark in evaluating the alternatives. That benchmark will be different
for different individuals and for different benchmark levels of income as well. Life
sometimes forces us to take chances. Will the object of your affection say “yes” or
“no” to a date? Will you get that part in the school play? Should a lawyer accept you
as a client? Decisions must be made. Sometimes all the alternatives one faces are
bad. It is believed that individuals become less “loss averse” in such instances (des-
peration?). However, other things equal, in prospect theory a certain outcome is pre-
ferred to an uncertain one. This is not the general case in traditional theory.
It should be obvi-
ous that prospect theory
undermines generally +
accepted principles of
economic reasoning.
Loss aversion might ex-
plain the fact that our
valuation of posses-
sions may change over
time in either direction,
suggesting that the util- –200 –100
– +
ity derived from them 100 200 Dollar
also varies over time. amount
We may purchase a
piece of art for $1,000
today but not wish to
sell it for $2,000 a Losses Gains
month later. However, it
remains to be seen
whether prospect the-
ory can be more robust
in promoting economic Psychological
Value
understanding. So far, it
has not come close to –
overturning the existing
paradigm of economics, Figure 26-4 The psychological value of gains and
which remains stead- losses based on evaluation from a neutral reference
fastly committed to the point, diminishing sensitivity to changes in wealth, and
rationality principle. loss aversion.
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664 Part VI ■ Back to the Future

Nevertheless, the human dimensions of social behavior are indeed complex,

offering perhaps large opportunities to integrate economics and psychology in
meaningful ways. At this writing, prospect theory represents a supplemental rather
than an integral tool of economic analysis. It is confined mostly to the world inside
of the laboratory, where experiments are conducted to test whether animal “con-
sumers” are “rational” or “irrational.” The weight of these experiments has been to
show that the behavioral assumptions involving rational behavior are minimal inso-
far as they apply to animals as well as humans. Prospect theory has far to go if it is
to revolutionize economic theory. At least one critic argues that it is “not ready-
made for economic applications,” (Barberis, “Thirty Years,” p. 174). We shall have to
wait and see its lasting impact, if any. (For now, we invite you to take a look at the
box, The Force of Ideas: Veblen Redux and the Behaviorists, to see parallels in the
divergence from traditional economic methodology.)

The Force of Ideas: Veblen Redux and the Behaviorists

The traditional nexus of economic theory (repeatedly exercised in this book) has been
jolted, but not replaced, by the “behavioral economics” of psychologists and experimentalists.
Other assaults on traditional notions of utility maximization have included the argument that
higher pecuniary income (or GDP) may not be a good indicator of “happiness.” But readers
might recall from chapter 19 that dissent from methodological orthodoxy was alive and well a
century ago in the core of Veblenian “institutional” economics, which proffered a basic and
(necessarily) less sophisticated “take” on human nature quite similar to modern methodologi-
cal critics. Consider only two of Veblen’s conceptions for comparison: rationality and emulation.
Veblen attacked the “rationality postulate” enshrined in neoclassical and Austrian eco-
nomics. As he put it, human beings were more than simply “lightening fast calculators” (see
chapter 19). The self-interested nature of individuals was operative to an extent but it was
assumed, not proven, to be the central driver of economic behavior. Standard economic the-
ory assumed that human nature was unalterable and divorced from
the cultural elements involved in the theoretical scheme, elements that are of the nature
of institutions, human relations governed by use and wont in whatever kind and con-
nexion, are not subject to inquiry but are taken for granted as pre-existing in a finished,
typical form and as making up a normal and definitive economic situation, under which
and in terms of which human intercourse is necessarily carried on. (“Limitations,” p. 157)
In short, just as Kahneman and Tversky argued, Veblen suggested that human behavior was
complex and that habits and instincts played a heuristic role in choice. Heuristic “short-cuts” to
thinking—explainable perhaps in the wired system of the brain—constitute what Veblen
called instincts and habits. A major criticism of neoclassical economics, Veblen argued, is that
rather than admit that knowledge is “bounded” by instincts and habits, neoclassical econom-
ics simply assume them away. The modern behaviorists are reprising similar arguments.
The importance of relativity in gauging satisfaction (utility) was also stressed by Veblen,
although he gave the subject of utility an “anthropological” twist. In early stages of civilization
honor and esteem were achieved by the possession of wealth or property, whether obtained
from one’s own efforts or through inheritance. In the emerging pecuniary economy—where
making money becomes a contrast to making goods—a new “propensity” arises in human
nature. Says Veblen:
Under the regime of individual ownership the most available means of visibly achiev-
ing a purpose is that afforded by the acquisition and accumulation of goods; and as
the self-regarding antithesis between man and man reaches fuller consciousness, the
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Chapter 26 ■ Changing the Boundaries of Microeconomics 665

propensity for achievement—the instinct of workmanship—tends more and more to

shape itself into a straining to surpass others in pecuniary achievement. Relative suc-
cess, tested by an invidious pecuniary comparison with other men, becomes the con-
ventional end of action. (Theory, pp. 39–40)
What Veblen terms “conspicuous leisure” coupled with “conspicuous consumption”
becomes an elusive “end” to human behavior. When one has finally caught up with “the Jone-
ses,” the Joneses, or at least some of them, advance further in consumption or pecuniary
wealth, and one’s satisfaction (or utility) is lowered because of his or her new relative position.
These attributes of human nature mean that the kind of rationality and utility maximiza-
tion proffered in traditional theory, as well as substitute theories advanced by today’s behav-
iorists and psychologists, miss the mark in analyzing economic activity and results. If utility
cannot dependably be linked to higher GDP or income or wealth, the connection between
happiness and overall well-being is questionable. While these matters cannot be fully dis-
cussed here, we note that “new” investigative tools, however intriguing, have not replaced tra-
ditional economic notions of rationality and utility maximization any more than Veblen
succeeded in displacing Marshallian and Austrian neoclassicism. Identifying parallels in eco-
nomic criticism, however, reminds us that traditional methods of economics have been under
close scrutiny in much the same manner over time.

Happiness Theory
Something called “happiness theory” is an offshoot of the Kahneman–Tversky
emphasis on “experienced” utility rather than hypothesized utility. In this field one
does not assume that an individual is “happy” to some degree, or attempt to mea-
sure happiness in money; one simply asks the individual. The basic idea here, not
unlike “prospect theory,” is that happiness and well-being have nonpecuniary as
well as pecuniary dimensions. (Once more, traditional theory assumes that individu-
als rationally maximize income or wealth.) Like prospect theory happiness theory is
an attempt to integrate psychology with economics, while calling on empirical
results from specialized and global studies. Happiness “theorists” look at actual data
to see how people behave. From observations they derive the (sometimes not too
surprising) conclusions that married or partnered people are happier or more satis-
fied than single people; that the employed are happier than the unemployed; that
(for example) Danes are happier than U.S. citizens; and many other conclusions
that might seem obvious to the casual observer (for details see Frey, Happiness, A
Revolution in Economics, and Layard, Happiness: Lessons from a New Science).
One critical aspect of both “happiness” theory and “prospect” theory must be
carefully examined—the stability of preferences at any moment and over time. One
speculation on this matter is the “Easterlin Paradox,” formulated by Richard Easter-
lin (“Does Economic Growth Improve the Human Lot?”) in 1974. The Easterlin Par-
adox holds that more per-capita income is not related positively to happiness, at
least at higher income levels. While empirical evidence since Easterlin’s paper does
not support his hypothesis (rather some studies indicate a positive correlation
between per capita income and happiness even at higher levels of income), Easter-
lin’s reasoning is nevertheless important, because it relates to a so-called relative
income hypothesis.9 One part of this idea is based on acculturation—the idea that

9
See notes for further reading at the end of this chapter.
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666 Part VI ■ Back to the Future

individuals become accustomed to higher levels of income through time. By the

acculturation principle people may be made happier by higher income in the short
run, but over time they find that other people’s incomes have increased along with
theirs, leaving their relative position (and happiness level) about the same. Clearly,
it can be shown that very wealthy countries contain happier people than very poor
countries, but that is not what the relative income hypothesis is about. The utility of
increases in income adjusts to former levels through time.
The relative income hypothesis is associated with the issue of “interdependent
utility functions,” which is the notion that one person’s utility is linked to the utility
experienced by others, especially one’s friends or associates. An increase in the sta-
tus or income or wealth of A, may cause a decrease in the utility of individuals B
through N, leaving the group A though N no better off. Based on this premise, if your
salary rises and your coworkers’ does not, the group’s utility does not change. If you
purchase a new Porsche and your friends do not, the group’s utility remains the
same.10 Acceptance of this notion has led to proposals to tax luxury goods and higher
incomes (Frank, Luxury Fever), actions that meet with criticism and resistance on
grounds that taxes violate economic freedom and lead to distortions in the allocation
of resources (Salerno, “Clamping Down on the Joneses”). It goes without saying that
taxation reduces welfare—a consequence that would have to be set against any
increases that would come from taxes on luxury goods or higher incomes. According
to Frey, “keeping up with the Joneses” in income or wealth or luxury goods has coun-
terparts in the attainment of political power, awards (such as the Pulitzer or Nobel
prizes), educational “status,” distinction in the arts and in scholarship, and in many
other areas (Happiness, p. 172). The important point is that such behavior does not
comport with the traditional “economic” assumption of rationality.

Neuroscience
Another avenue to explaining human behavior has been the scientific approach
called “neuroscience.” Neuroscience measures brain activity in various ways to
identify both pleasure and pain and the degrees of pleasure and pain from some
stimuli. In other words, neuro research is aimed at finding the source and measure-
ment of “utility” and “happiness.” Neuroscience uses various methods to “explain”
happiness by way of brain “imaging.” The electroencephalogram measures stimuli
from outside the brain. Other techniques, such as the MRI (magnetic resonance
imaging) or PET (positron emission tomography) scans measure blood or blood
characteristics to arrive at conclusions concerning action or intelligence. Rather
than just assume that humans are rational calculators, neuroscience studies Homo
sapiens as an intuitive, emotional, and “nonrational,” being capable of making non-
rational (in an economic sense) decisions.
Neuroscience, happiness theory, and prospect theory have raised interesting
and important issues in economic theory, but the broad brush of “nonrational”
human behavior has yet to alter the fundamentals of economic teaching. Instead the
science of choice as elaborated within traditional economics is subjected to reality
tests by ever-expanding and improving econometric techniques (see chapter 25).
Calculations using the “nonrational” assumptions discussed above have been tested
by experimentation on groups of people (students), animals (rats and pigeons), field
surveys, government surveys, and international data sets. Still in its infancy, the

10
This idea should sound familiar if you have digested the narrative, “The Force of Ideas: Veblen
Redux and the Behaviorists” in this chapter.
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Chapter 26 ■ Changing the Boundaries of Microeconomics 667

new behavioral economics and the results to date have yet to be given the “real-
world” scrutiny that traditional economic theory has been put through over an
extended period of time. Nontraditional assumptions concerning behavior may yet
hold promise for “revolutionizing” economics, but a radical reorientation of eco-
nomic thinking does not appear to be in the cards anytime soon.

■ CONCLUSION
Contemporary microeconomics teems with many provocative issues and inter-
esting applications. To borrow Hemingway’s aphorism about Paris, today’s micro-
economics is a movable and ever-changing feast. In this chapter we have tried to
convey the flavor of several new developments relating to consumption and
demand. Even a small taste of the feast conveys the clear and correct impression
that economic theory has made and is making giant leaps in the direction of “real-
ism.” Economists are learning to recognize and to account for all kinds of actual
market circumstances that were held in abeyance by earlier writers. This is not, of
course, to criticize the genuine pioneers of microeconomic theory such as Marshall,
Jevons, or Walras. Rather, it is evidence that the operation of markets is a more
complex process than could be handled by the earlier conceptual apparatus. In real-
ity, the modern directions of microeconomic theory are testimony to the ongoing
nature of earlier contributions and the vibrancy of economics.

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Alchian, Armen A., and Harold Demsetz. “Production, Information Costs, and Economic
Organization,” American Economic Review, vol. 62 (December 1972), pp. 777–795.
Barberis, Nicholas C. “Thirty Years of Prospect Theory in Economics: A Review and
Assessment,” Journal of Economic Perspectives, vol. 27 (Winter 2013), pp. 173–196.
Barzel, Yoram. “The Entrepreneur’s Reward for Self-Policing,” Economic Inquiry, vol. 25
(January 1987), pp. 103–116.
Becker, Gary S. “A Theory of the Allocation of Time,” The Economic Journal, vol. 75
(September 1965), pp. 493–517.
Coase, Ronald H. “The Nature of the Firm,” Economica, vol. 4 (November 1937), pp.
386–405.
Darby, Michael, and Karni, Edi. “Free Competition and the Optimal Amount of Fraud,”
Journal of Law and Economics, vol. 16 (April 1973), pp. 67–88.
Easterlin, Richard. “Does Economic Growth Improve the Human Lot? Some Empirical
Evidence,” in Paul David and Melvin Reder (eds), Nations and Household in Eco-
nomic Growth: Essays in Honour of Moses Abramowitz. Amsterdam: Academic
Press, 1974.
Frank, Robert. Luxury Fever: Why Money Fails to Satisfy in an Era of Excess. New York:
Free Press, 1999.
Frey, Bruno S. Happiness: A Revolution in Economics. Cambridge, MA: The MIT Press, 2008.
Jensen, Michael C., and William H. Meckling. “A Theory of the Firm: Governance, Resid-
ual Claims, and Organizational Forms,” Journal of Financial Economics, vol. 3
(October 1976), pp. 305–360.
Kahneman, Daniel. Thinking Fast and Slow. New York: Farrar, Straus and Giroux 2011.
———, and Amos Tversky. “Prospect Theory: An Analysis of Decision Under Risk,” in
Daniel Kahneman and Amos Tversky, Choices, Values, and Frames. Cambridge, UK:
Cambridge University Press, 2000 [1979], pp. 17–43.
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668 Part VI ■ Back to the Future

Klein, Benjamin, and Keith Leffler. “The Role of Market Forces in Assuring Contractual
Performance,” Journal of Political Economy, vol. 89 (1981), pp. 615–641.
Knight, Frank H., Risk, Uncertainty and Profit. New York: Houghton-Mifflin, 1921.
Lancaster, Kelvin J. “A New Approach to Consumer Theory,” Journal of Political Econ-
omy, vol. 74 (April 1966), pp. 132–157.
Layard, Richard. Happiness: Lessons from a New Science. London: Penguin Books, 2005.
Nelson, Phillip. “Information and Consumer Behavior,” Journal of Political Economy, vol.
78 (1970), pp. 311–329.
———. “Advertising as Information,” Journal of Political Economy, vol. 82 (1974), pp.
729–754.
Rubin, Paul. “The Theory of the Firm and the Structure of the Franchise Contract,” Jour-
nal of Law and Economics, vol. 21 (1978), pp. 223–233.
Salerno, Joseph. “Clamping Down on the Joneses,” Mises Daily, August 21, 2012. Ludwig
von Mises Institute. http://mises.org/daily/6155/Clamping-Down-on-the-Joneses.
Stigler, George J. “The Economics of Information,” Journal of Political Economy, vol. 69
(June 1961), pp. 213–225.
———, and Gary S. Becker. “De Gustibus Non Est Disputandum,” American Economic
Review, vol. 67 (March 1977), pp. 76–90.
Thaler, Richard H., and Cass R. Sunstein. Nudge: Improving Decisions about Health,
Wealth, and Happiness. New Haven, CT: Yale University Press.
Veblen, Thorstein. The Theory of the Leisure Class, with an introduction by John Ken-
neth Galbraith. Boston: Houghton Mifflin Company, 1973 [1899].
———. “The Limitations of Marginal Utility,” Journal of Political Economy (1909), in
Wesley C. Mitchell, What Veblen Taught, New York: A. M. Kelley, 1964.

NOTES FOR FURTHER READING

No short narrative of contemporary trends in the microeconomic analysis of
demand, consumption, and “rationality” (or any other subject) could possibly do justice
to the ideas themselves. As always, there is no substitute for the original sources. One
source stands out in bringing the largest number of original papers on the “new” micro-
economics together under one cover: see William Breit, Harold M. Hochman, and
Edward Saueracker (eds.), Readings in Microeconomics (St. Louis: Times Mirror/Mosby
College Publishing, 1986). For another excellent compendium of original essays on the
“new microeconomics” and its broad applicability, see Richard B. McKenzie and Gordon
Tullock, The New World of Economics: Explorations into the Human Experience, 3d ed.
(Homewood, IL: Irwin, 1981). The authors take up such matters as marriage, child pro-
duction, law, crime, presidential elections, and college and university education, examin-
ing each issue as a straightforward application of basic microeconomic principles. The
principles underlying “nonrational” theorizing in economics are well covered in the Kah-
neman and Frey texts listed in the references to this chapter.
The relation between goods quality, advertising, and information is an ongoing sub-
ject of contemporary microeconomics. In addition to the papers by Stigler, Nelson, and
Darby and Karni cited above in the references, empirical papers on the nature of goods
and information transmission exist. On the issue of search and experience goods, see
three papers by David Laband: “Advertising as Information: An Empirical Note,” Review
of Economics and Statistics, vol. 68 (August 1986), pp. 517–521; “The Durability of Infor-
mational Signals and the Content of Advertising,” Journal of Advertising, vol. 18 (March
1989), pp. 13–18; and “An Objective Measure of Search versus Experience Goods,” Eco-
nomic Inquiry, vol. 29 (July 1991), pp. 497–509. Robert B. Ekelund, Jr., Franklin G.
Mixon, Jr., and Rand W. Ressler, “Advertising and Information: An Empirical Study of
Search, Experience and Credence Goods,” The Journal of Economic Studies, vol. 22
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Chapter 26 ■ Changing the Boundaries of Microeconomics 669

(1995), pp. 33–43; extend this discussion to include credence goods as well. The concept
of a “meta-credence” good—one that goes beyond the existence of a simple credence
good—is applied to religion by Robert B. Ekelund, Jr., Robert F. Hébert, and Robert D.
Tollison, The Marketplace of Christianity (Cambridge: The MIT Press, 2006).
Many other important innovations in resource allocation and the theory of the firm
and firm operations bear careful study. In our view, one of the most interesting exten-
sions of time costs and resource allocation involves the problem of welfare dissipation
under differing schemes of distribution and retrade. A central contribution that clearly
reveals the implicit costs of queuing is that of Yoram Barzel, “A Theory of Rationing by
Waiting,” Journal of Law & Economics, vol. 17 (April 1974), pp. 73–95. Harvey Leiben-
stein, “Allocative Efficiency vs. ‘X-Efficiency,’” American Economic Review, vol. 56 (June
1966), pp. 392–415, raises and evaluates the question of whether firms minimize costs as
assumed in orthodox theory. Problems relating property rights and contracting to firm
size and organization have been developed in a number of contributions by Oliver E.
Williamson: see, for example, “Hierarchical Control and Optimum Firm Size,” Journal of
Political Economy, vol. 56 (April 1967), pp. 123–138; and Markets and Hierarchies (New
York: The Free Press, 1975). The modern approach to the theory of the firm is evaluated
and expanded in an unpublished doctoral dissertation by Donald J. Boudreaux, Con-
tracting, Organization, and Monetary Instability: Studies in the Theory of the Firm
(Auburn University, 1986). A contemporary brief for the generally positive contribution
of advertising to efficient market functioning and information provision is given in Rob-
ert B. Ekelund, Jr., and David S. Saurman, Advertising and the Market Process: A Mod-
ern Economic View (San Francisco: Pacific Research Institute for Public Policy, 1988).
The intrusion of modern microeconomic theory into other realms of social behavior
is evident by the success of Stephen D. Levitt and Steven J. Dubner’s Freakonomics: A
Rogue Economist Explores the Hidden Side of Everything (New York: HarperCollins,
2005). One of the “politically incorrect” arguments set forth therein by Levitt, an econo-
mist at the University of Chicago, is that the dramatic lowering of the crime rate in the
1990s—usually attributed to more police resources, passage of mandatory sentencing
laws, and so forth—may have been a result instead, or as well, of the institutionalization
of legalized abortions following the 1973 Supreme Court decision, Roe v. Wade. Pushing
the envelope ever further, Levitt utilizes conventional economic tools to analyze Internet
dating, sumo wrestling, student cheating on standardized examinations, and why drug
dealers live with their mothers.
The revolution in microeconomic theory—especially that related to property rights,
the modern theory of the firm, and rent-seeking and interest group behavior—has
spawned an enormous amount of interest in neoinstitutional economics. The work of
Nobel laureate Douglass North has already been mentioned in connection with the
extension of microeconomic theory to the development of institutions (see chapter 19,
notes for further reading). In addition to the works cited there, see North, Institutions,
Institutional Change and Economic Performance (Cambridge: Cambridge University
Press, 1990); and same author, “Institutions and Economic Growth: An Historical Intro-
duction,” World Development, vol. 17 (1991), pp. 1319–1332. Also see Steve Pejovich,
Economic Analysis of Institutions and Systems (Dordrecht: Kluwer Academic Publishers,
1995); and for a view that argues that neoclassical economics (even as expanded in mod-
ern settings) is not up to the task of providing a workable theory of institutions, see Eirik
G. Furubotn, Future Development of the New Institutional Economics: Extension of the
Neoclassical Model or New Construct? (Jena: Max Planck Institute for Research into
Economic Systems, 1994).
Finally, the father of research on cognitive behavior, including what is now labeled
behavioral economics was Herbert Simon (1916–2001) who won the Nobel Prize in Eco-
nomics in 1978. Simon introduced the concept of “bounded rationality,” which simply
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670 Part VI ■ Back to the Future

indicates that individuals have limited abilities to compute all possible information when
making decisions. Individuals (and organizations) must make decisions based on neces-
sarily limited information. See Simon, “A Behavioral Model of Rational Choice,” Quar-
terly Journal of Economics, vol. 69 (1955), pp. 99–188.
The central questions are: Do individuals act “rationally” when they choose on the
basis of limited information and what is the nature of choice? A traditional interpretation
would be that we do not act on the basis of cost and benefit. Information is costly with
uncertain benefits. We do not invest in information concerning a decision when the costs
of attaining that information exceed the benefits. This does not suggest that investiga-
tions into cognition are worthless; only that there are competing approaches to “rational-
ity.” And from a scientific perspective, brain mapping is a promising area of research on
decision making and “happiness,” although it has hardly borne much fruit. Without ques-
tion many decisions are made heuristically—through “shortcuts” in mental processing.
(We do not have to go through all the mental steps to explain our tooth cleaning behavior
every morning—it is done “automatically.”) But how these shortcuts affect decision mak-
ing is not always clear. The question and results of “happiness research” are also prob-
lematic. The challenge to stable preference functions may be substantive, but many of
the conclusions to the hypothesis that luxury goods should be taxed or that happiness
surveys justify higher taxes on higher incomes are debatable. In the limit, according to
economist Thomas DiLorenzo, “happiness research” is really a crusade to persuade the
public that poverty and servitude to the state are superior to prosperity and freedom”
(“The Trojan Horse of ‘Happiness Research,’” Mises Daily, June 9, 2011. Ludwig von
Mises Institute, http://mises.org/daily/5356). The idea that one person’s increase in utility
from buying a Porsche is counterbalanced by her friend’s disutility from that purchase—
providing grounds for taxing Porsches or income—is also soundly attacked by economist
Joseph T. Salerno who calls the research of Robert Frank (see references) “pseudoscien-
tific social welfare.” According to Salerno, “The plain truth is that these policies consti-
tute an attempt to forcibly impose the arbitrary values of an arrogant and self-appointed
intellectual elite on the most intensely private affairs of the productive majority who are
choosing to spend their money according to their own preferences and personal-welfare
evaluations” (see references). Thus, the new developments surrounding the fundamental
basis of economics—traditional rationality, self-interest, and utility maximization—are
something of an ongoing process. Some of the conclusions are appealing but many are
highly questionable. For example, Barberis (see References) concludes that, while pros-
pect theory may have some applications in risk and insurance, it is unlikely to find gen-
eral application within general economics or economic policy. With respect to the latter
view, also see the comments of Gary Becker, “Interview with Gary Becker,” Federal
Reserve Bank of Minneapolis (June 14, 2002), at http://www.minneapolisfed.org/pubs/
region/02-06/becker.cfm. These approaches will undoubtedly continue to elicit comments
both positive and negative as the twenty-first century progresses.
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27

The Resurgence of Economics

as a Social Science

New developments in consumption theory introduced in chapter 26, including a

potentially fundamental alteration in how economists approach utility, demand, and
preferences (e.g., Becker’s theory of full price, Bruno Frey’s and Richard Layard’s
happiness theories, and Daniel Kahneman’s and Amos Tversky's “prospect theory”)
are only part of the ambitious reach of economic analysis in contemporary econom-
ics. Much to the chagrin of other social scientists—some of whom regard the econo-
mist’s reach into sociology, anthropology, and political science as “poaching”—
contemporary economic analysis is in fact shedding new light on issues from the
fields of art, sociology, religion, and politics. Concepts such as “full price” (i.e.,
money price plus value of time foregone) and implicit (nonpecuniary) markets have
been integrated into traditional economics, and newer concepts of search, signal-
ing, and information theory have been introduced. Indeed, economics is moving
toward an integration of the social sciences envisioned centuries ago by Adam
Smith and John Stuart Mill.
Arguably, economics is the queen of the social sciences. A brief look at the
index of Adam Smith’s Wealth of Nations conveys its enormous scope. Smith dealt
with religion, politics, literature, history, and many other matters. Yet, possibly as a
consequence of specialization and division of labor, contemporary economics has
increasingly enriched the technical aspects of the field. Perhaps as a backlash to the
ever-growing technical nature of economic inquiry, a contrary movement is afoot
with the aim to reintegrate economics—specifically modern and received economic
theory—with issues that have, through the past two centuries, been cleaved from
economic inquiry. These matters concern, among other things, history, sociology,
anthropology (especially archeology and culture) and politics.
The present chapter surveys, albeit briefly, some of the new developments link-
ing economics to social and cultural phenomena. We first discuss a few of the appli-
cations of economic analysis to sociology, specifically to the sociology of mating and
the family. Next we consider some of the inroads that economics has taken to
increase our understanding of aspects of culture—art, religion, and primitive societ-
ies. Finally, we consider some of the links between economics and practical politics,
revisiting some of the issues previously raised in chapter 24.

671
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672 Part VI ■ Back to the Future

■ ECONOMICS AND SOCIOLOGY

As economics spread its wings in the twentieth century it began to engulf issues
that were formerly considered strictly within the purview of sociology. Nobel laure-
ate Gary Becker (Economic Approach to Human Behavior) has been at the forefront
of developments involving economic theories of social interactions and family orga-
nization. While sociologists and psychologists typically view the family as a com-
plex set of interpersonal activities and relations, Becker treats it as a form of
economic organization. In the language of the economist, marriage is a two-party,
incompletely defined contract carrying explicit and implicit obligations. In this view
prenuptial dating is an investment in information about prospective mates. Being
“in love” implies interdependent utility functions, inasmuch as most successful mar-
riages are made by people who have a sense of mutual caring and whose prefer-
ences and values are closely related.
The economic theory of the family maintains that a “head of household,” who
cares for the welfare of family members, directs and allocates household resources
in Pareto-optimal fashion (see chapter 17). All family members have incentives to
act in a way that maximizes the household head’s utility function. This arrangement
allows every family member to be better off than he or she would be in isolation.
Becker constructs the household head’s single utility function in a way that cap-
tures the utility of the entire household, so that the resulting function represents the
collective utility of the family. Within this context decisions are made regarding the
transformation of leisure into household work or market work, as suggested in
chapter 26. The sociological-psychological category of “role-playing” within the
family unit finds a place in this analysis as a consequence of specialization based on
rational economic principles of cost and choice. This approach is not without ardent
critics, but Becker’s insights give meaning to a number of social phenomena that
sociologists have been at pains to understand and explain. Marriage rates and birth-
rates can be understood within this framework, but before marriage, or partnership,
and child rearing come dating and mating.

The Economics of Dating and Mating

Sociologists often treat dating as “ritualistic” behavior—one of the oldest rituals
known to humanity. Certainly, dating and mating practices have a long and success-
ful history as adaptive survival techniques to protect children. However, economists
bring a different perspective. The process of dating and mating is an organized
activity that takes place within a highly competitive environment of searching and
acquiring information (see chapter 26). We refer here to contemporary practices
and activity.
Information, like any product or service is never free, a principle that applies as
much to finding a suitable mate or partner as it does to automobiles. Costs of
searching for a mate include the opportunity costs of time, clothing, grooming, and
entertainment expenses, to name a few. Internet “niche” dating services (e.g., “It’s
Just Lunch,” “Christian Mingle,” “Our Time”) provide an alternative means of
search but require subscription fees or other payments. On the one hand, at the
margin search costs rise with the time spent searching. On the other, given your
stock of information the marginal benefits of finding a mate or “permanent” com-
panion declines with time spent searching. From an economic perspective finding
the “right” mate and the optimal search time will occur where marginal cost equals
marginal benefits.
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Chapter 27 ■ The Resurgence of Economics as a Social Science 673

“Personality assessments” are routinely a part of Internet dating and are cost
lowering, but indirect measures of personality, habits, outlook, and philosophy are
more difficult to determine. On entering the dating-market game most people put
on their “best face,” and many are inclined to exaggerate their “genuine” physical
and psychological traits, a fact that might help account for early divorce in some
instances. (Two of the biggest Internet deceptions are reputedly the self-described
female as “blonde” and exaggeration of earned income by the self-described male.)
Given high information costs, the process of self-selection takes place through sig-
nals as well as information provided by character-identifying facts and institutions.
The whole system is devised to reduce information costs among the market partici-
pants in their search for a date or a mate.
Mating signals take different forms. Where you go to college and what your major
is tell a lot about you as a potential mate by signaling probable IQ, parents’ income or
wealth, and parents' socioeconomic status. Religious preferences (or lack thereof) also
provide vital signals. Each organization to which a prospective mate belongs (e.g.,
garden club, sky-diving club, Rotary, book-of-the-month club) reveals something of
his or her personality and character. Signals therefore provide information that tends
to lower search costs and improve selection of dates, mates, or companions.
In a market economy institutions/agencies/arrangements continuously arise in
order to lower the costs of search, and independent, disinterested evaluators
emerge. “Matchmakers” are a staple of some Jewish communities to this day. Inter-
net matchmaking has become a thriving industry, providing detailed profiles of
physical, emotional, and social preferences. Dating agencies will record your
height, weight, taste for sushi, music and entertainment preferences, and so on,
matching people of like characteristics. “Personals” are carried by many newspa-
pers for couplings of various kinds. Singles bars that cater to different age groups,
young and old, education levels, and income brackets dot the urban landscape. Bars
and clubs for gays, lesbians, transvestites, and transgendered individuals exist in
large part to reduce information costs. The bottom line is that contemporary dating
occurs within a highly organized economic market in which institutions emerge to
reduce the costs and increase the benefits of searching for a mate.

Marriage as an Economic Contract

Given biological and other kinds of specialization, there has always been an
economic aspect to marriage. In medieval times love was one of the least compel-
ling reasons people got married; among the upper classes marriage was a means of
promoting “mergers” for the maintenance of family dynasties. Even today, in some
non-Western societies, marriages are “arranged” by parents without consideration
of intimate feelings between the betrothed.
Becker sees marriage as a frequent (though not universal) outcome of the dat-
ing game. It can therefore be studied as a long-term, written, oral, or implicit con-
tract between (mainly) two parties to produce and nurture children and to satisfy
other wants of a household unit. This “economic” definition of marriage as contract
lends itself to civil unions, gay marriage, and cohabitation, as well as traditional
family formation. A key point is that an individual’s success at fulfilling the contract
is determined in large part by how successful he or she is in searching for a mate
(see Becker’s A Treatise on the Family; or Richard Posner’s Sex and Reason for in-
depth discussion of this process).
Viewing marriage as an incompletely defined contract that is entered into
according to the perceived costs and benefits of the participants makes it possible to
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674 Part VI ■ Back to the Future

bring those costs and benefits explicitly into the decision nexus. On the cost side,
marriage means that each partner sacrifices some independence and makes many
compromises regarding personal habits, friendships, and the nature and direction
of expenditures. On the benefit side, marriage facilitates the production and rearing
of children by providing love, companionship, nurture, and reciprocal caring. In
addition to these benefits, however, marriage often provides an opportunity to enjoy
the economic gains from specialization and division of labor. Until recently in the
United States, most familial division of labor made the male marriage partner the
primary breadwinner through outside-the-home employment, while the female
partner specialized in household production and child rearing. As long as skills vary
widely between spouses, the gains to husband and wife from specialization and
trade are positive and potentially large.
Changing cultural values and in particular the feminist movement have
changed the traditional familial configuration for a significant number of individu-
als. Laws and practices have greatly lessened discrimination against women in the
workplace. Women have, in increasing numbers, become engineers, lawyers, and
physicians. In many areas of the marketplace, opportunities for educational attain-
ment and other investments in human capital have been expanded for women. The
result is that skill levels of men and women are drawing closer together. With men
and women having more and more similar skills, the economic gains from special-
ization and trade between men and women within the organizational framework of
marriage are clearly reduced. Holding constant all other noneconomic factors, eco-
nomic theory predicts that a reduction of the gains to marriage will lead to a decline
in marriage rates and an increase in divorce rates—precisely the experience of
many developed nations in recent times.
As more women have entered the workforce and as family incomes have risen,
we have observed another phenomenon with economic implications: a decline in
the birthrate. Population growth requires a sustained demand for children on the
part of parents. Long ago the classical economists argued that income increases
would encourage an increase in the production of children, which, if you remember
Ricardo’s scenario, would eventually lead to the stationary state. Becker’s analysis
goes beyond the simple Malthusian framework of population growth by adding an
important additional consideration: It is not only the level of income that explains
population growth but also the relative “price” of children.
The full cost of raising children depends on both the direct expenditures
incurred and the opportunity costs borne by parents. These opportunity costs
increase as family income increases, particularly as the mother’s market wage
increases. Consequently, economic growth often contains a bias against child pro-
duction. In most underdeveloped countries, especially those surviving on subsis-
tence agriculture, children represent direct labor inputs and are considered
valuable to their parents as a source of labor. Low wages in such countries keep the
opportunity costs of having children at a low level. By contrast, in advanced econo-
mies the “price” of additional children is high because children are less valuable to
their parents as direct labor inputs, and because parents’ opportunity costs are
high. Instead of raising an additional child, parents may decide to improve their
own living standards and/or that of their existing children by spending more on
education, housing, or a wide array of other goods. In part, then, rational economic
decision making and a novel application of the law of demand explain low birth-
rates in developed nations and high birthrates in underdeveloped countries.
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Chapter 27 ■ The Resurgence of Economics as a Social Science 675

Despite these recent forays into areas traditionally considered outside the prov-
ince of economics, no economist, including Becker, argues that economics is the
sole or even the central factor in explaining sociological phenomena. Rather, con-
temporary microeconomics offers additional insights into certain aspects of human
behavior that complement and/or supplement explanations proposed by other
social scientists. This same economic approach has reached into other allied areas,
not usually considered “economic,” such as art, religion, archeology, and politics.

■ ECONOMICS AND ART

Practical economic questions are evident in the art market, especially issues
involving the production of art, and buying and selling all types of art through gal-
leries and auction houses. Because private data on gallery transactions or “out-of-
market” sales arranged privately between collectors are not generally available,
most studies of art purchases and sales have been principally limited to use of auc-
tion data, supplemented by anecdotal materials.1 One area of interest (as one might
expect from economists) is the question of how remunerative art investments could
be in a portfolio of investments. A study by Jianping Mei and Michael Moses (“Art
as an Investment”) suggests that some kinds and genres of art (for example,
Impressionist, Modern, American) outperform others and therefore may be suitable
for inclusion in a diversified investment portfolio. Other writers have suggested that
certain segments of the art market are countercyclical (i.e., prices and sales go up
when the market turns downward and vice versa), thereby suggesting that art can
be used to “balance” a portfolio of investments (as is often said of precious metals).
Yet, other investigations, including a massive study of over one million art transac-
tions at auction by Luc Renneboog and Christophe Spaenjers (“Buying Beauty”),
find only a modest rate of return (about 3.97 percent) per year on art investments.
When storage, insurance, and other costs are taken into account, not to mention
risk or variance in value, art “investment” does not appear so appealing. A missing
element in the investment approach is how value is determined. Surely there is an
implicit “consumption” value to owning and looking at fine art and other art objects.
The full “return” to holding art, therefore, cannot be only an investment return—it
must also include an implicit return in terms of utility gained. Ongoing studies are
attempting to gain traction in this regard.
In addition to more traditional studies concerning art and its investment rate of
return, contemporary economics is able to provide insights into other issues that
might seem outside the purview of economics. Museum attendance, for example,
yields to this approach. Conventional wisdom says that museums tend to prosper in
upswings in the cycles of income and economic growth. But a study by Skinner,
Ekelund, and Jackson (“Museums, Funding, and Business”) shows that insofar as
attendance is concerned the opposite is correct. Museum attendance actually
increases during downturns in the business cycle and decreases during upswings in
incomes and growth. This of course causes problems for museums since donations
and grants typically follow the business cycle, causing increased expenditures for
art venues at the very time of lowered revenues. One proposed remedy would make
1
The inability to utilize price data from art galleries is not the only problem in the empirical study of
art markets. Auction houses only record prices of art objects that are in private hands or are being
“deaccessioned” by museums. In the case of American art, many (most) of the highest quality pieces
are and have been in museum collections for the past one hundred years, which must be taken into
account in identifying correlations between price and suggestions of quality of art at auction.
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676 Part VI ■ Back to the Future

grants from private and public organizations (such as the National Endowment for
the Arts) countercyclical rather than procyclical. Economic analysis can inform the
phenomenon of countercyclical attendance; obviously people have more “time on
their hands” when unemployed (during a recession). But to an economist, it is the
value of time that matters. Some museums impose an entry fee, others do not. All
things considered, the full entry price is lower when one is unemployed whether or
not an entry fee is charged. When the value of time falls, the full price of every activ-
ity, including recreation, also falls, leading to greater consumption. This is one rea-
son for the enormous growth in motion picture attendance during the Great
Depression. (Child actor Shirley Temple and comedian Buster Keaton kept America
smiling in the 1930s in part due to a lower full price of movie admittance.)
Economics has been able to shed new light on other poorly understood aspects
of the art market as well. Conventional wisdom has it that the value of an artist’s
work rises at or around his or her death—the so-called “death effect.” Economic
theory, aided and abetted by Nobel laureate Ronald Coase, offers at least one plausi-
ble reason for this phenomenon. Coase’s analysis of the “durable goods monopolist”
has direct and important relevance to the art market (“Durability and Monopoly”).
He asked a simple question: Are monopolies always successful and if not, why not?
To learn the answer, consider the actions of two diverse groups: real estate develop-
ers and artists (of any kind). Assume that real estate developers have exclusive
ownership and control over portions of land that are particularly desirable for hous-
ing development. To make it even simpler, assume that some individual (or collec-
tion of individuals) exerts monopoly control of all the land in America, which the
monopolist can sell at rates identified by the demand curve in Figure 27-1.
If we assume that the total amount of land available is Qc, the monopolist would
want to sell Qm land and charge customers the monopoly price Pm. But in actuality
who would pay Pm for a plot of land? On reflection, a “durable goods monopolist”
would not be able to charge more than the competitive price for land (Pc). Market
imperatives would force the monopolist to devise some means of guaranteeing buy-
ers that QmQc of land will not be sold so as to protect the value of their investment.
Coase indicated a number of ways that this might be accomplished. Guaranteed
“buy- backs,” leasing arrangements, and giving away QmQc for nonmarket purposes
(public parks, for example) might allow the monopolist to charge monopoly price
Pm. The set-aside land would be taken off the market to warrant the “quality” of the
land sold. Otherwise, the durable goods monopolist cannot behave as a monopolist
at all—he or she must charge the competitive price.
This principle applies to artists as well because most artists find themselves in
the position of the durable goods monopolist who can only imperfectly make con-
tractual arrangements with demanders of their art. Although some living artists
(e.g., Janet Fish or Chuck Close) charge top dollar for their work, the average artist
makes only between $17,000 and $25,000 per year from his or her art sales. Each
artist is, in effect, a durable goods monopolist having at least some degree of
monopoly over his or her style. Some artists enter contractual arrangements to guar-
antee that they will not “overproduce” their art, which would have the effect of driv-
ing down its price. Artists who work in duplicative media (woodcuts, lithographs,
linocuts, prints, and so on) typically limit the edition of particular works, destroying
plates at the end of a run as a warranty to consumers of the value of their purchase.
Artists may also limit their output by frequently changing their styles. (Picasso
(1881–1973) famously went through numerous styles: for example, blue period, rose
period, cubism, and neoclassical). Additionally, some artists “advertise” that a por-
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Chapter 27 ■ The Resurgence of Economics as a Social Science 677

Price per
unit of land MR D

PM

Pc

QM Qc Quantity
of land
MR

Figure 27-1 Demand and marginal revenue functions facing a land monopolist.

tion of their output will not enter traditional markets (through their dealers). During
his lifetime, Mexican artist Rufino Tamayo (1899–1991) behaved like the land devel-
oper who created “set-asides” in the example above. He established separate muse-
ums to display his artistic output in Mexico (in Oaxaca and Mexico City). Pablo
Picasso’s legacies and endowments of hundreds of pictures in France and Spain
both before and after his death also established that “nonmarket” part of his output.
This economic principle has intuitive content as well. One of the reasons for a
spike in the price of an artist’s work at his or her death is the obvious fact that no fur-
ther output (short of fakes) will be forthcoming from the deceased artist. Sometimes
this “death effect” on an artist’s prices is offset (or postponed) by the posthumous
release of the artist’s atelier—those unsold pieces stored by the artist prior to his or
her death. In general, however, no ironclad arrangements can be made between sup-
pliers and demanders during the artist’s lifetime to assure that the artist will not
spoil the market by overproduction. Hence, the prospect of devaluation will, ceteris
paribus, keep prices and returns at competitive levels, and this may be one reason
for the “starving artist” syndrome. In other words, some would-be monopolists who
have exclusive control over particular resources and/or talents cannot always be suc-
cessful at capturing the consumer surplus that monopoly pricing permits. This does
not mean that other factors do not enter the art market that would have the contrary
effects described above. “Hot” artists with aggressive dealers and vigorous advertis-
ing can stimulate demand while artists are alive—a common feature of the New York
art market for example. But prices are determined by both supply and demand and
the supply effect described above is always a factor in this market.
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678 Part VI ■ Back to the Future

■ ECONOMICS AND RELIGION

Religion in some form or fashion has been a staple of virtually all known societ-
ies. It is likely that the prehistorical beliefs and rituals of Homo sapiens (and possi-
bly Homo neanderthalensis) were infused with “supernatural” speculation, magic,
myth, and sacrifice almost as long as people walked upright. Religion entered the
realm of economics in formal fashion when Adam Smith (see chapter 5) made it
part of his inquiry into the nature of economic development. Smith, a staunch Pres-
byterian, believed participatory “bottom–up” religions that allowed competition
among sects would lead to efficiency in provision of desirable services to congre-
gants. In contemporary times, the focus (thanks in large part to Becker’s extension
of the “rationality postulate”) has shifted toward economic rationality in the study
of religion.
During the long hiatus between Adam Smith and Gary Becker sociologists
steadily and persistently enriched the field. Max Weber’s provocative study
appeared in German in 1904–1905 (The Protestant Ethic and the Spirit of Capital-
ism) and was followed shortly by Émile Durkheim’s The Elementary Forms of Reli-
gious Life in 1915. What economics adds to the discussion is the persistent analysis
of religious behavior as an exercise in rational choice—that is, decisions involving
resources of money and time. Religion, in other words, like many other products
available in a market context, provides utility. Some prominent sociologists, such as
Rodney Stark, Andrew M. Greeley, and William Sims Bain (see notes for further
reading), have acknowledged the usefulness of an economic model of rational
choice and embraced its insights in advancing their sociological studies of religion
and religious behavior. Inasmuch as we cannot deal extensively with the ever-
increasing multiplicity of contemporary economic studies of religion—both as a
microeconomic phenomenon and as related to economic growth—we reserve our
discussion in this chapter to two topics: the matter of religion as a cult and the
application of industrial organization to the history of religion.

Cult Behavior
The Beckerian approach to religion (an activity or implicit market that requires
both demanders and suppliers to expend time and money) was embraced initially by
Corry Azzi and Ronald G. Ehrenberg (“Household Allocation”), and later in a some-
what different context by Laurence R. Iannaccone (“Sacrifice and Stigma”). Azzi and
Ehrenberg developed a model of religious participation based on Becker’s theory of
household consumption, using empirical data on statewide church membership and
a survey sample of church attendance. They tested a number of propositions that
were traditionally in the purview of sociologists, such as male versus female partici-
pation in church-related activities (women participate more) and the age distribution
of church attendance (attendance is positively related to age). Their approach allows
that individuals allocate their resources (time and goods) to both temporal and
“afterlife” consumption. (Afterlife consumption, consisting of heaven, eternal peace,
communion with God, and so on, is a function of time engaged in religious activities
during one’s lifetime.) By connecting membership in time-intensive religions to
households with lower alternative time costs (lower wages imply a lower cost of
engaging in nonwage activity), Azzi and Ehrenberg were able to explain why reli-
gions that are less time intensive grow faster in the United States than more time-
intensive religions. While some of their conclusions have been challenged (statisti-
cally), their study had an important catalytic effect on further research.
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Chapter 27 ■ The Resurgence of Economics as a Social Science 679

Lawrence Iannaccone extended the Azzi-Ehrenberg approach by including

human capital (i.e., knowledge, familiarity with ritual and dogma, etc.) and infer-
ring that the service (“product”) sold was something more than simply an afterlife.
Defining a specific stock of religious experience that an individual has built up at
any given time as a function of previous activities and experiences, Iannaccone
raised the possibility that religion can be a kind of addiction that can grow over
time, making it likely that individuals adhere to the faith they were born into. (How-
ever, recent evidence from Pew Research indicates a growing degree of switching
from one sect to another religion, or to no religion.) Importantly, Iannaccone's theo-
retical apparatus was aimed at a problem of mounting concern in religion markets:
the issue of cults. Early on, Adam Smith believed that religious cults had the poten-
tial to create civil disorder and unrest, and he clearly understood that membership
in religious organizations had “club” effects—that is, that the utility a person
receives from his or her consumption of a club good depends on the number of
other persons with whom he or she must share its benefits. Iannaccone recognized
that this meant sects, clubs, or churches inevitably face a free-rider problem—the
prospect that some members will receive the benefits of membership without bear-
ing the proportionate costs.
Iannaccone argued that strictness is the mechanism used by religious sects to
control the free-rider problem. He explained, for example, why some people prefer
religions that demand greater sacrifice—that is, why individuals might choose
strictness over leniency. He argued that religious sects turn to strictness as a means
of controlling the free-rider problem because the cost of monitoring group utility-
reducing behavior is high. Imposing strictures such as shaven heads, colored robes,
or meeting in isolated locations might mitigate the problem. These strictures make
it easier for cult members to police noncult behavior. A member must go all in or not
at all because violations of these strictures will result in dismissal from the cult.
Note, however, that while such membership rules (which may also apply to terror-
ists of one sort or another) may help control free riding in small groups, the prob-
lem cannot be monitored easily in large churches.

Industrial Organization and Religion

In order to introduce religion into a market framework Azzi and Ehrenberg
defined the religious product as “an afterlife.” This idea does not transfer easily to
cult analysis, however, which has labored to identify a “product.” There are both
private and public aspects to the religious product, but (at least from the standpoint
of Christianity) “promises of eternal salvation” comprise a large part of what reli-
gion is selling. This “promise” is what might be termed a “meta-credence good.”
Recall from chapter 26, credence goods require that certain types of assurances be
given in order to satisfy purchasers about the quality of the product, because its
genuineness cannot be determined either before or after the sale. By its very nature,
the promise of an “other worldly” experience cannot be verified by earthly expendi-
ture of resources. This puts the “product” beyond the terms of normal credence
goods (such as psychiatric counseling), hence the designation, meta-credence good.
Attempts may be made to establish assurances for the faithful (e.g., grand medieval
cathedrals), but no church offers a money-back guarantee to a soul dissatisfied with
his or her afterlife experience.
The admission that the product(s) of religion are “bought and sold” implies that
religious behavior can be analyzed within the context of an implicit market. That
means that churches can be viewed as economic organizations that establish gover-
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680 Part VI ■ Back to the Future

nance, modes of production, selling techniques, competitive strategies, and market

shares. This “industrial organization” approach can be traced back at least to Adam
Smith. Although it can be applied to any religion, it has been applied most exten-
sively to Christianity (see Ekelund, Hebert and Tollison, Marketplace). History
recounts how Christianity rose, against long odds, as a fledgling competitor in a
faith market dominated by varieties of late Greek and Roman Gnosticism. Robert
Ekelund and Robert Tollison assert that the success of Christianity can be traced to
the fact that it offered a superior “product” (Economic Origins of Roman Christian-
ity). Christian theology established an “other-worldly” reward for those who lead a
good life on earth. At a historical epoch when the vast majority of people were
downtrodden and without much hope of accumulating material wealth the appeal of
such a product should be obvious. The church that offered this product grew as it
took advantage of its product appeal and then enlisted the efforts of missionary
entrepreneurs (such as St. Paul) who reached out to “customers” everywhere, gen-
tile and Jew, rich and poor, advantaged and disadvantaged.
The diverse forms of early Christian belief that took hold over the first three
hundred years after Christ were eventually melded into a single belief system by the
Council of Nicea in 325, convened by Emperor Constantine. The economic argu-
ment is that Constantine recognized the opportunity to reduce the agency and polic-
ing costs of the Roman state by adopting a uniform religion with a coherent, but
simple, set of rules. Accordingly, he went about confiscating all “non-Nicean” Chris-
tian assets and those of “pagan” temples as well. Later in the fourth century he
made Christianity the official religion of the Roman Empire, giving it new impetus
as additional lands were conquered and conquered tribes were converted to the
new religion. Missionaries were extremely effective in creating “outposts” or “mis-
sions” far from Constantinople and Rome. This effectively created a “top-down,”
vertically integrated church. The hierarchy that was put in place established Rome
and the pope at the top of the organizational structure; monasteries and parish
churches were downstream firms that marketed the “product.”
In part because of this organizational structure the power of the Roman Church
grew steadily, cemented through what might be called reciprocity—civil govern-
ments protected the Roman papacy in return for the Church’s legitimization of par-
ticular civil governments. The descendents of Charles Martel, whose military
victory at Tours in 732 prevented the Muslim takeover of the European continent,
established the Carolingian dynasty that further consolidated the interests of the
Roman Church (often called the Western Church). By 800, when Charlemagne was
crowned Holy Roman Emperor, the Church had managed to acquire vast quantities
of the lands of Europe and England. Over the next few centuries, conflicts with the
Eastern Church (established in Eastern Europe and non-European areas) were set-
tled in favor of Rome, the Roman bishop assumed titular leadership of the Church,
the Viking invasions were quelled, and the Church became the monopoly religion of
vast reaches of the European continent.
The Roman Church behaved as a monopoly roughly over the period 1100–1500.
It used its interpretive powers to manipulate doctrine and interpret Scriptures in
order to repatriate revenues from both civil governments and its downstream
church divisions. The rules regarding marriage were expanded beyond existing civil
requirements in order to thwart dynastic families from usurping the power of the
Church. At one point marriage could not be within the fifth degree of kinship,
although exemptions were often granted when it favored Rome’s interests. The
usury doctrine was invoked when the Church borrowed money but waived when
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Chapter 27 ■ The Resurgence of Economics as a Social Science 681

the Church lent money (Ekelund et al., Sacred Trust). The doctrine of purgatory
provided an opportunity for the Church to gain revenues through the sale of indul-
gences, and auricular confession was a means to warrant passage to heaven for the
penitent. The Church ultimately acquired large parts of what became Italy (the
Papal States) and commanded about one-third of the arable land of Western
Europe. In sum, the medieval Roman Church became, in economic structure, a ver-
tically integrated, global corporation.
But monopolies, even large ones, are difficult to sustain over time. The doctrine
of purgatory, which provided a convenient avenue for growing Church revenue
through the sale of indulgences, also led to many abuses. At first indulgences were
granted to living sinners. Later such indulgences were extended to the dead and to
the long dead. One could lessen purgatory time of one’s deceased grandfather (for
example) by donating money to the Church—an indulgence purchase. At one point
indulgences were used as a kind of “nonwage payment” to Crusaders to induce
them to fight so the Church could gain access to lands it did not control. To many,
such as Martin Luther, the Church became a venal institution.
Roman Church abuses, combined with Gutenberg’s invention of the printing
press in the mid-1400s, encouraged Martin Luther in 1517 to enter the religion mar-
ket as a competing “firm.” He was the first, but not the last, to successfully chal-
lenge the monopoly position of the Roman Church. The history of religion from the
sixteenth century to the present is a history of ever-changing faiths, each seeking
out a peculiar niche in a vast religious market. New religious organizations were
sometimes sponsored by monarchs, but more the product differentiation was
accomplished by religious entrepreneurs—Luther, Huldrych Zwingli, John Calvin,
John Knox, and others. The pattern was repeated over time. By some counts, more
than two thousand religious firms currently compete in the market for Christianity,
which is only one of the world’s religions. Thus, Christianity is constantly being
modified, adapted, and reinterpreted according to religious demands that are them-
selves determined by factors such as income, education, and the state of science.
Even as secularism (the rejection of religious faith and worship) extends its reach in
the developed world, the number of religious entrepreneurs continues to grow,
along with the number of new sects, often through schism. A theory of economic
and industrial organization and the new economic history, while never the entire
story, continues to shed light on these developments.

■ ECONOMICS AND ARCHEOLOGY

The fundamental importance of property rights has been known from the days
of the ancient Greeks. Whereas Plato denied private property to the ruling class
(only), Aristotle (see chapter 2) was a staunch defender of private property as a
means of preserving social harmony and encouraging economic efficiency. In addi-
tion, private property rights establish built-in incentives to conserve and protect
limited resources. As is sometimes the case, the benefits of private property are not
appreciated until the privilege of ownership is gone. In the middle ages sections of
land were set aside for “common grazing” of farm animals. The predictable result
was that no one had an incentive to preserve and protect lands for the future. In
modern times, increasing environmental concerns have raised awareness of prob-
lems with common property. In essence, when everybody owns something each
individual behaves as if no one owns it. The resulting behavior leads to what econo-
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682 Part VI ■ Back to the Future

mists call the “tragedy of the commons.” The tragedy arises because, as Armen
Alchian explained, individual costs and benefits in such instances differ from soci-
ety’s costs and benefits (“Property Rights”).
While the problem has long been known to economists, its implications stretch
beyond economics. Archeologists and biologists, have discovered environmental
problems in primitive cultures that can be traced back to the tragedy of the com-
mons. Whereas a market system based on private property rights assignment might
have resolved some of these issues, failure to establish private property rights led to
perverse incentives and, ultimately, to what was identified as market failure.2 The
tragedy of the commons explains how and why some animals have become extinct
due to overhunting or destruction of habitat. Some examples of the famously
extinct are the Mauritian dodo, the North American passenger pigeon, the New
Zealand moa, the Falkland Islands wolf, Darwin’s Galapagos mouse, the Caribbean
monk seal, the Tasmanian emu, and many more. Jared Diamond recounts how in
prehistoric times the wooly mammoth and many other species were overhunted and
eventually disappeared (“The American Blitzkrieg”).
Scientists have analyzed other cases involving common property that should
serve as notice and warning to human populations concerning slow, nondramatic
changes in resource use. The rather sudden disappearance of the Anasazi Indians
from Chaco Canyon in New Mexico may have resulted from the systematic defores-
tation over many years of the areas surrounding their settlements. Common prop-
erty provides no incentives to conserve scarce natural resources necessary to
support civilizations. Jared Diamond analyzed the fascinating and dramatic case of
Easter Island in the Pacific Ocean, once peopled by a great, isolated civilization.
Only about 65 square miles, and known for its massive but partially destroyed stone
heads, this island is possibly the most inaccessible and isolated piece of land in the
world. Diamond investigated its fate from the perspective of modern science, poring
through the accumulated studies of biologists, paleontologists, geneticists, pollen
analysts, archeologists, and other researchers.3
Myth has always surrounded Easter Island and the mysterious monolithic stat-
ues found there. Speculations abound. It has been claimed that the statues were
built by aliens from another planet or that the island was settled by highly devel-
oped societies of American Indians. Science has debunked these speculations. Lin-
guists and radiocarbon dating of materials confirm the islanders were Polynesian.
Other scientific evidence is that human activity began around A.D. 400 to 700, with
the period of statue construction occurring between 1200 and 1500. At the height of
its culture, the island supported an agrarian population of approximately seven
thousand people. Scientists have found evidence of abundant plant species, includ-
ing fiber from which rope could be made and large trees that could be used to trans-
port the stones to the sites where they were carved (facing outward). Chickens were
plentiful and boat-building materials were available to harvest porpoises and other
fish from the sea.
2 Other areas of anthropology have not escaped the long arm of economics either. See two provoca-
tive papers, one on insurance (or lack thereof) in primitive societies by Richard Posner (“Theory
of Primitive Society”) and the other on how economic incentives affected primitive hunter cul-
tures by Vernon Smith (“Economics of the Primitive Hunter Culture”); both are in the references
and are discussed in notes for further reading.
3
This section draws heavily from Diamond’s essay, “Easter Island’s End” (see references). His ana-
lytical method is repeated with additional examples in Collapse: How Societies Choose to Fail or
Succeed (see references). Some of Diamond’s conclusions concerning Easter Island have been
challenged by Carl Lipo and Terry Hunt, The Statues that Walked (see references).
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Chapter 27 ■ The Resurgence of Economics as a Social Science 683

So, what happened to this once-creative and thriving civilization? According to

Diamond, destruction of the forests began as early as 800, when palms and other
trees and scrubs began to disappear because their wood was used as fuel. The pau-
pau tree, used for making rope, declined in number, and the forests were cleared to
increase the cultivation of crops. Native birds were overharvested and their num-
bers declined, which led to reduced pollination of trees, plants, and scrubs. As this
long but steady process continued, the population grew faster than it could be sus-
tained with declining available resources. According to Diamond:
People [of Easter Island] also found it harder to fill their stomachs, as land birds,
large sea snails, and many seabirds disappeared. Because timber for building sea-
going canoes vanished, fish catches declined and porpoises disappeared from the
table. Crop yields also declined, since deforestation allowed the soil to be eroded
by rain and wind, dried by the sun, and its nutrients to be leeched from it. Intensi-
fied chicken production and cannibalism replaced only part of all those lost foods.
Preserved statuettes with sunken cheeks and visible ribs suggest that people were
starving. (“Easter Island’s End,” p. 6)

The decline of Easter Island was clearly tragic. Chaos ensued, and by about 1700
the native population had fallen to about one-tenth its peak level. Warring tribes
desecrated the monuments and denuded the island; today it supports a population
of only about 1,000–1,500 people. The Easter islanders were victims of the tragedy
of the commons.
The tragedy of the commons has modern faces as well. The country of Haiti has
been denuded of trees as more and more wood was taken for fuel and other uses
without efficient resource management that would have allowed replacement of this
renewable resource. The owners of moas (large flightless birds related to the
ostrich), once a source of nutrition to New Zealanders, would have had an incentive
to preserve stocks for reproduction, but the moa population disappeared in the face
of common property assignment. Without ownership no one conserves for the future
when it is personally costly and not very beneficial to do so. Gorillas, redwood trees,
deer, elephants, and oysters sometimes met similar fates in different locales. For obvi-
ous reasons, no one worries much about the extinction of dairy cattle because legal
rights to them are clearly defined. Ownership is a useful principle of economic effi-
ciency and conservation. Loose definitions of property rights are less productive, and
the absence of property rights can be destructive, as the above examples indicate.

■ ECONOMICS AND POLITICS

Contemporary economics also has reached into political science. The field of
public choice, as we learned in chapter 24, is a study of how political mechanisms or
institutions affect decisions concerning taxing and spending by government. It
explains the demand for public goods and formally expresses the impact of the
median voter. Our earlier discussion also contained lessons about the supply of
“political goods” in bureaucracies and political institutions, but it did not detail the
clear analogies between rational behavior in economic markets and political mar-
kets. A public-choice approach to politics is based on the idea that political actors
are no different from anyone else: They behave in predictable ways and seek to
obtain their goals efficiently.
The two arenas of human activity, economics and politics, differ in one important
respect: The private market is a proprietary setting—one in which individuals bear
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684 Part VI ■ Back to the Future

the economic consequences of their decisions; whereas the political arena is a non-
proprietary setting—one in which individuals do not always bear the full economic
consequences of their decisions. For example, the political entrepreneur who devises
a new program or policy does not bear the full costs of the program if it is a failure;
nor does he or she reap all the benefits if it is a success. That is not the case with an
individual who buys a car that might be a “lemon” (see chapter 26) or a firm that
makes an ill-advised decision to expand. In the market economy individuals and
firms must internalize all the costs and benefits of their economic decisions. Politi-
cians operate under a different set of rules. “Pork barrel” expenditures by Congress
may benefit a politician at election time but may harm all members of society when
the projects must be paid for through future taxes and/or deficits. Politicians may be
said to behave under a “reelection constraint,” which often means spending now (to
get those votes) while “kicking the can down the road” insofar as paying for the proj-
ects. Defenders of democracy are wont to say that offending politicians will be “voted
out,” but economically, that may not be practical or even possible in some cases.

Voting
Consider how economic rationality affects the voting process. Consumers make
marginal choices in economic markets, but voters must evaluate package deals in
political markets. A consumer of market goods can buy one more, or one less, pen-
cil, hot dog, or computer—i.e., purchases are made at the margin and in (relatively)
small increments. But an electoral process works differently. Voters typically face
all-or-nothing alternatives involving one political platform or bundle of policies over
another. In these package deals a voter usually ends up choosing a number of items
he or she does not want in order to get a few things he or she does want. This may
seem efficient in that it reduces the number of individual decisions to be made, but
with many candidates and issues on the ballot at the same time, voting in a political
market also leads to greater complexity and cost in exercising choice.
Another important difference is that under private market rules and actions,
consumption tends to be frequent and repetitive, so that learning takes place and
feedback is timely. One shops for groceries frequently so that the ability to discard
bad products and try new ones is apparent. In (democratic) politics, voting is infre-
quent and irregular, with voters typically casting their votes every year or every two,
four, or six years, as the case may be. This “discontinuity” makes it more difficult
for the voter to identify reliable policies and candidates.
These two factors add up to the principle that voters have little incentive to be
informed. Voting is a political choice that is far more complicated than economic
choice. Voters have difficulty evaluating candidates and issues, and public costs and
benefits cannot be easily internalized. Therefore, voters have little incentive to
gather information about their public choices. How can the average voter hope to
obtain the information needed to make rational decisions about international con-
flicts, energy sources, foreign aid, welfare, the money supply, jobs, and so on? Vot-
ers are quite rationally uninformed about such matters; they estimate that the costs
exceed the benefits of being fully informed. Indeed, they may become free riders by
not gathering information, not voting, and letting those who do vote make the
choices for them. If the choices of other voters happen to be beneficial to nonvoters,
the nonvoters benefit without bearing any of the costs.
An economic analysis of the voting process has important implications. On the
one hand politicians do not typically receive very useful information from constitu-
ents because voters are not well informed and therefore do not transmit their wants
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Chapter 27 ■ The Resurgence of Economics as a Social Science 685

effectively. On the other hand, politicians do not have an incentive to be precise or

firm regarding their position on various public issues. Politicians who are vague
about their “commitments” are therefore more likely to be rewarded with reelec-
tion. Pork barrel spending that can be targeted to particular states or congressional
districts also improves one’s chances of reelection. Nevertheless, the transmission
of information in political markets is less direct. In economic markets, if consumers
want more carrots, they can effectively signal producers by buying more (using dol-
lar “votes,” if you will). In political markets, if voters want more domestic spending
and less defense spending, it is difficult and costly to make this preference known
to politicians.

Interest Groups
Political science and economic theory also have much to say about the impact
of interest groups, as alluded to in chapter 24. The behavior of interest groups helps
explain a significant amount of government activity. George Stigler (“Theory of
Economic Regulation”) and Sam Peltzman (“Toward a More General Theory of Reg-
ulation”) maintain that interest groups will form in order to obtain benefits from
politicians in the form of regulation. The democratic state has the power to coerce
monopolies and to enact regulations that favor one group over another (e.g., Wall
Street instead of Main Street). But interest groups that lobby legislators for special
rules or regulations face organizational costs as well.
There are multiple regulations capable of producing benefits to special interest
groups: licensing, quotas, subsidies, as well as taxes and entry barriers. The history
of physicians’ attempts in the United States to organize is particularly instructive.
Toward the end of the nineteenth century many physicians complained that rogue
competitors were tainting the market for medical services by preying on the igno-
rant and threatening the safety of consumers. They called for an organization to put
an end to these threats. But organizations are difficult and costly to form and main-
tain. One difficulty is posed by the free-rider problem. Individual doctors have an
incentive to remain outside the interest group because if the group succeeds at
some objective—say restricting the number of doctors and thereby raising the price
of medical services—the nonmembers benefit without paying membership dues or
fees. The benefits “spill over” to the doctors who did not join the group. Interest
groups seek ways to restrict benefits to members for such reasons.
Free riding makes the formation of interest groups difficult, but by no means
impossible. The physicians’ groups successfully organized and their representatives
went to state legislatures seeking licensing statues for physicians. In some states,
physicians were able to eliminate competition from chiropractors in this manner.
Restrictive licensing elevated “legal” physicians’ prices and profits to an artificial
level because there were fewer competitors in the market. Without government’s
help in reducing competition, these higher profits would be competed away in the
long run. Learning from the experience, doctors have managed to extend a network
of regulations to increase their profits. They have established quotas (through
entrance exams) on admissions to medical school; restricted the number of hospi-
tals, or interns at hospitals; and limited the duties and responsibilities of nurses to
below their technical competency.
Actions by interest groups to restrict supply operate on one side of the market
while leaving the market vulnerable to changes in demand. Population increases
and federal Medicare and Medicaid programs have increased the demand for physi-
cians, yet the increased demand cannot be met due to state and federal regulations
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686 Part VI ■ Back to the Future

that favor incumbent physicians. Much of the so-called crisis in medical care in the
United States finds its origin in these circumstances. Similar situations occur in
other markets as well: lawyers, dentists, drug companies, florists (in Louisiana),
morticians, and so on. While the benefits of regulations are usually proclaimed
loudly, the costs are most often muted or ignored. Most, if not all, regulations result
in higher product/service prices achieved through a coercive political process paid
for by voter-consumers.
Plato recognized eons ago that such welfare transfers are endemic in a democ-
racy. Why do such arrangements that transfer wealth from consumers to profes-
sions, businesses, and industries, persist? Politicians serve as brokers by pairing up
demanders and suppliers of wealth transfers in political markets. A political miscal-
culation that transfers too much power to one group or another may raise the prob-
ability that the errant politician will be replaced in the next election, but incumbents
are hard to dislodge. Interest-group politicians are supported by votes and money to
repel election challenges in the next election. Legislators find it easy to be per-
suaded by powerful interest groups because the benefits they bestow are narrowly
focused on members of the favored group but the costs are widely dispersed among
(mostly uninformed) voters. Protests are therefore likely to be weak and muted. In
sum, the political market allows power and influence (i.e., political goods) to be
bought and sold to the detriment of broader, social interests. In the process, politi-
cians subvert the general welfare, consumers pay higher than competitive prices,
and societal economic growth is restricted.

■ CONCLUSION
Despite sometimes shrill complaints of economic imperialism from other social
scientists, incursions of economics into sociology, history, and allied social sciences
have not attempted to replace but to supplement the work and research of kindred
social scientists. The payoff to introducing the rationality postulate into the other
social sciences will ultimately have to be determined, but the hope is that it adds a
new dimension to its human understanding in the complex arena of social phenom-
ena and behavior. (See the box: Method Squabbles: Traditional Economics under
Fire (Again): The New Pushback, for an example of one scholar who believes that
an emphasis on economic reasoning to interpret history is a backward approach.)

Method Squabbles: Traditional Economics under Fire (Again): The New Pushback
Traditional economics has never been without critics from within and without the profes-
sion. In chapter 26 we saw that the rationality and standard utility maximization postulates
have been challenged by contemporary behaviorists. But while proceeding apace, these
“internal” challenges to conventional economic theory have not displaced standard neoclassi-
cal analysis. In general, “received theory,” based on classical and neoclassical contributions,
remains the basis for the applications of economics to the other social sciences such as those
considered in this chapter and in the last chapter (e.g., Becker’s theory of household produc-
tion). There has been some “pushback” from the other social sciences and the humanities,
including attacks on applications of economic theory to historical questions (cliometrics).
One of the most vehement and questionable critics is Francesco Boldizzoni (see notes for
further reading) who decries the application of economic theory and statistical methods to
history as usurpation of the traditional European-Marxist-historical traditions of investigation.
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Chapter 27 ■ The Resurgence of Economics as a Social Science 687

Boldizzoni regards the incursions of economics into allied fields (perpetrated by an “all-star”
list of prominent economists, such as Robert Fogel, Douglass North, Gary Becker, and Richard
Posner) as an essentially American push of the liberal political tradition of investigations in
social sciences. He asserts the primacy of institutions, environments, time and place, and
other sociological elements, and rejects the self-interest axiom. Boldizzoni wishes to replace
economic man/woman with sociological man/woman, which implies that some meta-theory
must be carved out of actual events for each era or episode if we are to truly understand eco-
nomic history and the development of human societies.
Intellectual history tells us, however, that Boldizzoni’s method of inquiry reduces economic
history and behavior to mere prose—a narrative that is always anecdotal and never falsifiable.
The suggestion that neoclassical economics be replaced by a vague theory derived from
“facts” (induction) is an old one that, despite being repeated through the past two centuries,
offers no example of success. Criticisms of this ilk have existed from the time of the Industrial
Revolution. Romantics and Marxists challenged economic theory in the classical period as a
justification of the status quo in income distribution, and assaulted the wages-fund doctrine
as “trickle-down economics” gone bad (see chapters 11 and 12). The German and British “his-
torical schools” raised similar objections, and their critiques were to some extent revisited
later by American institutionalists (see chapter 19). None of this dissent has halted the trajec-
tory of contemporary economics and its new applications to history, sociology, anthropology,
or culture. “Theory” without facts is sterile, and facts without (falsifiable) theory is nonsense.
No able economist would reject the value of multiple approaches to history and the other
social sciences. However, it is unlikely that “external criticisms” will divert economics from its
current path of intellectual integration and incorporation. Boldizzoni has merely added one
more weak voice of dissent to a lonely chorus.

Whatever the outcome, the assumption that individuals respond to full prices in
both explicit and implicit markets has carried economics further (and further) into
the areas of social science. This has been demonstrated particularly with regard to
dating, mating, marriage, and household production. Judging by derivative litera-
ture, it would also appear that economics can advance our understanding of reli-
gious behavior, particularly in regard to how religious institutions supply products
to their consumers. Moreover, conventional economic theory has shown early
promise in understanding culture and the arts, as well as biological and evolution-
ary effects of common versus private property arrangements. The “tragedy of the
commons” makes societal collapse understandable in a number of cases.
Perhaps nothing is more emblematic of the success of economics in penetrating
new fields than the fact that some journals are now focused exclusively on narrow
fields of economic inquiry. The Journal of Cultural Economics regularly publishes
works on the economics of the arts. The Journal for the Scientific Study of Religion
is a forum for research and publication on the economics of religion. The directions
of twenty-first century economics cannot be fully anticipated (see the following
chapter), but clearly there is a move toward economics embracing matters that have
been traditionally, but myopically, claimed as nonmarket behavior. Economists have
slowly but surely discovered that much nonmarket activity submits to the same
organizing principles and logical outcomes as market activity.
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688 Part VI ■ Back to the Future

REFERENCES
Alchian, Armen. “Property Rights,” The Concise Encyclopedia of Economics. Library of
Economics and Liberty http://www.econlib.org/library/Enc/PropertyRights.html.
Azzi, Corey, and Ronald Ehrenberg. “Household Allocation of Time and Religiosity: Rep-
lication and Extension,” Journal of Political Economy, vol. 85 (1975), pp. 415–423.
———. The Economic Approach to Human Behavior. Chicago: University of Chicago
Press, 1976.
———. A Treatise on the Family. Cambridge: Harvard University Press, 1981.
Coase, Ronald. “Durability and Monopoly,” Journal of Law and Economics, vol. 15
(1972), pp. 143–149.
Diamond, Jared. “The American Blitzkrieg: A Mammoth Undertaking,” Discover (June
1987), pp. 82–88.
———. “Easter Island’s End,” Discover (August 1995), pp. 63–69.
———. Collapse: How Societies Choose to Fail or Succeed, (rev. ed.). New York: Penguin
Books, 2011.
Durkheim, Émile. The Elementary Forms of Religious Life: A Study in Religious Sociol-
ogy, Joseph Ward Swain (trans.). New York: Macmillan, 1915.
Ekelund, R. B. Jr., Robert F. Hébert, Robert D. Tollison, Gary M. Anderson, and Audrey
B. Davidson. Sacred Trust. New York: Oxford University Press, 1996.
Ekelund, R. B. Jr., Robert F. Hébert, and Robert D. Tollison. The Marketplace of Christi-
anity. Cambridge: MIT Press, 2006.
Ekelund, R. B. Jr., and Robert D. Tollison. Economic Origins of Roman Christianity. Chi-
cago: University of Chicago Press, 2011.
Iannaccone, Lawrence. “Sacrifice and Stigma: Reducing Free-Riding in Cults, Com-
munes and Other Collectives,” Journal of Political Economy, vol. 100 (1992), pp.
271–292.
Lipo, Carl, and Terry Hunt. The Statues that Walked. New York: Simon and Schuster
Digital Sales, 2011.
Mei, Jianping, and Michael Moses. “Art as an Investment and the Underperformance of
Masterpieces,” American Economic Review, vol. 92 (2002), pp. 1656–1668.
Peltzman, Sam. “Toward a More General Theory of Regulation,” Journal of Law and
Economics, vol. 19 (August 1976), pp. 211–240.
Posner, Richard A. Sex and Reason. Cambridge: Harvard University Press, 1994.
———. “A Theory of Primitive Society with Special Reference to Law,” Journal of Law
and Economics, vol. 23 (1980), pp. 1–53.
Renneboog, Luc, and Christophe Spaenjers. “Buying Beauty: On Prices and Returns in
the Art Market,” Management Science, vol. 59 (2013), pp. 36–53.
Skinner, Sarah J., Robert B. Ekelund, Jr., and John D. Jackson. “Museums, Funding, and
Business,” American Journal of Economics and Sociology, vol. 68 (2009), pp. 491–516.
Smith, Vernon. “Economics of the Primitive Hunter Culture with Applications to Pleisto-
cene Extinction and the Rise of Agriculture,” Journal of Political Economy, vol. 83
(August 1975), pp. 727–755.
Stigler, George. “The Theory of Economic Regulation,” The Bell Journal of Economics
and Management Science, vol. 2 (Spring 1971), pp. 3–21.
Weber, Max. The Protestant Ethic and the Spirit of Capitalism, Talcott Parsons (trans.),
foreword by R. H. Tawney. London: George Allen & Unwin, 1930.

NOTES FOR FURTHER READING

Economists such as Gary Becker, Nobel laureate in economics (1991), and Richard
Posner have by themselves and by demonstration helped extend the reach of modern
economics. In a long series of papers and books Becker has redefined the scope of eco-
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Chapter 27 ■ The Resurgence of Economics as a Social Science 689

nomics to include much of what has been considered the province of sociology. In partic-
ular Becker has set the economic principles of time costs and household maximization at
the center of labor theory and consumer behavior. His work on marriage, courtship, fam-
ily, and divorce is far reaching and profound. See Becker, Economic Approach to Human
Behavior (see references); and same author, A Treatise on the Family (see references),
plus individual papers referenced therein. Posner has also penetrated “anthropological”
and “sociological” topics with the vigor (and rigor) of modern economic analysis. See
Posner, Sex and Reason (see references); and with specific reference to the AIDS crisis,
Posner and Thomas J. Philipson, Private Choices and Public Health: The AIDS Epidemic
in an Economic Perspective (Cambridge, MA: Harvard University Press, 1993).
Economics and the arts is a major component of the broader designation, “cultural
economics.” The Journal of Cultural Economics is devoted to economic aspects of cul-
ture, including music, museums, movies, opera and theater, visual arts, government sub-
sidies of the arts, and myriad other issues. James Heilbrun and Charles M. Gray, The
Economics of Art and Culture (New York: Cambridge University Press, 2d ed., 2001),
provide an overview of the literature cascade that has been forthcoming in this field. Art
markets have received a great deal of attention. Mark Blaug, “Where Are We Now on
Cultural Economics,” Journal of Economic Surveys, vol. 15 (April 2001), pp. 123–143,
offers a survey of recent developments. Another useful compendium of papers is, Eco-
nomic Engagements with Art, Neil De Marchi and Craufurd D. W. Goodwin (eds.),
Annual Supplement to Volume 31, History of Political Economy (Durham and London:
Duke University Press, 1999). Other useful references are William D. Grampp, Pricing
the Priceless: Art, Artists, and Economics (New York: Basic Books, 1989); The Economics
of Art Museums, Martin Feldstein (ed.) (Chicago: University of Chicago Press, 1991);
Economics of the Arts: Selected Essays, Victor A. Ginsburgh and Pierre-Michel Menger
(eds.) (Amsterdam: Elsevier, 1996); Bruno S. Frey and Werner W. Pommerehne, Muses
and Markets: Explorations in the Economics of the Arts (Oxford: Basil Blackwell, 1989).
Cultural economics, especially as it relates to the arts, has brought a number of
issues to the fore. One issue is whether price estimates published online and in auction
catalogues are “efficient,” i.e., do they accurately express the values of art and other
objects? For a treatment of this issue, see R. B. Ekelund, Jr., R. W. Ressler, and J. K. Wat-
son, “Estimates, Bias and ‘No Sales’ in Latin-American Art Auctions 1977–1996,” Journal
of Cultural Economics, vol. 22 (1998), pp. 33–42; and R. B. Ekelund, Jr., John D. Jackson,
and Robert D. Tollison, “Are Art Auction Estimates Biased?” Southern Economic Journal
(forthcoming 2013). For an alternative approach to price estimation, see Clare McAn-
drew, Rex Thompson, and James L. Smith, “The Impact of Reservation Prices on the Per-
ceived Bias of Expert Appraisals of Fine Art,” Journal of Applied Econometrics, vol. 27
(2012), pp. 235–252. Whether art is a good “investment” is the subject of lively debate
inasmuch as art has consumption value as well as appreciation potential. Two excellent
papers on this subject are those of Jianping Mei and Michael Moses (see references);
and same authors, “Vested Interest and Biased Price Estimates: Evidence from an Auc-
tion Market,” The Journal of Finance, vol. 60 (2005), pp. 2409–2435.
The economics of religion has clearly “arrived” judging by the growing output of
papers on the subject (and on the new designation granted to the field by the Journal of
Economic Literature. In addition to the works cited in the references to this chapter, a
good place to begin an in-depth study is Lawrence Iannaccone, “Introduction to the Eco-
nomics of Religion,” Journal of Economic Literature, vol. 36 (1998), pp. 1465–1495. Inso-
far as religion is concerned the rationality postulate is embraced by (some) sociologists
as well. In particular, see Rodney Stark, The Rise of Christianity: How the Obscure, Mar-
ginal Jesus Movement Became the Dominant Religious Force in the Western World in a
Few Centuries (San Francisco: HarperOne, 1997); and same author, Cities of God: The
Real Story of How Christianity Became an Urban Movement and Conquered Rome (San
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690 Part VI ■ Back to the Future

Francisco: HarperOne, 2006). Rachael M. McCleary, The Oxford Handbook on the Eco-
nomics of Religion (New York: Oxford University Press, 2011), is a vital collection of
papers on the subject. Also see, same author, “Religion and Political Economy in an
International Panel,” Journal for the Scientific Study of Religion, vol. 45 (2006), pp. 149–
175; and, Rachael McCleary and Robert J. Barro, “Religion and Economy,” Journal of
Economic Perspectives, vol. 20 (Spring 2006), pp. 49–72. The subject of religion itself has
generated a massive literature comprised of works in history, sociology, anthropology,
psychology, and (maybe) surprisingly, biology. On the latter see Pascal Boyer, Religion
Explained: The Evolutionary Origins of Religious Thought (New York: Basic Books,
2001); and Andrew Newberg, Eugene D’Aquili, and Vince Rause, Why God Won’t Go
Away: Brain Science and the Biology of Belief (New York: Ballantine, 2001). Ryu Susato,
“Taming ‘The Tyranny of Priests’: Hume’s Advocacy of Religious Establishments,” Jour-
nal of the History of Ideas, vol. 73 (April 2012), pp. 273–293, provides an interesting con-
trast between Hume and Smith on religion.
Jared Diamond is a geographer whose proficiency graces other fields. His studies
that are particularly amenable to economic analysis deal with the collapse of Easter
Island, the decline of the Anasazi, the dissolution of the Mayan culture, and the wither-
ing of a Greenland colony (see Collapse in the references). His earlier Pulitzer-prize win-
ning book, Guns, Germs and Steel (New York: W. W. Norton, rev. ed., 2005), examines
how geography and environment created the first great spread of civilization in Eurasia.
Diamond emphasizes the nature of plants and animals (in terms of their availability and
adaptability to domestication) as inducing “east to west” movement of population and
civilization and discouraging “north to south” settlement. Diamond’s thesis easily fits
into the economist’s full-costs-and-benefits model that yields an adjunct explanation.
Just as economists sometimes are charged with economic determinism, Diamond has
been criticized for “environmental determinism.”
Some questions in archeology and anthropology yield easily to economic analysis.
Richard A. Posner (“Theory of Primitive Society” in the references), one of the founders
of the law and economics paradigm, contributed a brilliant paper on the role that insur-
ance (or its lack) plays on the structure of primitive (that is, nonliterate) societies. Posner
shows how the structure of society and family is altered when no market insurance
exists. Vernon Smith (references) attributes the decimation of large animals (e.g., bison,
mastodon, and mammoth) by Paleolithic hunters to the “tragedy of the commons.” Using
archeological and anthropological evidence Smith compares free access (open property
rights where “first come, first served” reigns) to controlled access to resources using
strict ownership. One of the most interesting recent excursions by economists into
anthropology and genetics is a paper on human prehistory by Quamrul Ashraf and Oded
Galor, “The ‘Out of Africa’ Hypothesis, Human Genetic Diversity and Comparative Eco-
nomic Development,” American Economic Review, vol. 103 (2013), pp. 1–46, which pres-
ents empirical evidence that the prehistoric exodus of Homo sapiens out of Africa and
the varieties of genetic diversity that followed had long-term effects on rates of economic
development around the world.
The economics of politics finds its most ready application in today’s society, but that
should not be surprising in a discipline that began as “political economy.” It is interesting
to speculate on how a rapidly changing digital technology might affect changes in demo-
cratic processes. Direct or participatory democracy, in which each citizen has an opportu-
nity to cast his or her vote on all public issues, is often held up as an ideal method of
reaching political consensus. Attempts to approach this ideal include Athenian democ-
racy (the agora), the New England Town Meeting, and the Swiss cantons. Such attempts
at the ideal have fallen short, however, due to the costs of organizing large groups. But
the advent of relatively inexpensive computers, “smart” phones and other methods of dig-
ital communication have lowered the cost of direct voting. These developments are fore-
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Chapter 27 ■ The Resurgence of Economics as a Social Science 691

told in a paper by James C. Miller, III, “A Program for Direct and Proxy Voting in the
Legislative Process,” Public Choice 6 (Fall 1969), pp. 107–113. While information costs on
the part of voters remain high, they might be mitigated by engaging “specialist proxies” to
represent voters on issues such as regulation, taxes, defense, and so forth. The proxies
could be engaged by contracts of varying length, with the highest proxy specialists engag-
ing the narrowest interests but subject to quick recall in the event of poor performance.
There are other interesting ideas that might lower costs of more efficient decision
making. One idea that has commonsense appeal but has failed to gain traction would be
to increase the number of voter’s representatives. The minimum number of people that a
member of the House of Representatives can represent is 30,000, but there currently is
no maximum. In 2013 the actual number of citizens represented by each elected solon is
700,000 on average. Individuals’ preferences would be better represented if there were
more representatives per electoral district, which would allow representatives to better
know their constituents’ preferences. The downside, however, is that with larger num-
bers of representatives, consensus may be more difficult to achieve. These and other
problems are discussed by George S. Ford, Mark Thornton, and Marc Ulrich, “Constitu-
ency Size and the Growth of Public Expenditures: The Case of the United Kingdom,
Journal of Public Finance and Public Choice (PFPC)/ Economia delle svelte pubbliche,
vol. 24 (2006), pp. 127–141. Also see Mark Thornton, “The Case for Bigger Government,”
The Lew Rockwell Show, November 17, 2008. Lew Rockwell interviews Dr. Mark Thorn-
ton (podcast) http://www.lewrockwell.com/lewrockwell-show/2008/11/17/69-the-case-for-
bigger-government/.
The extension of economic analyses into allied fields shows no signs of abating,
despite “pushback” from some avidly “territorial” social scientists. Cliometrics, the use
of economic theory and quantitative tools to study history and social phenomena, has
established a foothold in the United States and, increasingly, in Europe and elsewhere.
Some European scholars persist in questioning the value of the kind of economic analy-
sis found in contemporary economic history by such scholars as Gary Becker, Robert
Fogel, and Douglass C. North, who have seen their life’s work crowned by Nobel prizes.
It would appear that European methods in social sciences are fundamentally socio-
logical in nature—focused primarily on collectivist institutions as driving forces in soci-
ety—whereas economists (primarily, but not exclusively American) predominately take
an individualist approach that concentrates on the consequences and implications of
rational behavior, full prices, and implicit markets. One critique stands out for its
defense of the study of history and institutions as a mass of “facts” without falsifiable
theory. Francesco Boldizzoni, The Poverty of Clio (Princeton: Princeton University Press,
2011), argues against the implied “takeover” of history and other social sciences by
economists. It is an odd and idiosyncratic book, displaying massive confusion and mis-
representation of economists’ forays into other social sciences, as it assumes that econo-
mists accept the economic approach to historical questions as the only explanation of
the unfolding of events. Boldizzoni’s call for a “renewal of methods” (p. 170) is a thinly
veiled plea for a return to the kind of methods advanced by German and English histori-
cal “schools” and Karl Marx (see chapters 11 and 12 in this text).
Some criticisms of applying economics to the social sciences have been even more
vigorous than Boldizzoni’s. Church historian Ramsay MacMullen (“The Translation of
History into Economics,” Journal of Interdisciplinary History, 43 [2012], 289–294) looks
with extreme disdain on economists and sociologists (in particular) who use rational-
choice theory to study religion and its history. His criticism stems from the extension of
traditional areas of inquiry into the realm of implicit markets, full-price, and “goods”
under the rubric of utility production. But such applications have helped economists to
understand facets of markets for art, marriage, politics, anthropology, and religion. Mac-
Mullen also makes the erroneous observation that analysis based on nonrational behav-
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692 Part VI ■ Back to the Future

ior—exemplified by the interesting insights of Kahneman and Tversky (see chapter 26)—
has displaced the modern approach that has been used with respect to religion and in
other applications of economics to the social sciences. Yet, in a recent assessment of
Kahneman’s nonrational “prospect theory,” based on its influence during the last thirty
years, Barberis (see references chapter 26) concluded, “Even prospect theory’s most
ardent fan would concede that economic analysis based on this theory is unlikely to
replace the analysis that we currently present in our introductory textbooks” (p. 195).
Studies using Kahneman’s ideas have been limited principally to risk and insurance and
especially to laboratory experiments, not to “real-world” experience or historical testing.
Psychology, in this instance, appears to have given far less to economics than economics
has given to the other social sciences. It bears repeating that in modern science facts
without theory are meaningless, and theory without facts is unconvincing. The resur-
gence of economics as a social science does not mean that facts are irrelevant, only that
they must be assembled in a coherent method to be considered alongside the efforts of
historians, sociologists, and anthropologists.
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28

Quo Vadis?
Economics in the Twenty-First Century

“I think, therefore I am,” wrote the philosopher René Descartes, thereby underscor-
ing the centrality of ideas in the panorama of human existence and activity. This
book is about ideas—some that have stood the test of time and some that have not.
But a history of ideas, in any field, raises certain critical questions. What, exactly, are
ideas? How do they originate? Once shaped, what directions do ideas take? Do ideas
matter in the history of humankind, and does a grasp of ideas help us understand
events and historico-institutional change? Are ideas and “ideologies” the same thing?
Finally, what are the ideas that are shaping twenty-first century economics and what
are their likely “fates”? Up to this point, our lengthy review of important ideas in the
history of economic thought has avoided raising such questions much less posing
even tentative answers. Indeed, answers to such questions are not easily derived. But
at the end of our historical survey, we pause to consider the nature and consequences
of economic ideas and the method of analysis that economists choose in plying their
trade. For insight into these issues, we look first to the assembly of economists who
have captured their science’s highest honor—the Nobel Prize in Economics.

■ NOBEL LAUREATES AND ECONOMICS

Economics has been cultivated as a separate science since Adam Smith penned
The Wealth of Nations in 1776. Since that time, economists have expanded the hori-
zons of economic theory and policy in virtually all areas of inquiry. In 1969, Sweden’s
Nobel Prize Committee, long vested with the authority to award Nobel Peace Prizes,
instituted the Sveriges Riksbank Prize in Economic Science in Memory of Alfred
Nobel. Winners have received recognition for many different kinds of contributions
and applications: macroeconomics, econometrics, general equilibrium theory, eco-
nomic history, economic development, input-output analysis, institutional economics,
allocation theory, money, national-income accounting, administration, industrial orga-
nization, public finance, market design, and financial economics. Prizes for these con-
tributions provide outward signposts that economics is an ongoing activity of varied
scope and widespread interest. They also hark to the past and point to the future—
simultaneously supplying indirect evidence that contemporary advances continue to
build on earlier contributions and provide new directions in the twenty-first century.
Table 28-1 lists the Nobel Prize winners in economics from 1969 through 2012, along

693
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694 Part VI ■ Back to the Future

Table 28-1 Nobel Prize Winners in Economic Science

1969 RAGNAR FRISCH (Econometrics) 1979 THEODORE W. SCHULTZ (Economic
Oslo University Development)
JAN TINBERGEN (Econometrics) University of Chicago
The Netherlands School of Economics W. ARTHUR LEWIS (Economic Development)
1970 PAUL A. SAMUELSON. (Partial and General Princeton University
Equilibrium Theory) 1980 LAWRENCE R. KLEIN (Macroeconometrics)
Massachusetts Institute of Technology University of Pennsylvania
1971 SIMON KUZNETS (Economic Growth and 1981 JAMES TOBIN (Macroeconomics)
Economic History) Yale University
Harvard University 1982 GEORGE J. STIGLER (Industrial Organization)
1972 JOHN R. HICKS (General Equilibrium Theory) University of Chicago
Oxford University 1983 GERARD DEBREU (General Equilibrium
KENNETH J. ARROW (General Equilibrium Theory)
Theory) University of California, Berkeley
Harvard University
1984 J. RICHARD STONE (National Income
1973 WASSILY LEONTIEFF (Input-Output Analysis) Accounting)
Harvard University Cambridge University
1974 GUNNAR MYRDAL (Macroeconomics and 1985 FRANCO MODIGLIANI (Macroeconomics)
Institutional Theory) Massachusetts Institute of Technology
University of Stockholm
1986 JAMES M. BUCHANAN, Jr. (Public Finance)
FRIEDRICH A. HAYEK (Macroeconomics and
George Mason University
Institutional Theory)
University of Freiburg 1987 ROBERT M. SOLOW (Economic Growth
Theory)
1975 LEONID KANTOROVICH (Theory of Optimum
Massachusetts Institute of Technology
Allocation of Resources)
Moscow Academy of Sciences 1988 MAURICE ALLAIS (Partial and General
TJALLING J. KOOPMANS (Theory of Optimum Equilibrium Theory)
Allocation of Resources) École Nationale Supérieure des Mines de Paris
Yale University 1989 TRYGVE HAAVELMO (Econometrics)
1976 MILTON FRIEDMAN (Macroeconomics) Oslo University
University of Chicago 1990 HARRY M. MARKOWITZ (Financial Economics)
1977 BERTIL OHLIN (International Economics) City University, New York
Stockholm School of Economics MERTON M. MILLER (Financial Economics)
JAMES E. MEADE (International Economics) University of Chicago
Cambridge University WILLIAM F. SHADE (Financial Economics)
Stanford University
1978 HERBERT A. SIMON (Administrative/
Management Science) 1991 RONALD H. COASE (Theory of Institutions)
Carnegie-Mellon University University of Chicago
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Chapter 28 ■ Quo Vadis? 695

1992 GARY S. BECKER (Microeconomics and 2002 VERNON L SMITH (Economic Psychology
Economic Sociology) and Experimental Economics)
University of Chicago George Mason University
1993 ROBERT W. FOGEL (Economic History) 2003 ROBERT F. ENGLE (Econometrics)
University of Chicago New York University
1993 DOUGLASS C. NORTH (Economic History) CLIVE W. J. GRANGER (Econometrics)
Washington University, St. Louis University of California, San Diego
1994 JOHN C. HARSANYI (Game Theory) 2004 FINN E. KYDLAND (Macroeconomics)
University of California, Berkeley Carnegie Mellon University
JOHN F. NASH (Game Theory) 2004 EDWARD C. PRESCOTT (Macroeconomics)
Princeton University Arizona State University
REINHARD SELTEN (Game Theory) 2005 ROBERT F. AUMANN (Game Theory)
University of Bonn Hebrew University
1995 ROBERT LUCAS (Macroeconomics) THOMAS C. SCHELLING (Game Theory)
University of Chicago University of Maryland
1996 JAMES A MIRRLEES (Economics of 2006 EDMUND S. PHELPS (Macroeconomics)
Information) Columbia University
Cambridge University 2007 LEONID HURWICZ (Market Design
1996 WILLIAM VICKREY (Economics of University of Minnesota
Information) ERIC S. MASKIN (Market Design)
Columbia University Princeton University
1997 ROBERT C. MERTON (Financial Economics) ROGER B. MYERSON (Market Design)
Harvard University University of Chicago
MYRON S. SCHOLES (Financial Economics) 2008 PAUL KRUGMAN (International Economics)
Stanford University Princeton University
1998 AMARTYA SEN (Welfare Economics) 2009 ELINOR OSTROM (Institutional Economics)
Cambridge University Indiana University /Arizona State University
1999 ROBERT A. MUNDELL (International OLIVER E. WILLIAMSON (Institutional
Economics) Economics)
Columbia University University of California, Berkeley
2000 JAMES J. HECKMAN (Econometrics) 2010 PETER A. DIAMOND (Economics of Search)
University of Chicago Massachusetts Institute of Technology
DANIEL L. McFADDEN (Econometrics) DALE T. MORTENSEN (Economics of Search)
University of California, Berkeley Northwestern University
CHRISTOPHER A. PISSARIDES (Economics
2001 GEORGE A. AKERLOF (Economics of
of Search)
Information)
London School of Economics &
University of California, Berkeley
Political Science
A. MICHAEL SPENCE (Economics of
Information) 2011 THOMAS J. SARGENT (Macroeconomics)
Stanford University New York University
JOSEPH E. STIGLITZ (Economics of CHRISTOPHER A. SIMS (Macroeconomics)
Information) Princeton University
Columbia University 2012 ALVIN E. ROTH (Market Design)
2002 DANIEL KAHNEMAN (Economic Psychology Harvard University
and Experimental Economics) LLOYD S. SHAPLEY (Market Design)
Princeton University University of California, Los Angeles
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696 Part VI ■ Back to the Future

with a parenthetical description of their contributions cited by the prize selection

committee. Why is this instructive? No book on the history of economics can hope to
accurately predict the future direction of economic inquiry. Nevertheless, the achieve-
ments of the past may contain useful hints.1
The preponderance of econometrics, economic dynamics and growth theory,
macroeconomic theory, general equilibrium analysis, and, more recently, game the-
ory certainly provides a clue to the directions of modern economics. Individuals
within these categories are difficult to classify because there is wide variation in
interests and results. Nevertheless, they are united in a common technical approach
to economic problem solving. This shared technique emphasizes mathematical rea-
soning and empirical research. Empirical studies of macroeconomic (economy-
wide) behavior have become more and more complex through time, as have investi-
gations in public finance and game theory. The quest to understand the underlying
interrelationships of aggregate economies and the causes of and factors relating to
economic growth will continue—if not through easily testable hypotheses, then
through mathematical designs and simulations. Game theory and experimental eco-
nomics, so clearly recognized by the Nobel Institute, are other fields of important
research being carried out at major universities around the world. Much of this
work requires solid grounding in advanced mathematics. As economics stretches its
mathematical muscle, we may expect more and more of such activity.
There is, however, another side to the past as prologue to the future. We might
call it the “movement to reinvigorate economics as a social science.” Some of the
prize winners have shown the ability to incorporate technical economics and empir-
icism into their explorations of the interstices of economics, history, politics, sociol-
ogy, and anthropology. A few examples will suffice to emphasize this point. James
M. Buchanan, Jr., developed a contractual and constitutional framework for study-
ing decision making by economic and political agents. George J. Stigler proposed
that market outcomes could not be studied apart from an integration of economic
and political interests and the incentives faced by each. Douglass C. North has per-
sistently attempted to treat changes in institutions as endogenous factors in bring-
ing about historical change. Robert W. Fogel has introduced quantitative methods
into the study of economic history to enrich our understanding and appreciation of
the subject. Ronald Coase has underscored the importance of property rights in
ongoing studies of historical and contemporary institutions. William Vickrey, James
Mirrlees, George Akerlof, Michael Spence, and Joseph Stiglitz have enriched our
understanding of the operation of economic markets by recognizing and exploring
transactions and information costs. Elinor Ostrom approached science as a form of
artisanship and enriched our understanding of common-pool problems and the
tragedy of the commons. Rather than dance around the periphery of economic the-
ory, these contributions penetrate to the core of received economic analysis. Among
other things, they make the subject of history, sociology, political science, psychol-
ogy, and anthropology more robust. For this reason, we expect that contemporary
economics will continue to find increasing application in allied fields of interest.
1 The interested reader is directed to the Nobel prize site at http://nobelprize.org/economics/ for a
wealth of information concerning each winner, including the “acceptance” speech and articles
related to the particular economist. More importantly perhaps, eighteen of the winners them-
selves provided an analysis of his “evolution as an economist” in a lecture series given at Trinity
University (San Antonio, Texas). These delightful and important presentations are reproduced in
William Breit and Barry T. Hirsch (eds.), Lives of the Laureates (see references). A common theme
of this diverse group of winners, if there is one, is that they embarked on economics as a career
and as a means of confronting social and economic problems of the real world.
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Chapter 28 ■ Quo Vadis? 697

The ideas and theoretical extensions of Gary Becker have been particularly pro-
vocative as we saw in chapters 26 and 27. The application of economics to nontradi-
tional, nonmarket behavior, including marriage, family, dating, and so forth has,
judging from recent contributions to economics literature, stimulated many similar
avenues of research. Drawing heavily on biological and other social sciences, con-
temporary writers have applied the premises of self-interest and economic rationality
to an ever-widening array of issues, including sexual drives, polygamy, abortion, and
motherhood.2 Nobel Prize winning economists have helped spawn whole new areas
of interface, including two thriving areas, “law and economics” and the “economics
of religion.”3 It would therefore appear that the interface of economics with sociol-
ogy and other social sciences will receive continued attention for some time to come.
Finally, economics both informs and is informed by psychology. Game theory
with its myriad possible conjectures about behavior in market and nonmarket con-
texts most certainly employs assumptions about psychological behavior. Do individ-
uals always react in the rational manner posited by economists? Is rationality, like
information, limited? How do individuals behave under uncertainty? Experimental
economics—as exemplified in the work of Nobel laureates Daniel Kahneman (see
chapter 26) and Vernon L. Smith—whether it involves game theory or other types of
controlled experiments, relies heavily on psychological premises and laboratory
designs. The nature and form of these kinds of studies show no signs of letting up
as economics winds its way through this millennium.
George Stigler reminded us that “Contemporary fame does not ensure lasting
fame—the leaders of what prove to be scientific fads receded from even the histo-
ries of the science” (in Breit and Hirsch, Lives, p. 79). There is no guarantee that all
(or any) of the central ideas and achievements of the latter part of the twentieth cen-
tury or the beginning years of the twenty-first century will have a lasting impact.
The worlds of science and social sciences are filled with “also-rans” and “never-
rans.” Our purpose in examining a few of the ideas of the elite coterie of Nobel Prize
winners has been to at least acknowledge those economists who are currently rec-
ognized by the profession as having made important contributions. While these past
achievements might serve to indicate which way the intellectual winds are blowing,
we know from the contemporary state of meteorology that winds change often and
unpredictably. The evolution of the economics profession and the technology sur-
rounding it also has changed dramatically since its origins in the eighteenth century.

■ THE TRANSMISSION OF IDEAS AND THE

NEW “TECHNOLOGY” OF ECONOMICS
Any “count” of economists working today must be approximate. Some esti-
mates put the number of professional economists worldwide at between 40,000 and
65,000. The American Economic Association (AEA) constitutes the largest orga-
nized group of economists, although there are many organizations devoted to the
study and practice of economics in both the United States and around the world.
The amount of economic literature produced annually also grows apace. There
were, for example, about 100 journals indexed by the AEA in 1924, 140 in 1968, 300
in 2005, and about 350 in 2012 (a number that includes an estimate for e-journals).

2
See in particular works and writings of Richard A. Posner, including Sex and Reason (references).
3
The area of law and economics owes much to Ronald Coase and to other writers as well: see Rich-
ard A. Posner, The Economics of Justice (references).
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698 Part VI ■ Back to the Future

Membership in the AEA mushroomed in the past 40 years from 4,000 to about
20,000. Founded in Saratoga, New York, in 1886, the AEA once drew members pri-
marily from academics, but it now contains an increasing number of business econ-
omists and “government” economists affiliated with federal, state, and local
agencies. Professional associations of all kinds have flourished during the twentieth
and into the twenty-first centuries. Many hold annual meetings for communicating
ideas. Abstracts of papers, indices of economic journals, translation services, books,
monographs, specialized associations (e.g., the Econometrics Society, the Public
Choice Society, the Association for Cultural Economics, the History of Economics
Society, etc.), regional associations (e.g., Southern, Western and Eastern Economic
Association, etc.) have all established networks within which knowledge is gener-
ated and shared.
This aim of this book has been to chronicle major economic ideas of the past.
We have said little about how ideas are created and manipulated, accepted and
rejected, through time. Yet, the transmission of ideas is a key ingredient in progress,
and it is instructive to analyze changes in the generation of economic thought over
the past two-and-a-half centuries. Technology and its global reach have clearly and
dramatically altered the methods for transmitting ideas of all kinds, including eco-
nomic ideas (see Stigler, Stigler, and Friedland, “Journals of Economics”).
The Internet is growing in its use as a device to spread information, but before
it came of age the popular press served as a vehicle for “advertising” ideas with eco-
nomic content. The British popular and periodical press, in particular, produced (at
least for the “educated layperson”) a continuous flow of economic commentary and
information during the nineteenth and twentieth centuries, and continues to do so
today. Established in 1843 to campaign on one of the great political issues of the
day, The Economist remains a major organ for the dissemination of economic news
and ideas. During the heyday of classical economics substantial debates were con-
ducted in the press. Critical issues such as the Corn Laws, the Poor Laws, and the
Factory Acts were seriously debated by McCulloch, Malthus, Ricardo, and the Mills
(father and son). Jeremy Bentham and Edwin Chadwick (chapters 9 and 10) were
deeply engaged in police and criminal justice reform as well as in other issues. John
Stuart Mill (chapter 8) debated and ostensibly “recanted” the wages-fund doctrine
in an English periodical, the Fortnightly Review. Interchanges on many economic
issues were enacted in the periodical and popular press across Europe. Reading
rooms (often clubs with a small fee) emerged to accommodate an increasingly edu-
cated populace.
Naturally, the spread of literacy quickened the pace of economic knowledge,
but during its earliest formative years economics was commonly traduced in books
and pamphlets. Near the end of the nineteenth century professional economics
journals began to make inroads as a dominant vehicle for the dissemination of
knowledge among an expanding number of academic specialists. In the United
States the Quarterly Journal of Economics was established in 1886; followed by the
Journal of Political Economy in 1892; and the American Economic Review in 1896.
In England the Economic Journal was established in 1891, under the auspices of the
Royal Economic Society. Other countries, France, Germany, and Italy in particular,
also have long, rich traditions of economic publications, but the twentieth century
witnessed the rising hegemony of English-language periodicals in economics.
Although economics journals never displaced books in the transmission of new
ideas and theories, a noticeable shift toward periodical literature occurred in the
first half of the twentieth century. Journal literature was typically more concise,
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Chapter 28 ■ Quo Vadis? 699

conveniently brief, imposed shorter lead times in the presentation of novel ideas,
and instituted a quality-control measure in the form of the referee process. While a
few specialist journals emerged in this time period, the premier research found its
way into the major outlets mentioned above.
Traditionally, and almost without exception, papers and books having the great-
est impact on economic thought were singly authored. That all began to change as
the number of economists (however defined) increased and as mathematics, statis-
tics, and econometrics invaded the economics profession, circumstances that accel-
erated in the 1970s and 1980s, continuing apace today (Laband and Piette, “Relative
Impacts of Economics Journals: 1970–1990”). Simultaneously the “fields” that con-
stitute economics expanded greatly, with new fields emerging and old fields subdi-
viding. As a consequence the number of journals proliferated to accommodate the
ever-expanding fields of specialization within economics proper. In 2013, the Jour-
nal of Economic Literature listed hundreds of “fields” and “subfields.” As a conse-
quence of expansion in the number of “niche” journals in economics the legacy
journals have experienced increased competition and have, in some instances,
relinquished specialized contributions to specialized journals.
These developments have generated an area of inquiry within the economics
profession that might be called “economic technology,” a field designed to study the
efficiency and operation of the intellectual transmission of economic theory and pol-
icy. Contributions to this field examine important issues relative to how economic
ideas are promulgated. Whereas it might be expected that specific applications of
economic analysis in various subfields would provide fertile ground for innovations
in general economic theory (a bottom-up process), the hierarchy of journals and the
multiplication of subfields may have encouraged the reverse (a top-down process).
The multiplication of economics journals has engendered questions regarding
the quality of different journals and the value of economic articles in the production
and spread of knowledge. Typically, the articles that economists submit to academic
and business journals are subjected to scrutiny from journal editors and unpaid ref-
erees who are assigned to evaluate the papers submitted. Does this practice add
value to the papers (judged by citations)? Based on evidence he collected in corre-
spondence with journal editors, David Laband argues that referees do in fact add
value to economic research (“Is There Value-Added from the Review Process”). Eco-
nomics journal editors “match” the research topics submitted with recognized
experts in the relevant domain. (The “experts” themselves had to “earn their spurs”
by succeeding within the same kind of editorial gauntlet.) This process bestows a
great deal of power on editors as well as referees. Questions of favoritism arise.
Laband and Piette (“Favoritism versus Search”) did not find evidence of favoritism,
but anecdotal evidence is not always persuasive, and doubts most likely remain.
Transmission of new, creative, and influential ideas does not always proceed
smoothly and efficiently. Joshua Gans and George Shepherd (“How the Mighty
Have Fallen”) studied the academic biographies of Nobel laureates and winners of
the John Bates Clark Medal (an AEA award given to an outstanding economist
under the age of 40). They found that famous economists such as Nobel laureates
James Tobin, Bertil Ohlin, and Milton Friedman had their research rejected by jour-
nal editors at one time or another. Nobel laureate George Akerlof, who received the
Nobel Prize for his fundamental contribution to the economics of information and
exchange, had his highly influential article, “The Market for ‘Lemons’: Quality,
Uncertainty and the Market Mechanism,” rejected four times before it was finally
accepted in the Quarterly Journal of Economics!
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700 Part VI ■ Back to the Future

Not surprisingly specialization in authorship has accompanied specialization in

economics. In this respect, economics has trended toward common practice in the
“hard” sciences such as chemistry and biology. David Laband and Robert Tollison
looked at the dramatic rise in coauthorship in economics and the hard sciences.
They discovered that prior to 1950 practically no papers in the major economic jour-
nals were coauthored, but by the first decade of the twenty-first century almost 80
percent of the papers in economic journals had two or more authors. The practice is
more compelling in technical areas, such as macroeconomic theory and policy, than
in economic history or history of economic thought, but the significant issue is that
writers often find that specialization necessarily limits their range of knowledge
and technique. A theorist will work with an econometrician to produce a paper that
would (hopefully) be better than if either attempted to write alone—a straightfor-
ward application of the law of comparative advantage. Laband and Tollison con-
cluded that while formal collaboration in terms of number of coauthored papers
may be greater in biology than economics, informal collaboration—passing draft
papers around to colleagues and friends for evaluation—is far greater in economics
(“Intellectual Collaboration,” pp. 655–656).
Looking backward, it seems evident that the invention of the printing press
spurred certain “revolutions” (the Protestant Revolution, for instance). Looking for-
ward we might expect the digital age to have similar consequences—perhaps espe-
cially in economics because the full cost of computation has been dramatically
reduced. In the 1960s simple regression, a vital tool of the econometrician, was very
time consuming. Now, thanks to modern technology, thousands of complex econo-
metric computations may be done in less than a minute. This advance has in itself
sponsored greater econometric testing of complex econo/mathematical relations.
Digital technology has greatly increased accessibility to economic knowledge. (The
writing of this book was made considerably easier than earlier editions because of
so much useful information readily available on the Internet and because of the effi-
ciency of today’s word processing features.) Other things equal, lower research
costs should lead to more research, thus feeding the expansion of knowledge.
Within the university community the future path of economics is uncertain.
Undergraduate emphasis on mathematics and econometrics in university curricula
has met with some resistance. Laband and Piette speculate on “whether the strong
market showing (popularity) of the Journal of Economic Perspectives, with its
emphasis on [nonmathematical] presentation of arguments and findings in essay
form reflects a widespread reaction within the profession to the mathematical
emphasis” (“Relative Impacts,” pp. 244–286) so prevalent today. It remains to be
seen whether the increased knowledge output wrought by new technologies will
translate into progress in economic policy and understanding. The growing hege-
mony of mathematics and econometrics within the discipline of economics will be a
critical issue.

■ IDEAS, IDEOLOGY, AND HISTORY

How do we asses an idea in terms of how it will affect the future? How much
attention should we devote to ideology—the study of ideas? What is an idea, any-
way? We cannot afford to ignore semantics. Dictionary definitions run the gamut
from hazy perception, opinion, or belief, to detailed plan. We can probably agree
that an idea is the product of mental activity. Ideas are therefore notions that actu-
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Chapter 28 ■ Quo Vadis? 701

ally or potentially exist in the mind. What about ideology? One definition is that it is
the study of ideas, but a more popular meaning is that it comprises a set of ideas,
doctrines, or beliefs that form the basis of some cultural, political, or economic sys-
tem. Ideas and ideology can be understood as generalities, without reference to par-
ticular subject matter, or as specifics within a narrow field. Economic ideas, as you
may have silently observed throughout this book, might include a new technology
or knowledge base that finds application in a market framework. In a practical
sense, someone with a new idea potentially or actually increases the welfare of
someone else, or what amounts to the same thing, reduces transaction costs for
somebody. A new way to produce or package cat food constitutes a new idea. Better
ways to distribute cat food to customers also reduces costs to consumers—and like-
wise constitutes a new idea. This book has surveyed and evaluated many ideas—not
about cat food, to be sure, but about the varied theoretical elements of an economy
and the numerous institutions that affect market behavior. For example, Adam
Smith presented an analytical framework for economic development; John Stuart
Mill championed a politico-economic formula for judging the desirability of public
policy; Karl Marx advanced a historico-economic paradigm for structural change;
Alfred Marshall developed a set of analytical tools useful to businesspeople and
those seeking solutions to economic problems. This list is not exhaustive. The his-
tory of economics is a history of ideas because ideas form the raw material of any
academic discipline.
We have said little about ideology throughout this book. Yet, ideology cannot be
ignored. Without it, Marx’s analysis of a capitalist economy is incomplete, for exam-
ple. Social classes tend to coalesce around particular interests, with each group of
interests more often than not confronting an opposing interest group. This observa-
tion applies to “capitalist” and “socialist” ideologies alike. “Ideology” is the
teacher’s friend—it is a convenient device for ordering and categorizing ideas—but
as a moving force of history, its role is far from clear-cut.
Perhaps the question is not whether we can precisely define ideas or ideology,
but whether ideas have consequences in shaping individual activity of an economic
and social nature. The conventional wisdom states that ideas shape the modern
world. But as usual, timing is everything. For example, history reveals that certain
musical or artistic ideas “floated about” for long periods of time in relative obscurity
or outright neglect before they were “rediscovered.” One of the world’s most
revered composers, J. S. Bach, lapsed into obscurity in his time, relegating status to
his (far) less talented offspring, only to be rediscovered in the Romantic age by
great musicians of another generation, such as Felix Mendelssohn. Closer to the
present, twelve-tone music, a strikingly inventive conception developed by Arnold
Schoenberg early in the twentieth century, has yet to really “catch on.”4 These
examples also raise the issue of the “dating” of revolutions. Do they occur when the
idea is first expressed or, alternatively, when it is generally accepted—sometimes
generations after the idea is first expressed?
Economic ideas—while of enormous potential importance to society—may
catch on only when circumstances warrant. For all of the anticipations of “under-

4
George Stigler argued that influencing contemporaries is the only chance to become successful in
influencing science, citing the neglected genius of Gossen and Cournot who were only recognized
later (Breit and Hirsch, Lives, p. 79). Likewise, contemporary fame does not ensure lasting fame.
We demure on Stigler’s first point, inasmuch as later “revolutions” are often sparked from glean-
ings of past discoveries. Moreover, sciences and arts are often built from accretions to knowledge,
rather than by revolutions.
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702 Part VI ■ Back to the Future

consumption” arguments in the nineteenth century, and even after Keynes’s devel-
opment of it in the General Theory (1936) during a deep depression, persistent and
habitual deficit spending by Western central governments did not occur until the
1970s and 1980s. Likewise, the issue of peak-load pricing in the supply of public
utilities (electricity and telecommunications), firmly established in French eco-
nomic literature decades earlier, did not find practical application in the United
States until the 1960s. Moreover, analytical concepts such as “external economies
and diseconomies” (see chapter 16) preceded by almost a hundred years the recent
mobilization of public opinion regarding environmental concerns.
There are several impediments to a complete understanding of how ideas influ-
ence history. One of the most basic is the fact that the chain of causation is ambigu-
ous. Do ideas lead to events or do events precipitate ideas? More pointedly, do ideas
or events explain history? Do ideas lead change, with events following, or vice
versa? Or is it that sometimes ideas are leading variables and other times lagging
variables? These questions are significant, at least from a pedagogic standpoint.
Current pedagogy distinguishes between economic history (i.e., study of events and
their economic consequences) and intellectual history (e.g., the history of economic
thought). It appears that history can be read from either perspective. For example, it
could plausibly be argued that Adam Smith (chapter 5), armed with the concepts of
free markets and laissez-faire, was merely establishing an economic theory based
on observed events in the world of English commerce that had been underway for a
century or more. The same may also have been true of the Physiocrats (chapter 4)
in eighteenth-century France. At the same time, economic ideas that appear to be
novel at one historical moment may have been hotly debated within academic cir-
cles for years before coming to the fore or before actually stirring action. Again
drawing on Smith, his liberating idea that a basically free market could and would
supply an organizing principle that would improve economic welfare in a commer-
cial society, was the consequence of a philosophic inquiry stretching over two cen-
turies during which leading intellectuals searched for an answer to the Hobbesian
dilemma: that the only alternative to social chaos was an all-powerful central gov-
ernment. The world of science—from the production of the atomic bomb to the real-
ization of space travel—offers many examples of a similar nature.
In scientific pursuits, of course, technological prerequisites are always
required. No matter how fertile the mind of famed futurist author H. G. Wells, space
travel and rocketry did not become viable until other ideas and circumstances
(inventions, mathematical developments, war, etc.) precipitated action. Actualiza-
tion of scientific pursuits demands appropriate economic circumstances, which
underscores a critical point: Market incentives empower ideas to be actualized
through self-interested individuals or groups of individuals who seek to profit from
supplying products or services to a large body of consumers. Technological feasibil-
ity insists on economic feasibility (i.e., the benefits to some individual or group must
exceed the costs) before actualization takes place.
Nobel laureate George Stigler (1911–1991) stirred the troubled waters of these
issues more than any other modern historian of economic thought. In a collection of
essays entitled The Economist as Preacher (1982), Stigler emphasized the role of
self-interest in explaining the influence of economists. Stigler believed that econo-
mists, as preachers, are received well “in the measure that [they] preach what the
society wishes to hear” (p. 13). Economists, for example, are virtually unanimous in
their advocacy of free trade between nations, but their stance has little impact
unless free trade improves the welfare of those people who are in a position to enact
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Chapter 28 ■ Quo Vadis? 703

laws to maintain it. Economists and other enlightened citizens may therefore decry
protectionist legislation as mistaken, but Stigler warns that economists in particular
should be wary of taking such a position. In his words, “the discipline [economics]
that assumes man to be a reasonably efficient utility maximizer is singularly ill-
suited to assuming that the political activity of men bears little relationship to their
desires” (Economist as Preacher, p. 9). In other words, the world may be full of
“errant” policies from the economist’s perspective, but such policies are not mis-
taken in the eyes of their supporters.
The thorny question of when do ideas become action occupied Hamlet no less
than countless other individuals who have contemplated the meaning of life. Shake-
speare put these words into Hamlet’s troubled mind:
And thus the native hue of resolution
Is sicklied o’er with the pale cast of thought,
And enterprises of great pith and moment
With this regard their currents turn awry,
And lose the name of action.

Although we may never be able to satisfactorily answer the question of when ideas
become action, we are able to extract a valuable lesson from our survey of the his-
tory of economics: Ideas become action (i.e., receive a trial in the marketplace)
within context—within a framework of policies, constraints, or ground rules that are
established through a political process conducted by self-interested politicians and
interest groups. Metaphorically, there is an institutional skin that envelopes every
ideational corpse.
A holistic understanding of historical change, therefore, must be informed not
only by ideas and ideologies but by institutional parameters that establish the incen-
tives that ultimately motivate ideas and actions. Ideas and ideology alone are not
enough. Indeed, despite recognition that ideas and ideology may be of great impor-
tance in explaining particular movements or policies, the debate over the domi-
nance of ideology versus incentives has not run its course. The outcome, if indeed
one results, is critical to the ongoing activities of many contemporary economists
seeking to fathom the mysteries of economic development. Although it is generally
admitted that a political sector is integral to an explanation of institutional change
and in particular regulatory policies, evidence of ideology effecting legislation is
inconclusive (see Kalt and Zupan, “Capture”; Kau and Rubin, “Self-Interest”; Lott
and Bronars, “Time”). Depending on how it is defined, ideology itself may well be
the result of past and present “economizing”—the assessment of costs and benefits.

■ DOES METHOD MATTER?

Throughout this book you have been confronted with various “Method Squab-
bles,” or conflicting views, approaches, and procedures championed by different
economists. The purpose of highlighting differences has been to inform, not con-
fuse (although that is a calculated risk). When ideas become generally accepted
they have a tendency over time to become fixed in the public mind. New practitio-
ners invest time and talent in learning the prevailing technique (ideology?), and as a
consequence, they acquire a vested interest in certain operational procedures.
Although this is a natural progression, the danger is that accepted ideas may
become rigid doctrines, and their adherents in turn become doctrinaire. The intel-
lectual rigidity engendered by such doctrinism thwarts further ideational progress
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704 Part VI ■ Back to the Future

by stifling tolerance for opposing points of view. Such is the “noxious influence of
authority” that Jevons (chapter 15) complained of in his day. At the heart of this
issue is the question of what is the appropriate method of economic inquiry.
Economists, like other scientists, have worked in concert for well over two centu-
ries to build society’s “knowledge base.” The slow but steady accretions to this body
of economic knowledge have been the subject of this book. Knowledge has a way of
growing exponentially, in part because of the specialization and division of labor
applied to its construction and in part because of technological advance. The modern
age has witnessed a proliferation of outlets for research in economics and a huge
increase in the number of individuals identifying themselves as economists. While
economists at American universities have led the way since the twentieth century
(winning, for example, all but a few of the Nobel Prizes granted in economics
between 1969 and 2012), contributions to economic analysis have come from many
different quarters of the globe. In the context of our survey of the history of economic
thought, two important, interrelated questions beg to be answered: (1) How “new” is
it? and (2) Does its form encourage or constrain creativity in economic ideas?
“Keeping the record straight” has always been a major activity of the intellec-
tual historian, and every practitioner can cite examples of an idea’s fiery tail. For
example, Richard Cantillon and other preclassical writers have emerged as clear
anticipators of Adam Smith. An eighteenth-century engineer, A. N. Isnard, is now
known to have anticipated Walras on general equilibrium theory (see Jaffé, A. N.
Isnard). In the post–World War II period, John von Neumann, a mathematician, and
Oskar Morgenstern, an economist, teamed up to develop game theory as an edifice
constructed on Cournot’s foundation (see chapter 13). James Buchanan (chapter
24) pioneered the field of public choice after he discovered and translated an earlier
essays by Knut Wicksell and Antonio De Viti De Marco. Modern economists have
expanded the horizons of economic theory and policy in virtually all areas of
inquiry. These areas include the application of mathematics to economic theory; the
application of economic analysis to political behavior; and the economic analysis of
crime, the environment, taxes, health, safety, insurance, finance, labor, and product
quality. And, as we have seen, even areas previously reserved for sociology, such as
dating, mating, and marriage, have yielded to the economist’s deft touch (chapter
27). Albeit it reluctantly in some instances, most of the other social sciences are
yielding in some measure to economic analysis. The historian of economic thought,
by nature a generalist rather than a specialist, is in a unique position to evaluate the
importance, creativity, and originality of these contributions.
Increasingly the history of economic thought is lumped with methodology, and
the two are treated as companion fields of inquiry. It is therefore difficult to avoid
judgments about economic method. The hallmark of modern economic inquiry in
the first decades of this millennium is its mathematical character, which has
invaded virtually all areas of modern microeconomic or macroeconomic theory,
including the subfields of labor, public finance, and antitrust and government regu-
lation, to name a few. Contemporary macroeconomic model building and forecast-
ing of national income and employment would be inconceivable without such tools.
Courses in mathematics and econometrics form the basis of most (not all) graduate
curricula at major and minor universities around the world. It is legitimate to ask
whether creativity and originality take a backseat in the wake of widespread use of
this tool to express and develop modern economic ideas.
A meaningful evaluation must rest on the costs and benefits, the advantages
and shortcomings, of this development as it relates to a concept of progress in eco-
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Chapter 28 ■ Quo Vadis? 705

nomics. The chief argument for continued formalization and mathematization of

economics is that the discipline cannot become truly scientific unless and until it
attains the rigor and complexity of science—in other words, until its fundamental
propositions have been tested and proven. The contemporary consensus (however
loose) is that theory without verification (at least potential verification) is of limited
usefulness and that facts without theory forged in the logic of mathematics are
meaningless. Many “mainstream” economists argue, therefore, that increased
respect for economics as a separate, scientific discipline will only come about by the
steady application of rigorous mathematical and statistical tools.
Some economists (including a few who have been the most ardent practitioners
of the mathematical method) have voiced strong reservations about this view. They
argue that the nature of social science makes exact formulation and verification
impossible. The power of econometrics to predict, and mathematics to illuminate, is
the overarching issue. Some of the central problems of contemporary econometrics
relate to inexact or incomplete formalizations of economic theory and to various
inadequacies in data samples and in the random errors inherent in the measure-
ment of social variables. Modern econometric techniques are, generally speaking,
most appropriate when data samples are large; yet, in many instances, large-sample
data sets simply do not exist. Thus, the quantities and qualities of economic data are
often ill-suited to the task at hand. In contrast to conditions in the physical and nat-
ural sciences, the collection of most economic data is not predetermined or prede-
signed to fit various tests of economic theory. Indeed, much economic data is
collected by government agencies for less-specific purposes, often for purely politi-
cal reasons. While inadequate theory and poor data are not sufficient reasons in
themselves to reject quantitative methods, some critics argue that the design costs
and the collection costs required to secure high-quality data are prohibitive. More-
over, many economists are neither trained nor disposed to generate data that would
be more suitable to the solution of compelling problems. Many econometricians are
consumers (of data) rather than producers.
Some critics of contemporary economic method, especially those of institution-
alist or neo-Austrian persuasion (chapter 23), argue that the attempt to make eco-
nomics a science through mathematical formalization and empirical verification is
illusory. In their opinion, the actual return to decades-long intellectual investment in
mathematical and statistical techniques has been small, if not negative. According
to this argument, these futile attempts to make economics scientific have spawned
widespread distrust of the economic pronouncements of policy makers and an
almost total breakdown in communication between economists and other social sci-
entists. Even worse, mathematics and calculation techniques in the hands of those
equipped with tools but not ideas may lead economists away from basic truths
about markets and market functioning. In this view, mathematics inevitably diverts
attention away from the fundamental truths of the economic process originally for-
mulated by Adam Smith and refined by a host of other writers considered in this
book. At age 102, Nobel laureate Ronald Coase may be in a unique experiential
position to assess the present state of economics. Coase spins a cautionary tale:
Economics as currently presented in textbooks and taught in the classroom does
not have much to do with business management, and still less with entrepreneur-
ship. The degree to which economics is isolated from the ordinary business of life
is extraordinary and unfortunate. That was not the case in the past.
[But] in the 20th century, economics consolidated as a profession; economists
could afford to write exclusively for one another. At the same time, the field experi-
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706 Part VI ■ Back to the Future

enced a paradigm shift, gradually identifying itself as a theoretical approach of

economization and giving up the real-world economy as its subject matter. . . . The
tools used by economists to analyze business firms are too abstract and specula-
tive to offer any guidance to entrepreneurs and managers in their constant strug-
gle to bring novel products to consumers at low cost.
This separation of economics from the working economy has severely damaged
both the business community and the academic discipline. Since economics offers
little in the way of practical insight, managers and entrepreneurs depend on their
own business acumen, personal judgment, and rules of thumb in making deci-
sions. In times of crisis, when business leaders lose their self-confidence, they
often look to political power to fill the void. Government is increasingly seen as the
ultimate solution to tough economic problems, from innovation to employment.
Economics thus becomes a convenient instrument the state uses to manage the
economy, rather than a tool the public turns to for enlightenment about how the
economy operates. (“Saving Economics from the Economists”)

Another critical issue with respect to economic method may be identified in the
oversimplified questions: What is contemporary economics and by what adjective
should it be identified? Developments in late twentieth- and early twenty-first-cen-
tury economics, such as those discussed in the latter chapters of this book, have had
profound effects on both the study and the directions of the discipline. Neoclassical
economics is, at least approximately, what the entering university student learns in
his or her first courses and even later in the undergraduate curriculum. These ideas
are embodied in the rationality assumptions within consumption and production
theory, the assumption of perfect information among participants, and the mechan-
ics of equilibrium theory. But given the programs of study at most universities
around the world, and the current requirements of the discipline, the student aspir-
ing to professional status would be well served by the equivalent of a university
undergraduate degree in mathematics. Advanced classes introduce a variety of
technical models—many of which discard the abstract assumptions of mid-twenti-
eth-century neoclassical economics, such as perfect information, rationality, open
competition, and so on. Game theory, by its very nature, deals with a small number
of rivals, for example, not the large numbers of buyers and sellers assumed in
purely competitive markets. Is this “modern” or “contemporary” neoclassical eco-
nomics, or is it merely ad hoc learning—i.e., a “cafeteria” approach to questions
dealing with economic reasoning?

■ IS SCHISM IN THE CARDS FOR ECONOMICS?

Economics may well be at a crossroads of sorts. Will encroaching technical
refinement become the essence of economics? Alternatively, will economics become
merely another mathematics problem? Or will the ever-present demands for policy
analysis—economics in the service of society, if you will—prevent a complete
descent into barrenness? The answer to both questions may well be yes!
There is a persistent danger that highly technical but sterile analysis tends to be
self-perpetuating. Despite the perceived failure of esoteric lines of inquiry to achieve
much progress, those who have made heavy human capital investments in mathe-
matical and econometric techniques have a strong incentive to perpetuate the “mys-
tique of the cognoscenti.” Moreover, the formalization of economics too often raises
entry barriers in academics, whereby graduate curriculum requirements, university
hiring standards, journal editorial policies, and professional recognition hinge on
Ekelund-Hebert 6E.book Page 707 Thursday, August 1, 2013 11:03 AM

Chapter 28 ■ Quo Vadis? 707

the mastery and application of mathematical and empirical techniques. Some

observers believe that the cultivation of technique for technique’s sake has fostered
an environment wherein intellectual fads readily come and go. The shelf life of such
fads is often notoriously short. As soon as today’s new technique fails to live up to
the unrealistic expectations placed on it, it falls out of favor, only to grease the skids
for a new fad to replace it. Economists who indulge in the latest fad run the risk of
becoming obsolete, and quickly so. Worse yet, the ongoing process tends to drive a
wedge between those who regard economics as a powerful, though somewhat
imprecise, behavioral science, and those who regard the discipline as a branch of
applied mathematics. Some skeptics believe the very survival of economics will ulti-
mately require a formal split between the “economists” and the “mathematicians.”
Recognition of these problems as they relate to the development of creative
ideas in the discipline of economics appears to be increasing. Some years back,
there was evidence of a slowdown in the production of formal mathematical articles
that abound in contemporary economics literature.5 Genuine understanding of the
correct and useful place in economic science of mathematic and econometric tech-
niques is based on an awareness and appreciation of the limits of mere technique.
So long as these limits are understood (and respected), the value of mathematics
and econometrics in formulating and testing certain economic ideas is potentially
great. The choice should not be between “poetry” and “advanced mathematics.” The
trick is to forge ideas with meaningful economic content on the one hand and to
avoid shunning economic problems merely because they are not easily amenable to
mathematical manipulation on the other. If economic science as applied mathemat-
ics becomes unable to address and provide at least tentative answers to perpetual
economic policy questions, it will most likely lead to cleavage between political
economy and economics as a mathematical science. Whether this will happen can-
not be predicted at this time, but a schism within the profession is a real possibility.
There is no cleavage, however, between the progress of economics as a science
of scarcity and welfare maximization and the progress of the “hard sciences.” Nota-
bly there have been three great revolutions in the progress of humankind: the Agri-
cultural Revolution of about 10,000 years ago, the Industrial Revolution that
burgeoned in the seventeenth and eighteenth centuries and has been ongoing ever
since, and the digital/biological/atomic revolution that began in the last century and
continues into the present. Individuals and societies adapt to such cataclysmic
changes. We are on the threshold of the latest revolution, which recognizes time as
a vital resource. Consider what resource savings have been produced by digital and
satellite communications that make available massive quantities of (global) infor-
mation at our fingertips. Where will it ultimately lead? In the future, cars may “drive
themselves,” in the process generating more time savings and possibly reducing
transportation costs. Breakthroughs in medicine and medical technology will
invariably mean longer productive life spans. Robotics, artificial intelligence, and
the unlocking of the human genome will have critical impacts on products, markets,
and economic behavior (see Kaku, Physics of the Future). But economic markets
have evolved throughout history to deal with such dislocations and institutional
changes, and there is no reason to think they will not do so again, if not completely
stifled by unwise and improvident policy.
No science is perfect, and perfect truth, as Protagoras told us eons ago, is
always elusive, whether it is sought in physics, sociology, microbiology, meteorol-

5
See the interesting comments of mathematical economist and 1983 Nobel laureate Gerard Debreu
(“Mathematical Economics,” pp. 401–403).
Ekelund-Hebert 6E.book Page 708 Thursday, August 1, 2013 11:03 AM

708 Part VI ■ Back to the Future

ogy, or economics. Progress in economic ideas critically depends on the use and
application of many methods of science and on the progressive adaptation to both
large- and small-scale revolutions. It depends, in short, on the kind of methodologi-
cal pluralism that has been demonstrated in the broad expanse of economic inquiry
over time—the kind of pluralism that is perhaps best exemplified through study and
knowledge of the history of economic theory and method.

REFERENCES
Breit, William, and Barry Hirsch (eds.). Lives of the Laureates: Eighteen Nobel Econo-
mists, 4th ed. Cambridge, MA: The MIT Press, 2004.
Coase, Ronald. “Saving Economics from the Economists,” Harvard Business Review
(December 2012). http://hbr.org/2012/12/saving-economics-from-the-economists/ar/1.
Debreu, Gerard. “Mathematical Economics,” in J. Eatwell, M. Milgate, and P. Newman
(eds.), The New Palgrave: A Dictionary of Economics, vol. 3, pp. 399–404. London:
Macmillan, 1987.
Ekelund, Robert B., Jr., Robert F. Hébert, and Robert D. Tollison. The Marketplace of
Christianity. Cambridge, MA: The MIT Press, 2006.
Gans, Joshua S. and George B. Shepherd “How the Mighty Have Fallen: Rejected Classic
Articles by Leading Economists,” Journal of Economic Perspectives, vol. 8 (Winter
1994), pp. 165–180.
Jaffé, William. “A. N. Isnard: Progenitor of the Walrasian General Equilibrium Model,”
History of Political Economy, vol. 1 (Spring 1969), pp. 19–43.
Kaku, Michio. Physics of the Future: How Science will Shape Human Destiny and our
Daily Lives by the Year 2100. New York: Doubleday, 2012.
Kalt, J. P., and M. A. Zupan. “Capture and Ideology in the Economic Theory of Politics,”
American Economic Review, vol. 74 (June 1984), pp. 279–300.
Kau, J. B., and P. H. Rubin. “Self-Interest, Ideology and Log Rolling in Congressional Vot-
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Laband, David N. “Is There Value-Added from the Review Process in Economics? Pre-
liminary Evidence from Authors,” Quarterly Journal of Economics, vol. 103 (May
1990), pp. 341–352.
———., and Michael J. Piette. “Favoritism versus Search for God Papers: Empirical Evi-
dence Regard the Behavior of Journal Editors,” Journal of Political Economy, vol.
102 (1994), pp. 194–203.
———. “The Relative Impacts of Economics Journals: 1970–1990,” in Joshua S. Gans
(ed.), Publishing Economics: Analyses of the Academic Journal Market in Econom-
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———., and Robert D. Tollison. “Intellectual Collaboration,” Journal of Political Econ-
omy, vol. 108 (2000), pp. 632–662.
———. “Alphabetized Coauthorship,” Applied Economics, vol. 38 (2006), pp. 1649–1653.
Lott, John, and S. G. Bronars. “Time Series Evidence on Shirking in the U.S. House of
Representatives,” Public Choice, vol. 76 (1993), pp. 125–150.
Posner, Richard A. “A Theory of Primitive Society with Special Reference to Law,” Jour-
nal of Law and Economics, vol. 23 (1980), pp. 1–53.
———. Sex and Reason. Cambridge, MA: Harvard University Press, 1992.
———. The Economics of Justice. Cambridge, MA: Harvard University Press, 1981.
Smith, Vernon L. “The Primitive Hunter Culture, Pleistocene Extinction, and the Rise of
Agriculture,” Journal of Political Economy, vol. 83 (1975), pp. 727–756.
Stigler, George J. The Economist as Preacher and Other Essays. Chicago: University of
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———., Stephen M. Stigler, and Claire Friedland. “The Journals of Economics,” Journal
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Ekelund-Hebert 6E.book Page 709 Thursday, August 1, 2013 11:03 AM

Name Index

Akerlof, George, 660n Bernoulli, Daniel, 662n Chamberlin, E. H., 350, 498,
Alchian, Armen A., 657, Bertrand, Joseph, 314, 316, 510–517, 518n, 523
660n 317n, 508, 631 Chambers, Richard, 65
Alhazen, 25 Black, Duncan, 599, 599n Charles I (king of England),
Allen, R. G. D., 421, 626 Blaug, Mark, 4, 116, 223n, 62, 65
Allen, W. R., 442 26, 399, 407, 414n Chevalier, Michel, 380
Ambrose, Saint, 22 Bleiberg, Edward, 9 Cheysson, Émile, 330
Anderson, James, 157 Boccardo, Gerolamo, 461 Chung, Kuan, 23
Aquinas, Thomas, 29–32 Böhm-Bawerk, Eugen, 336, Clapham, J. H., 416n
Aristotle, 15–20 353, 354n, 355–358, Clark, John Bates, 383–384,
Arrow, Kenneth J., 444, 421, 533 385n, 389, 463
479n, 599, 599n, 638 Boisguilbert, Pierre le Clark, John Maurice, 388
Augustine, Saint, 22, 29 Pesant de, 72–73, 76–77 Cliffe-Leslie, T. E., 383, 478
Ault, R. W., 494 Boldizzoni, Francesco, 686 Coase, Ronald, 359, 407n,
Auspitz, Rudolph, 435 Bowen, Howard, 597, 597n, 419–420, 656–659, 676,
Averch, Harvey, 607 599, 599n, 600 705–706
Ayres, Clarence Edwin, 496, Buchanan, James M., 596, Colander, David, 637n
496n 596n, 597, 597n, Colson, Clément, 330
Azzi, Corry, 678 603–604, 704 Commons, John Rogers, 495
Buquoy, G. G. von, 458 Comte, Auguste, 184, 184n,
Bacon, Francis, 62 Buridan, Jean, 31–32 185–186, 477–478, 574
Bagehot, Walter, 476 Condillac, Étienne Bonnot
Bain, William Sims, 678 Cabarrús, Francisco de, 90, de Mably de, 88, 462
Barzel, Yoram, 660n 92–93 Confucius, 23
Basil, Saint, 22 Cairnes, John Elliot, 478 Copernicus, 96
Battalio, Raymond, 636 Calvin, John, 95 Cournot, Antoine-Augustin,
Bauer-Romazani, Christine, Campomanes, Pedro Rodri- 309–316, 435–437, 458,
196n guez de, 72, 90, 90n, 91, 461–462, 465, 467,
Baumol, William J., 56, 146, 91n 507–508, 516, 622–623,
175 Cantillon, Richard, 72–73, 625, 631
Baxter, Robert Dudley, 213, 77–83, 122, 125, 145, Courtois, Charlemagne, 329
215, 215n 449n, 577, 659 Crain, Mark, 612
Baysinger, Barry, 231n Carlyle, Thomas, 184n Creedy, John, 622
Beccaria, Cesare, 461, 622 Carroll, Lewis, 599 Crell, John, 32–33
Becker, Gary, 92, 146, 517, Celis, Manuel Rubin de, 90,
648–650, 672–673, 686 90n Dantzig, George, 627
Belpaire, Alphonse, 330 Chadwick, Edwin, 211–213, Darby, Michael, 653
Bentham, Jeremy, 137–140, 220, 221n, 222–224, Darwin, Charles, 20, 477
148–151, 203, 216 225–226, 238–251, 612 Davenant, Charles, 52,
Bentham, Samuel, 150 Chalk, Alfred F., 20n, 52 622n, 638

709
Ekelund-Hebert 6E.book Page 710 Thursday, August 1, 2013 11:03 AM

710 ■ Name Index

Davis, J. Ronnie, 529 Galbraith, John Kenneth, Hotelling, Harold, 599n,

Debreu, Gerard, 621 497–500 642, 642n
Demsetz, Harold, 612, 657, Galiani, Ferdinando, 88, 460 Hsun-tzu, 23
660n Galileo, 96–97 Hufeland, Gottlieb, 359, 458
DeQuincey, Thomas, 164 Garnier, Germain, 458 Hume, David, 50, 53, 115,
Diamond, Jared, 682, 682n, Genovesi, Antonio, 461–462 136, 144–145
683 George, Henry, 203n, 349n Hus, John, 96
Dickens, Charles, 168 Ghazali, Abu Hamid al, 25, Huskisson, William, 146
Dickinson, H. D., 586 25n, 26–27 Hutchison, T. W., 340, 383n
DiLorenzo, Thomas, 670 Ghazanfar, S. M., 25n
Dodgson, C. L., 599n Gladstone, William, 231 Iannaccone, Lawrence,
Duns Scotus, John, 31–32 Gomperz, Theodor, 9 678–679
Dupuit, Arsène-Jules- Gossen, Hermann Heinrich, Ingram, John Kells, 477–478,
Étienne Juvenal, 338–339, 458, 461–462, 480
316–318, 372, 435, 465 Islahi, A. A., 25n
461–462, 465, 465n, Gournay, Vincent, 84 Isnard, A. N., 458, 622, 704
466, 466n, 467–468, Gray, Alexander, 109
640 Greeley, Andrew M., 678 Jackson, John D., 675
Durkheim, Émile, 678 Greenhut, Melvin L., 337–338 Jaffé, William, 438, 444, 446,
Groenewegen, Peter, 448, 571
Easterlin, Richard, 665 463–464 James I (king of England),
Edgeworth, Francis Ysidro, Gutenberg, Johann, 97 62–63
314, 316, 317n, 433n, Jenkin, Fleeming, 330, 371,
435, 464, 508, 626, Haavelmo, Trygve, 642n 378
626n, 631–632, 636n Haberler, Gottfried, 572 Jerome, Saint, 22
Ehrenberg, Ronald G., Hales, John, 51–52 Jevons, William Stanley,
678–679 Halévy, Elie, 150 273, 354n, 367–368,
Ekelund, Robert B., Jr., 35, Haney, Lewis, 84 369–376, 377–379,
199n, 462, 467, 494, Han-fei-tzu, 23–24 380–383, 435, 444, 449,
675, 680 Hansen, Alvin H., 529 449n, 454, 639
Elizabeth I (queen of Eng- Hanssen, Georg, 339n John Chrysostom, Saint, 22
land), 57, 60–62 Harrod, R. F., 532 Johnson, Leland L., 607
Ellet, Charles, Jr., 330, 461, Hawtrey, R. G., 532 Jones, Richard, 476
463, 639 Hayek, Friedrich A., 492, Jovellanos, Melchor de,
Ely, Richard T., 273, 480 572, 574, 578–579, 90–91
Engels, Friedrich, 285, 297 587–588
Hébert, Robert F., 35, 443, Kagel, John, 636
Farr, William, 214 462, 467 Kahn, Richard, 532
Ferguson, C. E., 447n Heckscher, Eli, 48, 58–59 Kahneman, Daniel, 661–662,
Ferrara, Francesco, 461 Hegel, Georg, 286 663–664
Feuerbach, Ludwig, 286 Henry of Friemar, 31 Kalt, Joseph, 606n
Fisher, Irving, 421, 433n, Heraclitus, 19 Kantorovich, Leonid, 642n
553–555 Hermann, Friedrich, Karni, Edi, 653
Fourier, Charles, 269–270 359–360, 458, 463 Keynes, John Maynard,
Foxwell, Herbert, 370, 395 Hessen, Robert, 21n 144–145, 369, 379,
Franklin, Benjamin, 95 Hicks, John R., 410, 421, 528–531, 532n, 546,
Frey, Bruno, 666 444, 529, 626–627 559n, 564
Friedland, Claire, 607 Hildebrand, Bruno, 96, 275 Keynes, John Neville, 479
Friedman, David, 30 Hobbes, Thomas, 111 Khaldun, Ibn, 27, 27n
Friedman, Milton, 442n, Holcombe, Randall G., 596n, King, Gregory, 638–649
540n, 558, 559n, 601, 605 Kirzner, Israel, 572,
560–563, 564, 564n, 565 Hollander, Jacob, 383 585–586
Frisch, Ragnar, 642, 642n Horner, Francis, 146 Knatchbull, Edward, 216
Fuoco, Francesco, 461 Hornick, Philipp Wilhelm Knies, Karl, 275, 339, 346,
Furniss, Edgar, 52–53 von, 47 383, 458
Ekelund-Hebert 6E.book Page 711 Thursday, August 1, 2013 11:03 AM

Name Index ■ 711

Knight, Frank, 340, 388–389, 421–426, 427–428, Nelson, Phillip, 653

407n, 517, 521–522, 434–439, 440–442, Newman, Peter, 442n, 626n
658–660 443–446, 439–441, 445, Niehans, Jurg, 464
Koopmans, Tjalling, 642n 454, 463–468, 479, 508, Niskanen, William A., Jr.,
Kröncke, Claus, 456 530, 571, 596, 626, 604
Kuhn, Thomas, 544 639–640, 648 Nördling, Wilhelm von, 330
Kuznets, Simon, 642 Martineau, Harriet, 167–168, North, Douglass, 494
475 North, Dudley, 52
Laband, David N., 699–700 Marx, Karl, 87, 284–285,
Lachmann, Ludwig, 572 286n, 287–302, 490, 493 Odonis, Gerald, 32–33
Lancaster, Kelvin, 385, 655 Mason, E. G., 517 Olavide, Pablo de, 90
Lange, Oskar, 586–587 Maurice, Charles, 627n Oresme, Nicole, 17
Langholm, Odd, 31 Maurice, S. C., 421n Owen, Robert, 222, 268–269
Lardner, Dionysius, 330, McCormick, Robert E., 605,
370–371, 455–456, 462 612 Pantaleoni, Maffeo, 435
Launhardt, Wilhelm, 330 McCulloch, John Ramsay, Pareto, Vilfredo, 433n,
Law, John, 53, 145 164, 220, 222, 475 445–449
Leibenstein, Harvey, 487 Meade, James, 642 Patinkin, Don, 444, 545, 556,
Leijonhufvud, Axel, 529n Meek, Ronald, 88 558
Leontief, Wassily, 274n, Mei, Jianping, 675 Peltzman, Sam, 606n,
628–629, 642 Meldrum, John, 63 610–612, 685
Lerner, Abba, 587 Ménard, Claude, 465 Pesciarelli, Enzo, 127, 149,
Levi, Leone, 213, 213n Mencius, 23 149n
Lieben, Richard, 435 Mencken, H. L., 494n, 564n Peto, Morton, 215, 235
Lindahl, Erik, 596, 601–602 Mendel, Gregor, 467 Petty, William, 48, 72–75,
List, Friedrich, 265–267 Menger, Carl, 336, 340–341, 115, 622n
Llombart, Vicent, 90, 90n 342–345, 454, 571–572 Phillips, A. W., 561, 561n
Lloyd, William Forster, 455 Mill, James, 164, 183, 475 Piette, Michael J., 699
Locke, John, 52, 85 Mill, John Stuart, 108n, 147, Pigou, A. C., 326, 407n, 416n,
Longfield, Mountifort, 455 183–208, 212, 215n, 418, 421, 508–510, 518,
Louis XIV (king of France), 217, 221–222, 226, 520, 532–533, 545, 596
84 232–237, 425, 449, 455, Plato, 12–14, 20, 686
Louis XV (king of France), 445n, 466n, 477–478 Plott, Charles, 636
84 Minard, Charles, 458 Posner, Richard A., 608n,
Lowry, S. Todd, 15 Minard, Joseph, 329 682n, 597n
Lucas, Robert, 565 Mischler, Peter, 458 Protagoras, 14–15
Luther, Martin, 94, 681 Mises, Ludwig von, 572, Proudhon, Pierre Joseph,
575–578, 586–588, 604 270–273
Machlup, Fritz, 518n, 572 Misselden, Edward, 49–50
Magnus, Albertus, 29 Mitchell, Wesley Clair, 275, Quesnay, François, 84–87,
Malthus, Thomas Robert, 480, 495–496 629n
140–144, 157–159, Mo Ti, 24
164–167, 174, 222, 263 Mokyr, Joel, 232n Rae, John, 486n
Malynes, Gerard de, 49 Moore, Henry L., 642 Rau, Karl, 458
Mandeville, Bernard de, 52, Morgenstern, Oskar, 317, Redlich, Fritz, 169
65, 65n, 66, 220, 221n, 572, 634–635 Renneboog, Luc, 675
486n Morishima, Michio, 446 Ricardo, David, 124, 146–147,
Mangoldt, Hans Karl Emil Morris, Richard B., 64n 156–175, 385–386, 475
von, 330, 339–340, Moses, Michael, 675 Riedel, Adolph, 359
360–361, 425, 458 Mueller, Dennis C., 605n Robertson, Dennis H., 416n,
Markowitz, Harry, 642 Murray, James M., 81 531, 541
Marshall, Alfred, 31, 33, Musgrave, Richard A., 597n Robinson, Joan, 326, 508,
117, 188–189, 204, 516–521, 521n, 523
321–322, 329, 340, 361, Navier, Henri, 329 Rogers, James E. Thorold,
378, 394–408, 409–420, Nef, John, 62 381
Ekelund-Hebert 6E.book Page 712 Thursday, August 1, 2013 11:03 AM

712 ■ Name Index

Roll, Eric, 475 Snow, John, 213, 213n Valeriani, Luigi, 461
Roover, Raymond de, 35n Socrates, 11 Veblen, Thorstein Bunde,
Roscher, Wilhelm, 341n, 458 Solow, Robert, 627, 642n 20, 480, 481n, 482–487,
Rosenstein-Rodan, Paul, Soward, Alfred, 235 487n, 488–490, 490n,
572 Spaenjers, Christophe, 675 491, 491n, 492–494,
Rossi, Pellegrino, 461 Spencer, Herbert, 476–477 572, 664
Rothbard, Murray, 572, 577 Spengler, Joseph, 126 Verri, Pietro, 461
Spilman, John, 62 Viner, Jacob, 330, 403, 405n
Saint-Simon, Henri de, Sraffa, Piero, 508, 510 Von Neumann, John, 627,
259–262, 572 Stark, Rodney, 678 634–635, 704
Samuelson, Paul A., 544, Stigler, George J., 187, 352n, Von Thünen, Johann Hein-
597–599, 626–627 353, 424, 455, 517, 607, rich, 330, 337–338,
Say, Jean-Baptiste, 121, 166, 609–610, 648, 650n, 359–360, 458, 462–464
169, 202–203, 359, 445, 651, 685, 697, 701n,
445n, 458, 461 702–703 Walker, Donald, 446
Schäffle, Albert, 458 Stigler, Stephen M., 639 Walker, Francis A., 199, 445,
Schmoller, Gustav, 275–276, Stone, Richard, 642 480
341 Strachey, Lytton, 530 Walras, Léon, 339, 378,
Schoenberg, Arnold, 701 Street, Don, 90n, 91 382–383, 394, 433–450,
Schulz, Henry, 642 Streissler, Erich, 462–463 454, 558
Schumpeter, Joseph A., 20, Strom, Robert, 56 Weber, Max, 94–96, 678
126–127, 203, 224n, Stuart, Charles Edward West, Edward, 157
276, 353, 360, 362, 426, (prince of England), 97 Whewell, William, 455, 462,
446, 461, 543, 544n, Sutton, John, 464, 639n 622
571–572, 579–583, 613 Swithenbank, B. W., 530 White, Harry Dexter, 532
Schüz, C. W. C., 458 Wicksell, Knut, 357n, 385,
Schwartz, Anna, 563 Tamayo, Rufino, 677 433, 555–558, 596,
Seligman, E. R. A., 480 Taussig, Frank W., 198, 602–603
Senior, Nassau, 33, 169–174, 508–510 Wicksteed, Philip H., 10,
218, 358 Tavernier, René, 330 385, 433n
Shackle, G. L. S., 446, 572 Thaler, Richard, 662n Wieser, Friedrich von, 336,
Shaw, George Bernard, 164 Thornton, Henry, 146–148 346–352, 352n, 353,
Shepherd, George, 699 Thornton, William T., 146, 361–362, 483, 627
Sidgwick, Henry, 418 199, 371 Willan, W. E., 235
Simons, Henry, 607n Tiebout, Charles M., 602n Williamson, Olivier, 37
Sismondi, Simonde de, Tollison, Robert, 35, 231n, Wolfson, Murray, 293
262–265 605, 680
Skinner, Sarah J., 675 Tooke, Thomas, 555 Xenophon, 10–11
Smith, Adam, 11, 52, 60, 84, Toynbee, Arnold, 478
88, 107–136, 148–149, Tucker, A. W., 632 Young, Arthur, 52
160, 185, 191, 220, 373, Tullock, Gordon, 603, 603n, Yule, G. U., 642
678–679 604–605, 608, 612
Smith, Vernon, 636 Tversky, Amos, 661–662, Zeno, 20
Smithson, Charles, 627n 664 Zupan, Mark, 606n
Ekelund-Hebert 6E.book Page 713 Thursday, August 1, 2013 11:03 AM

Subject Index

Acculturation principle, Algebra/linear systems, critique of socialism,

665–666 625–629 586–588
Adaptive expectations the- Alienation, 286, 290–291, differences from main-
ory, 560 294, 299 stream neoclassical
Advertising Alternative costs, doctrine economics, 574–575
Austrian insights into, of, 190 gestalt of, 572–575
585 Althorp’s Act, 217–218 Hayek’s theory of busi-
demand discovery and, American Economic Associ- ness cycles, 578–579
585–586 ation, 273 Marshallian vs., 574–575
economic impact on American institutionalism, Mises’s theory of money
underdeveloped coun- Veblen’s, 479–493 and credit, 575–578
tries, 512n Ancient Greek economics, Schumpeter on competi-
as means of product dif- 9–20 tion, dynamics and
ferentiation, 511–512 Antinomy of value, Wieser growth, 579–583
as modus operandi of on, 347–348 Authority
Arab-Islamic economics, Chadwick on, 247,
monopolistic competi-
250–251
tion, 512 24–27
Friedman on, 563–564
provision of information Archeology and economics,
Plato on, 14
through, 651–653 681–683
Proudhon’s rejection of,
statistical evidence for Aristotle
270–272
relationship between on money and interest,
Scholasticism and, 28
concentration and, 641 18–19
Averch–Johnson effect, 607
Affluent Society, The (Gal- on nature of the polity, 16 Azzi–Ehrenberg model of
braith), 499 on the nature of trade, religious participation,
Aggregate demand 16–18 678–679
Chamberlin on, 512 on two-party exchange,
Henry of Friemar as pre- 15–18 Backward induction, princi-
cursor of, 31 Art market, practical eco- ple of, 635
Keynes on, 534–537, 539, nomic questions in, Backward-bending supply,
542–543 675–677 Walras vs. Marshall on,
Malthus on, 166 Artificial identity of inter- 442–443
Mill on, 186 ests, 137, 238–239, 246. Barter, Aristotle on
Robinson on, 519 See also Utilitarianism/ exchange by, 16
Veblen on, 486, 490 utility theory Becker, Gary
Wicksell on, 555 Austrian economics on family as form of eco-
Aggregate equilibrium, Sis- advertising and demand nomic organization,
mondi’s theory of, 262 discovery in, 585–586 672
Agriculture, primacy/pro- competition and the mar- on marriage as eco-
ductivity of, 85–86 ket process, 583–585 nomic contract, 673

713
Ekelund-Hebert 6E.book Page 714 Thursday, August 1, 2013 11:03 AM

714 ■ Subject Index

on theory of household Marx vs. Veblen on, 490 religion and, 95

production, 649–650 Schumpeter on, 582–583 Schumpeter on, 543
Behavioral economics, 664, Veblen’s theory, 489–491 Sismondi on, 263–264
667, 669 utopian socialist critique
Benefit-cost analysis, Calculus, 624–625 of, 267
Dupuit on, 327–329 Calculus of Consent, The Veblen on, 485, 488–492
Bentham, Jeremy (Buchanan & Tullock), Weber’s thesis on, 94–96
critique of, 139–140 603 Capitalist motion, Marxist
on entrepreneurism, Cambridge Equation, 540, laws of, 297–300
148–151 557–558 “Capture” theory of regula-
felicific calculus of, Cantillon, Richard tion, 490, 609–610
138–139 on competition and Causal sequence, Veblen on,
influence on Chadwick, entrepreneurship, 483–484
238 80–82 Causal-geneticism, 573–574
on inheritance tax, 234 on effect of money on Central planning, Smith on
rejection of natural law, prices and production, futility of, 109
234, 234n 82–83 Ceremony and technology,
theory of morals and leg- integration of monetary interaction of, 484–485
islation, 137–138 theory with value the- Ceteris paribus assump-
utilitarianism of, 137–140 ory, 83 tions, 83, 188, 398–401,
on welfare, 138–139 on market system, 79–80 403, 408–410, 421,
Birthrate, in developed vs. Capital 434–435, 464, 466n,
underdeveloped coun- accumulation, classical 541, 677
tries, 674
theory of. See Wages- Chadwick, Edwin
Bloomsbury group, 530
fund theory/doctrine on artificial identity of
Böhm-Bawerk, Eugen
Böhm-Bawerk on, interests, 238–239
biographical information,
356–358 Bentham’s influence on,
353–354
human. See Human capi- 238
capital theory of, 356–358
tal biographical information,
on contract management,
Iannaccone on religion 238
150–151
as, 679 on centralized control
on interest rate, 357–358
Keynes on marginal effi- and institutional
on production, 357
on subjective value and ciency of, 536 forms of competition,
exchange, 354–356 Marshall on, 424–427 247, 249
British 19th-century histori- Marx on, 294 on the common-pool
cism Ricardo on, 161 problem, 239
Bagehot, Spencer, and Senior on, 173–174, 218 on contract management,
Darwin, 476–477 Smith on, 129–130 249–251
Comte, Ingram, and Capital (Marx), 285, on economics of crime,
Cliffe-Leslie, 477–478 289–291 courts, and police,
impact of, 479 Capitalism, Socialism, and 239–242
Bubonic plague/black death, Democracy (Schum- on economics of justice,
98 peter), 581 241–242
Bullion Report of 1810, Capitalism on environmental con-
146–147 communism replacing, straints, 243
Bureaucracy and Represen- 300–301 institutional reforms
tative Government (Nis- Fourier’s criticism of, 270 through incentive
kanen), 604 impact of medieval sci- manipulation, 239
Burial insurance, infanti- ence on emergence of, on insurance and infanti-
cide, and moral hazard, 96–97 cide as moral hazard,
244–245 Martineau on, 168 244–245
Business cycle(s) Marx on, 290, 292–300 on police effectiveness,
Hayek’s theory, 578–579 Petty on, 73–75 240–241
impact of mechanization popular exceptions to political economy of,
on, 224 laissez-faire in, 196 238–251
Ekelund-Hebert 6E.book Page 715 Thursday, August 1, 2013 11:03 AM

Subject Index ■ 715

preventive principle of, Clark, John Bates Collapse: How Societies

239–240 biographical information, Choose to Fail or Suc-
on provision of suitable 383 ceed (Diamond), 682n
housing for the poor, on entrepreneurship, Collective action/collective
246 388–389 choice, 603n
on public goods and evaluation of, 388 Collusion/collusive agree-
institutional forms of Jacob Hollander on, 384 ments, 632, 635–636
competition, 247–251 marginal-productivity Commodities
rejection of mercantilist theory of distribution, Marx on, 293, 296
attitude toward the 385–388 Petty on, 74
poor, 220–221 on marginal-utility the- Ricardo on, 160–162
sanitation reform cam- ory of value, 384–385 Smith on, 115–118
paign of, 242–245 statics and dynamics the- Common property, prob-
Chamberlin, E. H. ory, 384, 389 lems of, 239–241,
demand curves of, 513 Class structure 681–683
evaluation/critique of, Chadwick on, 225 Communism, Marx’s vision
515 Marx on polarization in, of, 300–301
on industrial organiza- 294, 299 Communist Manifesto, The
tion, 517 mercantilist view (“util- (Marx), 300–301
theory of monopolistic ity of poverty”), 52–53 Competition
competition, 508, 510, nineteenth-century, Austrian economists’
515–516 212–213, 220 view of, 583–585
Change paternalistic view of, 221 Cantillon on, 80–82
dynamic vs. static view population estimates by Chadwick on, 247–251
of, 19–20 class (1867), 215 Chamberlin on, 508–517
economic, and future of Classical economics, 105–208 Clark on, 386
capitalism, 488–492 Bentham’s utilitarian- imperfect. See Imperfect
Characteristics, demand for, ism, 137–140 competition
654–655 elegant dynamics of, Kirzner on, 586
“Chicago” school of 175–177 Marx on, 290
thought, 648 generators of trade and Mill on, 190
Gary Becker, 649, 697 value in, 148–151 monopolistic. See
George Stigler, 651, List’s critique of, 267 Monopolistic competi-
696–697, 701n, 702 macroeconomic perspec- tion.
Child labor/female labor, tive of mechaniza- Pareto on, 448
217–219 tion’s impact on labor, perfect, 408, 515–516,
Children, Becker on cost of 222–223 583–585
raising, 674 Malthus’s population Proudhon on, 272
Chinese economics, 22–24 principle, 140–144 Schumpeter on, 579–580,
Christianity marketing, 167–168 613
economic impact of, 22, Mill’s, 183–204 Smith on, 111
35–38. See also money/monetary issues, Taussig–Pigou contro-
Roman Catholic 144–148 versy over railway
Church “real world” of, 212–213 rates, 508–510
impact on emerging capi- Ricardian system, welfare theory and, 448
talism, 96 156–177 Wieser on, 350
industrial organization Sismondi’s critique of, Competitive equilibrium,
approach to, 680 264–265 190, 422, 401–403, 408,
Circular flow, physiocratic Thornton’s, 147–148 444, 446, 466, 483, 508,
concept of, 85–86 Classical rent theory. See 514, 584, 659
Cities, growth as trading Land rent; Rents/rent Competitive monopoly. See
centers, 113 seeking Monopolistic competi-
City of God, The (Augus- Coal Question, The tion
tine), 22 (Jevons), 368 Confucian economic
Civilization, Fourier on, 269 Cobweb theorem, 443, 443n thought, 23
Ekelund-Hebert 6E.book Page 716 Thursday, August 1, 2013 11:03 AM

716 ■ Subject Index

Conspicuous consumption, Senior on, 171–172 Ricardo vs. Malthus on,

485, 486n, 487, 487n, Smith on, 119 165
488, 499, 661, 665 Countervailing power, Gal- utility-maximization
Conspicuous leisure, 485, 487 braith on, 497–498 approach to, 661
Constrained optimization, Cournot, Antoine-Augustin Veblen on, 487–488
625 biographical information, Walras on, 435
Consumer behavior theory, 309–310 Demand curves
625 duopoly analysis, community, for a public
Consumer demand, utility- 314–316, 507–510 good, 598
maximization approach economic method, effectual demand and,
to, 661 310–312 117
Consumer surplus, 322, evaluation of, 316 joint supply and, 189
324–326, 409, 411–413, game theory, 317 monopolistic competi-
461 law of sales, 311 tion and, 512–515
Consumer/consumption monopoly model, 312–314 price discrimination and,
technology theory theory of the firm, 319 520–521
economics of informa- Credence goods, 653–654 Demand elasticity
tion and, 651–654 Crime prevention, Chad- Chamberlin on, 512–513
household as factory, wick on, 239–242 Marshall on, 420–423
649–650 Crises and depressions, law Smith on, 117, 508
innovations in demand of, 299–300 Demand management,
theory, 654–655 Cross-elasticity, Marshall Keynes’s macroeco-
Consumption on, 420n nomic policy of, 564
conspicuous, 485–488 Crucible theory of entrepre- Demand regulation, and
Gossen on, 338 neurship, 224, 224n self-interest, 54
household, Becker on, Cult behavior and control of Demand theory/analysis
649–650 “free-rider” problem, Aquinas’s, 29
Keynes’s consumption 678–679 Chamberlin’s, 512–513
function, 535 Currency elasticity, Ricardo cost theory linked in
Mill on, 192–193 on, 147 principle with, 33
Pareto on, 447–448 Dupuit’s, 320–321
technology, modern the- Das Kapital (Marx), 285, Keynesian, 543
ory of, 649–655 289–291 Marshall on, 409–411
Veblen on, 486, 490 Dating and mating prac- Mill on, 187–188
Contract management tices, economics of, modern innovations in,
Bentham on, 150–151 672–673 654–655
Chadwick on, 249–250 Deduction vs. induction, of public goods, 597–600
Contribution to the Critique Marshall on, 464 proto-neoclassical per-
of Political Economy, A Defence of Usury (Ben- spective on, 461
(Marx), 285, 289, 291 tham), 149 Veblen’s, 488
Conversations on Political Demand Democracy
Economy (Marcet), 167 aggregate. See Aggregate Plato on, 13–14
Cooperative movement, 270 demand Protagoras on, 14
Coordination, market vs. analysis, time as neces- Depression/recession,
firm, 656–657 sary element in, 409 Veblen on, 489
Corn Laws controversy, Chamberlin on, 512–513 Derived factor-demand,
157–158, 164 Dupuit on, 319–322 421–423, 655
Corporations, modern doc- effectual, 166 Descriptive statistics,
trine of, 21, 21n excess, Walras on, 638–639
Cost(s)/cost theory 440–441 Development of the Laws of
demand theory linked in King–Davenant law of, Human Relationships
principle with, 33 638–639 and of Rules to Be
Marshall on, 400, Malthus on, 165, 167 Derived Therefrom for
404–407, 414–416 Marshall on, 400–403, Human Action (Gos-
Mill on, 190 409–413, 421–423 sen), 338
Ekelund-Hebert 6E.book Page 717 Thursday, August 1, 2013 11:03 AM

Subject Index ■ 717

Dialectical materialism, 287, on price theory applied to von Thünen’s, 337–338

293 public goods, 327–329 Wieser’s, 346–353
Differential pricing, increas- theory of price discrimi- Economic news, dissemina-
ing welfare through, nation, 324–326 tion of, 698–699
322, 324–325 Walras’s criticism of, 435 Economic rationality, 678,
Differential calculus, 625 684–685, 697
Diminishing returns, law of, Eclectic theory of profit, Economic science
187 Knight’s, 521 Dupuit and Marshall’s
Disequilibrium, 344, 350, École des Pontes et critique of, 639–640
441, 445, 580, 585, 587 Chaussées, 329 Marshall’s, 397–398, 463
Distribution Econometrics, 575, 638, 640, Veblen’s critique of,
Clark’s marginal produc- 642, 705 482–484
tivity theory of, Economic and Philosophic Economic societies, Spanish
384–388 Manuscripts of 1844 Enlightenment, 91
Marshall on, 423–424 (Marx), 289–290 Economic sociology in
Mill on laws of, 185–186 Economic Consequences of Enlightenment Spain,
See also Income distribu- the Peace, The 92–93
tion (Keynes), 531 Economics
Distribution of Wealth, The Economic method/theory aim, scope, and method
(Clark), 384–385 application of mathemat- of, 3–5
Diversification, Chadwick ics to economic ideas, analysis of religious
on, 225 626–642 behavior and, 678–681
Division of labor Böhm-Bawerk’s, 354–358 ancient/medieval thought
familial, 674 Clark’s, 384–388 and institutions, 9–39
Marx on, 287–288 Cournot’s, 310–312 archeology and, 681–683
Mill on, 191 critics of mathematical/ Austrian, 571–589
Mo Ti on, 24 empirical develop- classical, 105, 136–151,
Plato on, 12 ments in, 622 183–208
Smith on, 127–128 Gossen’s, 338–339 of dating and mating,
in theories of the firm, Jevons’s, 370–379 672–673
656 Keynes’s, 532–544 European evolutionary
Xenophon on, 10–12 List’s, 266–267 thought on, 259–267
Doctrinism, intellectual Mangoldt’s, 339–340 fame and notoriety in, 467
rigidity engendered by, Marshall’s, 397–427 history of, 1–3
703 mathematical/empirical Iberian, 89–93
Duopoly analysis, economics, 621–644 institutional, 475–501
Cournot’s, 314–316, Menger’s, 341–345 interest-group theory of,
507–510 Mill’s, 185–198, 232–237 219
Dupuit, Jules monetarist, 562–564 Marshall’s, 394–428
on benefit-cost analysis, new developments in mathematical/empirical,
328–329 microeconomics, 621–644
biographical information, 648–667 medieval Arab-Islamic,
316 Petty’s, 73–74 24–27
on consumer surplus, physiocratic, 84–87 neoclassical, 307,
monopoly, and price Proudhon’s 273 309–472, 454
discrimination, Ricardo vs. Malthus, new “technology” of,
322–324 164–166 697–700
economic method of, Roscher’s, 274–275 normative, 193–196
318–319 Schmoller’s, 275–276 origins/evolution of, 1–2
on entrepreneurship, Scholastic, 28–29 orthodox vs. heterodox, 2
326–327 Schumpeter’s, 543 physiocratic, 84–87
graphical analyses of, Senior’s, 170–171 politics and, 683, 686
325–326 Sismondi’s, 264–265 preclassical, 7–104
on marginal utility and Smith’s, 108–125 resurgence as a social
demand, 319–322 Veblen’s, 481–492 science, 671–687
Ekelund-Hebert 6E.book Page 718 Thursday, August 1, 2013 11:03 AM

718 ■ Subject Index

Roman/early Christian Dupuit’s, 465 Hermann and Riedel on,

contributions to, econometrics, 638, 642 359
21–22 Mandeville’s, 65–66 heterodoxy and, 276–277
scholastic, 28–35 medieval scientific Knight, Chamberlin, and
traditional, new push- method, 96 Robinson on, 388,
back against, 686–687 mercantilism derived 521–522
twentieth-century, from, 53 Mangoldt on, 360–361
473–614 Mill’s, 184–185 Marshall on, 424–427
twenty-first century, neoclassical theory, Mill on, 202–203
619–708 639–640 productive and unpro-
value of studying, 3 public-choice theory and, ductive, 55–57
Economics of Imperfect 604–606 Ricardo on, 169
Competition, The (Rob- Senior’s, 218 Riedel on, 359
inson), 516 See also Scientific eco- Schumpeter on, 203, 543,
Economics of Industry, The nomics 580–583
(Marshall), 395 Empirical public choice, Smith on, 125–127, 149
Economics of Welfare, The 604–606 von Thünen on, 359–360
(Pigou), 418 Engineering tradition, Walras on, 444–446
Economies of scale, Mill on, French, 329–330 Wieser on, 350
191 Engineers and the Price Sys- Environmental constraints,
Economist as Preacher, The tem, The (Veblen), 488 243, 245–246
(Stigler), 702–703 Engineers Environmental influences,
Education and cross-fertilization of impact on human char-
Chadwick, 243 economic ideas, acter, 220–222
Mandeville on ruination 329–330 Equality, ex ante vs. ex post,
of the poor and, 52–53 role in proto-neoclassi- 233
Mill on, 236 cal economics, 462 Equality of opportunity, 232,
mitigating poverty’s as saviors of capitalism, 235–236
effects through, 491–492 Equation of exchange,
224–226 Veblen on, 489 Fisher’s, 553–555
Spanish Enlightenment England Equilibrium, 587
reforms, 91–92 income distribution in, aggregate, Sismondi’s
Effective demand, 31–32 213 theory of, 262
Effectual demand, 117–120, Industrial Revolution’s Aristotle on, 17
166–167 impact on income dis- Austrian conception of,
Elasticity tribution in, 213–216 584
cross-elasticity, 420n mercantilism and inter- competitive, 190, 422,
currency, 147 nal regulation in, 401–403, 408, 444,
factor demand, 421–423 57–63 446, 466, 483, 508,
price elasticity, 26, Entrepreneurship/entrepre- 514, 584, 659
420–421, 462 neurism demand-and-supply,
Smith on, 117–118 Bentham vs. Smith on, Marshall on, 398
See also Demand Elastic- 148–151 Hayek on, 579
ity Cantillon on, 80–82 Lindahl, 601–602
Elements of Political Econ- Chadwick on, 224 long-run, 13, 402–403,
omy (Mill), 167 Clark on, 388–389 513–514
Elements of Pure Economics in contemporary society, Mill on, 191–192
(Walras), 444 57 monetary, 148, 554
Elizabethan Statute of Arti- crucible theory of, 224, partial. See Partial equi-
ficers, 58 224n librium
Empiricism/empirical eco- Dupuit on, 326–327 in scholastic economics,
nomics, 638–642 firm theory and, 29
Chadwick’s, 221, 224 658–660 Schumpeter on, 580
descriptive statistics and, in German and Austrian short-run, 399–401
638–639 economics, 359–362 Smith on, 118–119
Ekelund-Hebert 6E.book Page 719 Thursday, August 1, 2013 11:03 AM

Subject Index ■ 719

stationary-state, Malthus–Ricardo debate duopoly analysis,

176–177 on exchange value, 314–316
unemployment, 536, 164–165 Knight on, 658–660
538–539, 542 marginal rate of substitu- Lardner on, 455–456
wage differences, tion in, 447 Marshall’s, 399–403
122–123 Marx on, 292–294 newer, 655–661
Walras vs. Marshall on, Pareto on, 447 nexus of contracts the-
439–441 Plato’s theory of, 12 ory, 660n
See also Market equilib- principles of optimality Robinson’s contribution
rium in, 448 to, 518
Equilibrium price, Mill on, Proudhon on, 272–273 Smith on, 191
187 two-party, Aristotle’s the- Fiscal activism, 543
Equimarginal allocation, ory of, 15–18 Floods: An Examination of
principle of, 338 Excise and sumptuary the Means Proposed to
Equimarginal principle taxes, Mill on, 235–236 Prevent Their Return
Jevons’s, 373–375 Expectations, role in macro- (Dupuit), 318
Menger’s, 343–344 economic analysis, 557 Forced saving, Thornton’s
Essay on the Laws of Trade Experience goods vs. search doctrine of, 148
with Reference to the goods, 653 Foundations of Economic
Works of Internal Experimental economics, Analysis (Samuelson),
Improvement in the 636–638, 697 626
United States, An External/internal econo- France, proto-neoclassical
(Ellet), 461 mies, 405–407
economics in, 309–331
Externalities
European evolutionary Free riding, 237n, 668–679,
Coase on, 419–420
thought on economic/ 684–685
Marshall on, 417–419
historic development, Free trade
259–267 Boisguilbert on, 76
Factor demand elasticity,
Evolutionary economics vs. Campomanes on, 90–91
Marshall on, 421–423
mathematical formal- List on, 266
Factor substitution, 447–448,
ism, 637 physiocratic support of,
581
Ex post/ex ante investment, 87
Factor-price determination
167 Ricardo vs. Malthus on,
theory, 386, 388
Excess demand, Walras vs. Factors of production, Wal- 164
Marshall on, 440–441 ras’s, 444–445 Smith on, 113–114
Exchange Factory Acts, economic Spanish mercantilism
Aquinas on, 30 implications of, 218 and, 91
Aristotle on, 15–19 Fallacy of composition, 140 French engineering tradi-
Böhm-Bawerk on, Farmer’s Tour Through the tion, 329–330
354–356 East of England, The Futures markets, 443
classical representation (Young), 52
vs. Marxist represen- Female labor/child labor, as Galbraith, John Kenneth
tation of, 300 threat to adult male on countervailing power,
decline of mercantilism/ labor force, 219 497–498
dawn of capitalism Feudalism, 27–28, 113 critique of, 499–500
and, 97–98 Final degree of utility, institutional economics
Fisher’s equation of, Jevons’s theory of, of, 497–500
553–555 376n, 378, 435 on social imbalance, 499
Ghazali on, 26 Firm coordination vs. mar- Game theory, 630–638
gold as medium of, 18 ket coordination, 656 Cournot’s model, 631
history of, 2 Firm, theories of economic games, 633–636
isolated vs. market, Aris- Averch and Johnson on, Edgeworth’s model,
totle on, 15–16 607 631–632
Jevons’s theory of, Coase’s, 656–658 experimental economics
375–376, 378 Cournot’s monopoly and mathematics in,
Langholm on, 31 model, 312–314 636–638
Ekelund-Hebert 6E.book Page 720 Thursday, August 1, 2013 11:03 AM

720 ■ Subject Index

origins of, 317, 631–632 Heterodoxic thought Imputation

prisoner’s dilemma, 317, Condorcet’s historicism, Menger on, 344–345, 351
632–633 259 Wieser’s theory of,
General equilibrium theory/ entrepreneurism, 351–353
analysis 276–277 In Defense of the Corpora-
Marshall on, 435 German historicism, tion (Hessen), 21n
Pareto on, 446–448 273–276 Incentive manipulation,
Walras on, 434–436, 446, List, 265–267 institutional reforms
448, 571 Romanticism, 257–258 through, 239–245
General Theory of Employ- Saint-Simon, 259–262 Income
ment, Interest and Sismondi, 262–265 Marshall on, 410–411
Money, The (Keynes), utopian socialism, redistribution, Mill on,
529, 532–544 267–273 236–237
Generalized theory of rent. Historical determinism vs. Income distribution,
See Land rent; Rents/ utopian socialism, 214–215
rent seeking 284–302 Boisguilbert on, 76
German historicism, Historicism Industrial Revolution’s
274–276 British, nineteenth-cen- impact on, 213–216
German microeconomics, tury, 475–479 inequality among self-
336–362 Condorcet’s, 259 reporters, 213–215
German proto-neoclassi- German, 273–276 Mill on, 194–195, 217,
cists, 336–340 History, influence of ideas 233, 236–237
Gold, 18, 231, 380 on, 700–703 in nineteenth-century
Government Holy Inquisition, 90, 92–93, England, 211,
Ghazali on, 26–27 97 213–216
intervention, Mill on, 233 Household as factory, on no-rent land, 162–163
Mill on, 195–196, 237 649–650 Ricardo on, 162–163
nineteenth-century con- Human capital self-interest and, 54
straints on, 231 Becker on, 92 Smith on, 120
Owen on, 269 Chadwick on value of, Income redistribution
Saint-Simon on, 260–261 223–225, 243 Fourier on, 269
Graphical analysis/presenta- Friedman on, 559 Mill on, 233
tion investment of labor in, Mill’s position on,
Jenkin’s use of, 371 224–226 194–195
Jevons’s use of, 373–374 Marshall on, 424–425 Income tax, Mill on,
“Great contradiction” (of Spanish Enlightenment, 233–234
Marxist labor theory), 89, 91–93 Indigentia, 29–32
295 Human intellect, Comte on Individual choice, 573, 637,
Greeks, ancient, 9, 12–20 three stages of, 186 663
legacy to economic Human nature Induction vs. deduction,
thought, 19–20 Mill on, 197 Marshall on, 464
Plato, 12 Smith on, 111–112 Inductive method, Bacon’s,
Xenophon, 10–12 Veblen on, 481–482 73
Grumbling Hive The, or Industrial organization
Knaves Turn’d Honest Iberian economics, 89–93 Chamberlin on, 517
(Mandeville), 65 Ideas game theory and, 317
Grundrisse (Marx), 285–292 influence on history, integral calculus applied
700–703 to field of, 625
Happiness theory, 665–666 transmission of, 697–700 monopolistic competi-
Hedonic calculus, 10, 14–15, Imperfect competition, 508 tion as precursor of,
339 Chamberlin on, 510, 517 516
Hedonism, 11, 483 Joan Robinson on, Proudhon on, 271
Hegemony. See Authority 516–521 religion and, 679–681
Heterodox vs. orthodox eco- Sraffa on, 508 Industrial reserve army,
nomics, xi, 209–302 theory of, 408 Marx on growth of, 298
Ekelund-Hebert 6E.book Page 721 Thursday, August 1, 2013 11:03 AM

Subject Index ■ 721

Industrial Revolution/Indus- Information, economics of, Interest-group theory of

trialism 651–654 economics, 219
altered circumstances of Inheritance tax, Bentham, Internal/external econo-
labor and production Mill, and Smith on, mies, 405, 407
in, 227 234–235 Internet, spread of eco-
economic and social Innovation. See Entrepre- nomic information via,
problems resulting neurship/entrepreneur- 698
from, 211 ism Investment
as end of ancien régime, Input-output analysis, by capitalist-entrepre-
256 352–353, 588, 628–630, neurs. See Entrepre-
impact on wealth and 649 neurship
income levels in Eng- Inquiry into the Nature and Keynes on, 533–534,
land, 213 Causes of the Wealth of 536–538
negative impact on the Nations (Smith). See Malthus on, 167
working poor, 232 Wealth of Nations Marx on, 299
orthodox and heterodox Institutional economics Ricardo on, 169
responses to, 209–302 Galbraith’s, 497–500 Thornton on, 147–148
philosophy of limited Wieser on, 350 Invisible hand, Smith’s,
government required Institutional reforms, 109–111
by, 231 238–239, 246 Involuntary unemployment,
Romantics’ criticism of, Institutionalism, 473 Keynes on, 539
216, 258 American (Veblen’s), Islamic-Arabic economics,
Saint-Simon on, 259–262 479–493 24, 27
science of industrialism, Clarence Edwin Ayres, Isolated State, The (von
184 496 Thünen), 359–360
separation of owner-pro- Friedrich von Wieser, 350
ducers and managers John Kenneth Galbraith, Jevons, W. S.
in, 485 497–500 biographical information,
socialist/heterodox John Rogers Commons, 367–370
reformers, xvi 495 critique of, 377–379
technology’s impact on Thorstein Veblen, 664 economic method/theory
employment, 222 Wesley Clair Mitchell, 495 of, 370–379
urbanization and pov- Integral calculus, 625 equimarginal principle,
erty resulting from, Interest/interest rates 374–375
209 Aristotle on, 18–19 exchange theory of,
Weber on, 94–95 Böhm-Bawerk on, 375–376
Industry and Trade (Mar- 357–358 final degree of utility, the-
shall), 329, 395, 425 Cantillon on, 83 ory of, 376n, 378, 435
Industry supply and produc- Federal Reserve Board influence of Lardner and
tion economics, 403–408 and, 563 Jenkin on, 370–371
Industry centralization, con- Fisher on, 554 Keynes on, 369
centration of (Marx), Ghazali on, 26 labor supply theory of,
298 Keynes on, 534, 540 376–377
Infanticide, burial insur- medieval writers on, role in the spread of eco-
ance, and moral hazard, 33–35 nomic analysis,
244–245 neoclassical analysis of, 382–383
Inflation 558 statistical science of,
“Fisher Effect” and, Say’s Law applied to, 533 379–382
554–555 Senior on, 173–174 on sunspots and commer-
Friedman on, 560–561 Smith on, 123–124 cial activity, 381–382
monetarist explanation Thornton on, 147–148 utility theory of, 368,
of, 560–562 usury doctrine and, 33–35 370–375, 378–379
Phillips on, 561 Wicksell on, 555–557 value theory of, 370–377
unemployment and, Interest groups and politics, Joint supply theory, Mill’s,
561–562 685–686 188–190
Ekelund-Hebert 6E.book Page 722 Thursday, August 1, 2013 11:03 AM

722 ■ Subject Index

Justice Martineau on, 168 Liberalism

Aristotle on, 19 Marx on, 287, 290–291, Boisguilbert’s, 76–77
Chadwick’s economics 293–300 Cantillon’s, 77–83
of, 241–242 Menger on, 345 and free trade, Campo-
Plato on, 12–13 Mill on, 191–192 manes on, 90
Proudhon on, 272–273 productive/unproduc- physiocratic, 84, 89
Justices of the peace, tive, 128–129 transition from mercan-
monopolies enforced Protagoras’s “man-mea- tilism to, 65–66
by, 58–59 sure doctrine” as pre- Libertarianism, Proudhon’s,
Justinian Code, 21 cursor of, 15 270–273
Just-price doctrine, Aqui- proto-neoclassical per- Life in the Wilds (Martin-
nas’s, 30–31 spectives on, 462 eau), 168
Ricardo on, 160–162, 294 Lindahl equilibrium, 601–602
Keynes, John Maynard Smith on, 115, 127–129 Linear mathematical rela-
on aggregate demand, supply-and-demand the- tions/programming,
535–536, 543 ory vs., 172 627–629
biographical information, as utilitarian policy issue, Linear systems/algebra,
530–532 220 625–626
economics overview of, utility of poverty and, Liquidity preference,
528–529 52–53 Keynes on, 539, 541
fiscal vs. monetary pol- Veblen on, 491–492 Liquidity trap, 540, 541,
icy, 542–544 Wieser on, 350 541n,–542
Hicks-Hansen approach Labor contracts, impact on List, Friedrich
to Keynesian econom- efficiency of capital, on flaws of classical eco-
ics, 529 218 nomics, 267
on investment, 533, Laissez-faire, 76, 137, 149, on protectionism and
536–538 250, 376, 477 economic develop-
on involuntary unem- intellectual justification ment, 266–267
ployment, 539 for, 108–109 Literacy, impact on emerg-
on liquidity preference, Mill on, 195–196 ing capitalism, 97,
540–541 nineteenth-century, 224–225
on prices, 542 231–232 Local economic regulation,
reaction to classic eco- popular exceptions to, Elizabethan system of,
nomics, 532–535 195–196 58–60
Schumpeter vs., 543–544 transition to liberalism Location theory, von
on unemployment equi- from, 65–66 Thünen’s, 337–338
librium, 538–539, 542 utopian socialist rejec- Locke–Hume price-specie
Keynes effect, 542 tion of, 267 flow mechanism, 49, 51,
King–Davenant law of Lancaster’s characteristics- 53
demand, 638–639 based demand theory, Long-run equilibrium,
Knowledge, sociology of, 4 658 402–403, 513–514
Land rent Long-run supply theory,
Labor/labor theory Clark on, 386 119, 404–407, 413
Aquinas on, 29 Malthus on, 157158 Lorenz curve, 214, 214n
business cycle’s impact physiocratic policy, 88, Loss aversion, 662–663
on, 224 Ricardo on, 156, 385, Luddite Revolt, 264, 264n
child/female, 217–219 158–159
classical perspective on, Wieser on, 349 Machinery/mechanization
222 See also Rents/rent seek- impact on labor, classical
Jevons’s refutation of, ing view of, 222–224
376–378 Land tenure systems, 98 Marshall on, 406
Khaldun as originator of, Laws of capitalist motion, Marx on, 297–299
27 Marxist, 297–300 Mill on, 191
Magnus on, 29 Legalists, Chinese, 23–24 Sismondi on, 263–264
Marshall on, 424 Leisure, conspicuous, 665 Macroeconomics, 127–130
Ekelund-Hebert 6E.book Page 723 Thursday, August 1, 2013 11:03 AM

Subject Index ■ 723

Malthus, Thomas Robert Market process, Austrian influence of other econo-

Ricardo–Malthus corre- view of, 584–585 mists on, 463
spondence, 164–167 Market stability, Walras and on integration of mone-
on supply and demand, Marshall on, 443–444 tary theory and value
165 Market system, Cantillon theory, 557
“Man-measure” doctrine of on, 79–80 Keynes on, 396
Protagoras, 14–15 Markets on long-run/long-term
Manufacturing, sterility of, competitive equilibrium supply, 404–408
88 in, 401–402 on market adjustment
Manuscripts of 1844 (Marx), long-run equilibrium in, mechanism, 439–444
291 402–403 on monopoly and eco-
Marginal productivity the- partial vs. general equi- nomic welfare,
ory of distribution, librium approach to, 416–417
385–388 434–435 on optimum pricing and
Marginal utility problem of asymmetric monopoly, 413–419
Austrian, 571 information in, on partial/general-equi-
Clark on, 384–385 660–661 librium analysis,
Dupuit on, 319–322, 328, short-run equilibrium in, 434–436
465 399–401 on product distribution,
Gossen on, 339 Marriage, as economic con- 423–424
integration with mone- tract, 673–675 on resource allocation
tary theory, 577–578 Marshall, Alfred and product distribu-
Jevons on, 371–375 biographical information, tion, 423–424
Marshall on, 395, 412–413 394–396 on subsidies and decreas-
Menger’s product theory on capital and entrepre- ing costs, 415–416
of input valuation, neurship, 424–427 theory of labor supply, 424
344–345 comparison of Austrian on time and markets,
Mises on, 575–577 economics with, 399–403
proto-neoclassical contri- 574–575 utility theory, 395
butions to, 461 on consumer surplus, Walras compared with,
Senior on, 172 411, 413 433–437
Walras on, 435, 438 on continuous change Marx, Karl
Wieser on, 346–348, and ceteris paribus biographical information,
352–353 assumptions, 399 284–285
Market adjustment mecha- definition of economics, on capitalist production,
nism, Walras and Mar- 397–398 289–292
shall on, 439–444 on demand and con- on communism, 300–301
Market coordination vs. sumer surplus, on concentration of
firm coordination, 656 409–413 industry centraliza-
Market demand, long-run/ demand curve specifica- tion, 298
short-run distinctions tion, 409–411 criticism of Adam Smith
on the condition of, on derived-factor- and political econ-
400–403 demand elasticity, omy, 290–292
Market demand. See Aggre- 421–423 economic interpretation
gate demand economic method/theory of history, 287–288
Market equilibrium of, 397–403 on economic structure of
Jenkin on, 371 on externalities, 417–419 society, 288–289
neoclassical framework on increasing and “great contradiction” (of
of, 462 decreasing costs, Marxist labor theory),
Smith on, 116–120 404–407 295
Walras on, 443–444 on increasing-cost indus- Hegel’s and Feuerbach’s
Market exchange. See try, 414–415 influence on, 284,
Exchange on industry supply and 286–287
Market gluts, theory of, 186, economics of produc- on labor, 287, 290–291,
192–193, 262 tion, 403–408 293–300
Ekelund-Hebert 6E.book Page 724 Thursday, August 1, 2013 11:03 AM

724 ■ Subject Index

on laws of capitalist Mathematical Principles of international trade and

motion, 297–300 Economics (Laun- specie flow, 49–51
manuscripts of 1844, hardt), 330 judiciary’s role in break-
289–291 Matrix algebra, 625 down of national
on market exchange, Mechanization. See monopolies, 60–63
293–294 Machines/mechaniza- labor and the utility of
on mechanization’s tion poverty, 52–53
impact on labor, 223n Median-voter model, empir- liberal criticism of,
on nature of capitalism, ical support for, 605 65–66
292–300 Medieval Arab-Islamic eco- process vs. doctrinal
Outlines of the Critique of nomics, 24–27 approach to, 46–47
Political Economy Medieval church, economic real-world ideas of, 48
(Grundrisse), 291–292 impact of, 35–38 role of money and trade
on political economy, Medieval economic doc- in, 49
289–292 trine, 24, 27, 33–35 Meta-credence good, 679
on production, 287–289 Medieval science, impact on Method/methodology,
on property relations and emergence of capital- importance to economic
human relations, 288 ism, 96–97 thought, 703–706. See
on religion as “the opiate Menger, Carl also Economic method/
of the masses,” 286n biographical information, theory
Sismondi compared to, 340 Methodological essential-
263 on disequilibrium, 344n ism, 574
Smith compared to, 292 on economic goods and Methodological individual-
terminology of Marxism, the valuation process, ism, 573, 577
295 342 Methodology of Economics
on transformation of val- on economizing man, The, or How Econo-
ues into prices, 341–342 mists Explain (Blaug), 4
295–297 equimarginal principle Methodology, and sociology
on wages and capital, of, 343–344 of knowledge, 4
294 on imputation and factor Microeconomics
Materialism, Feuerbach on, values, 344–345 ceteris paribus used in,
286 Schmoller vs., 276 399
Mathematical economics Mercantilism in England and America,
applications to economic ambiguity in policies of, 367–390
ideas, 626–638 51–52 German/Austrian,
common mathematical American style, 63–64 336–362
tools, 623–626 Boisguilbert’s critique of, increasing focus on
Cournot’s, 623 76–77 mathematics, 637
Ellet’s contribution to, decline of, 63–65, 232n modern consumption
461 definition of, 46 technology and,
evolutionary economics doctrinal approach to, 649–655. See also
vs., 637 46–53, 66 Consumer theory
history and development as domestic policy, quality of goods and ser-
of, 622–623 51–52 vices, 653–654
importance of, 465 as economic process, 53, Mill, John Stuart
Marshall’s approach to, 63 biographical information,
395–396 enforcement of local eco- 183–184
modern neoclassical nomic regulation, 58, Comte’s influence on,
emphasis on, 637 60 184–185
supporters vs. detractors English, economic regu- contributions to neoclas-
of, 704–705 lation in, 57–63 sical economics, 193
Mathematical Exposition of entrepreneurship and, criticism of Martineau,
Some Doctrines of Polit- 55–57 168
ical Economy historic process vs. doc- on doctrine of alterna-
(Whewell), 622 trinal approach, 46–47 tive costs, 190
Ekelund-Hebert 6E.book Page 725 Thursday, August 1, 2013 11:03 AM

Subject Index ■ 725

doctrine of reciprocal Fisher’s equation of dual demand curves of

demand, 193 exchange, 553–555 firms engaging in,
on economic develop- Friedman’s money 512–513
ment, 187 demand theory, product differentiation
on entrepreneurship, 559–560 and, 510–511
202–203 Keynes’s, 542–544 tangency solution to,
on income redistribu- Marshall’s Cambridge 513–514
tion, 236–237 equation, 557–558 Taussig–Pigou contro-
on joint supply, 188–190 modern, theory and pol- versy on railway rates,
legacy of, 196–197 icy, 558, 566 508–510
on limits of laissez-faire money and credit, Wieser on monopoloidal
principle, 196 Mises’s theory of, interest groups, 350
nature and scope of eco- 575–578 Monopoly
nomic policy, 232–237 neoclassical, 553–558 Austrian notion of, 586
normative economics of, preclassical, 144, 146 Chadwick on, 249–250
193–196 reaction to inflation and competitive, 498, 508–516,
on personal liberty and unemployment, 585. See also Monopo-
equality of opportu- 561–562 listic competition
nity, 232 simplified explanation of Cournot on, 312–314
on poverty and income inflation, 560–561 disequilibrium and, 350
redistribution, 236–237 supply-side economics Dupuit on, 322–326, 328
on production, 186 vs., 564–566 English, effects of judi-
cial competition on
rejection of paternalistic Wicksell’s, 555–557
durability of, 61–63
view of class struc- See also Quantity theory
impact of changing con-
ture, 221 of money
straints on economic
Romanticism’s influence Money
activity in mercantil-
on, 184 Aristotle on, 18–19
ist England, 60–63
social and economic poli- Bentham on, 138
Marshall on, 413, 416–417
cies of, 232–237 Cantillon on, 82–83
Marx on, 290
on stationary state, 194 Ghazali on, 26
mercantilism and, 51,
on supply and demand, Jevons on marginal util-
58–59, 60–63
187–188 ity of, 378
natural, Chadwick on,
taxation and poverty, Keynes on, 539–541
250–251
233–236 Marshall on, 557 optimum pricing, Mar-
theory of jointly supplied Marx on, 300 shall on, 413
goods, 188–190 mercantilism and, 49 perfect competition and,
theory of market gluts, Mill on, 193 408, 515–516, 583–585
192–193 Mises on, 575–578 price discrimination and,
theory of noncompeting Petty on, 74–75 324, 328, 518–520
labor groups, 191–192 subjective use value vs. Robinson on, 516
on wealth redistribution, objective exchange by the Roman Catholic
194–195, 233–235 value, 575–577 Church, 37–38, 680
Moist economic thought, 24 Weber on, 95 Senior on, 172–173
Monetarism/monetary theory See also Monetarism/ Smith on, 112, 119–120,
attempts to integrate Monetary theory 124–125
with value theory, 552, Money illusion, 534, 538, 562 Moral hazard, Chadwick on,
555, 557–558, 578 Money, Credit and Com- 244–245
Bentham on, 148 merce (Marshall), 395 Morals and legislation, Ben-
Cantillon’s, 82–83 Monopolistic competition tham’s theory of,
classical, 146–148 advertising as modus 137–138
economic policy of, operandi of, 511–512 Multiple regression, 641
562–564 Chamberlin’s theory of,
effect of changes in 508–516 Nationalism/nationaliza-
money on relative critique/evaluation of, tion, mercantilist doc-
prices, 577–578 514–516, 585 trine and, 47–53
Ekelund-Hebert 6E.book Page 726 Thursday, August 1, 2013 11:03 AM

726 ■ Subject Index

Natural law Opportunity, equality of, Philosophy of Wealth, The

Bentham’s rejection of, 232, 235–236 (Clark), 384
234, 234n Optimality, 448, 603–604 Physicism, 261
Physiocracy and, 84–85 Optimum pricing and Physiocracy, 84, 89
Smith on, 108–111 monopoly, Marshall on, criticisms of, 88–89
Natural monopoly, 250–251 413 economics of, 84–87
Natural Value (Wieser), 346, Orthodox competitive the- manufacturing as sterile,
353 ory, joint-cost argu- 88
Natural value theory ment in, 509 policies of, 86–87
Ricardo vs. Smith on, 160 Orthodox vs. heterodox eco- rule of nature, 84
Smith’s, 114–120 nomics, 209–302 Pigou–Robinson theory of
Wieser’s, 349 Outline of General Eco- price discrimination,
Neoclassical economics, nomic Theory 518–520
307–472 (Schmoller), 275 Plan of a National Bank
Austrian, 571–588 Outline of the Science of (Ricardo), 147
empiricism in, 639–640 Political Economy Police effectiveness, Chad-
English/American micro- (Senior), 169 wick on, 240–241
economics, 367–390 Outlines of the Critique of Political business cycles,
German/Austrian micro- Political Economy 605
economics, 336–362 (Marx), 291 Political economy
hegemony of, 454 Output effects, in price dis- Chadwick’s, 238–251
integration with modern crimination theory, in classical economics,
statistical analysis, 520–521 167–168, 258
639 Overaccumulation, Mill’s List’s, 265–267
market equilibrium, 462 aversion to, 195 Marx on, 289–292
Marshall’s, 394–428 Overproduction Mill on, 184–185, 193–194
mathematical vs. evolu- Marx on, 298–299 Plato on, 12
tionary, 637 Say’s Law on, 192 Proudhon on, 271
Mill’s contribution to, 193 Veblen on, 490 public choice and regula-
Walras’s, 433–450 Overvaluation, Wieser on, tion, 595–614
See also Proto-neoclassi- 351 regulation theory,
cal economics 606–612
Neoinstitutional economics, Panopticon, 150 Romantic Movement cri-
493 Parliament, rise of, 63, tique of, 258
Neuroscience/neuroeco- 65–66 as “science of industrial-
nomics, 666–667 Partial equilibrium ism,” 184
New View of Society, A general equilibrium vs., Senior on, 169–174
(Owen), 268 434–435 Sismondi on, 264–265
Nobel laureates in econom- Jenkin on, 371 Smith, 108, 114, 126–127
ics, 693–697 Marshall on, 397–398, Political Economy Applied
Nominal interest rate, 407–408, 427, 434–435, to Public Works
554–555, 560 555 (Dupuit), 318
Noncompeting labor Robinson on, 516 Political science and eco-
groups, Mill’s theory of, Smith on, 116 nomics, 683, 686
191–192 Walras’s critique of, 448 Politics
Normative economics, Pecuniary emulation, agency problems in, 606
193–196 Veblen’s theory of, 486 economics of political
Pecuniary rationality, 483 representation, 605
Objective exchange value Peltzman model of regula- Peltzman model of regu-
vs. subjective use value, tion, 610–612 lation and, 610–612
575–577 Perfect competition, 408, rents and regulation,
On Labour (Thornton), 200 515–516, 583–585 608–612
Opportunity costs, 80, 116, Philanthropy, Mill on, Politics of Bureaucracy, The
124, 203, 327, 344, 352, 236–237 (Tullock), 604
359, 554, 674 Phillips curve, 561 Polity, Plato on nature of, 19
Ekelund-Hebert 6E.book Page 727 Thursday, August 1, 2013 11:03 AM

Subject Index ■ 727

Poor Laws and Factory Acts, Price(s) Production

Factory Acts and Poor adjustments, vs. quantity Böhm-Bawerk on, 357
Laws, 218, 220, 223, 227 adjustments, Mar- Cantillon on, 82–83
Poor Laws and Paupers shall vs. Walras on, Clark on, 385–388
Illustrated (Martineau), 439–441 classical representation
168 Aquinas on, 30 vs. Marxist represen-
Population estimates by Austrian view of, 585–587 tation of, 300
class in United King- Cantillon on, 82–83 early Christian thought
dom, 1867, 215 critique of Veblen regard- on, 22
Population growth, 143, ing, 492–493 Ghazali on, 26
175–177, 674 Dupuit’s theory, applied Hayek on, 578
Populationism, Malthus’s, to public goods, household, Becker on,
140–144 327–329 649–650
Position of the Laborer in a Ghazali on, 261 industry supply and,
System of Nationalism, Hume’s price-specie flow 403–408
The (Furniss), 52 mechanism, 49–50 Marx on, 287–291
Positive Theory of Capital, Keynes on, 542 Mill on, 186
The (Böhm-Bawerk), Malthus vs. Ricardo on, Pareto on, 447–448
354, 354n 165 Physiocrats on, 85
Positive time preference, Marshall on, 413 principles of optimality
Böhm-Bawerk on, Mises on, 577–578 in, 448
357–358 Smith on, 115–118 Schumpeter on, 582
Poverty Price-discrimination short-run, Marshall on,
“bootstrap theory” of Dupuit on, 324–326 399–400
upward mobility, 220 Pigou–Robinson theory technical coefficients of,
Chadwick’s position on, of, 518–520 629
220–221, 223, 225 Robinson on, 518–519 Productive vs. unproductive
environmental con- Principles of Economics labor, Smith on, 129
straints as cause of, (Marshall), 395–397 Profit
221–222 Principles of Morals and Clark on, 385n
inequality of opportunity Legislation (Bentham), falling rate of, law of
and, 232 138 accumulation and,
Mill on, 217, 221–222, Principles of Political Econ- 297–298
233–237 omy (Malthus), 263 Knight on, 521–522
poor laws and factory acts Principles of Political Econ- Marx on, 290
to mitigate, 216–220, omy (Mill), 183, Ricardo vs. Malthus on,
223, 227 185–187, 202 166–167
utility of, 52–53, 220 Principles of Political Econ- Smith on, 123–124
among the working omy and Taxation Profit maximization
classes, 211 (Ricardo), 160 Knight on, 521–522
Power Printing press, impact on Lardner’s theory of,
countervailing, Gal- emerging capitalism, 370–371
braith on, 497–498 97 Progress and Poverty
diffusion of, 118 Prisoner’s dilemma, 317, (George) n, 203
Preclassical economics, 632–633 Progressive vs. stationary
7–104 Producer surplus. See state economies, 187
Preventive principle, Chad- Rents/rent seeking Projectors and undertakers,
wick’s, 239–240 Product differentiation 126, 148–150, 202
Price discrimination advertising as means of, Proletariat, law of increas-
Dupuit’s theory of, 322, 511–512 ing misery of, 298–299
324–326 Chamberlin on, 510–512, Property rights
monopoly and, 324, 328 515 in ancient cultures, 682
Pigou–Robinson theory Dupuit on, 326–327 Bentham on, 234
of, 518–521 Product distribution, Mar- Chadwick on, 247, 249,
Price regulation theory, 607 shall on, 423–424 251
Ekelund-Hebert 6E.book Page 728 Thursday, August 1, 2013 11:03 AM

728 ■ Subject Index

Coasian revolution in, median-voter model, Patinkin on, 545

419–420 599–600, 605 Petty on, 74–75
entrepreneurship and, Plato on, 13–14 Ricardo’s formulation of,
56, 57n political representation 146–147
evolution of capitalism and, 606 Quasi-rent, Marshall’s con-
and, 97 Senior’s analysis of Fac- cept of, 424
Fourier on, 269 tory Acts as precursor
Marx on, 290–291, 300 of, 219 Radical subjectivism,
Mill on, 234–235, 237 theory of public-goods 572–573
physiocratic view of, 85 demand, 597–600 Railroad rates
Plato on, 16 Public finance Dupuit on monopoly
Proudhon on, 270–272 Ghazali on, 26–27 pricing and, 322–324
Smith on, 108–112 Gladstone’s policies of, Lardner’s theory of a
tragedy of the commons 231, 231n profit-maximizing
and, 681–683 industrial calculus railroad, 370–371
Veblen on, 486 applied to, 625 Taussig–Pigou contro-
Prospect theory, 661–664 Wicksellian, 602–604 versy over, 508–510
Protagoras, hedonic calcu- Public goods Railroads, contract manage-
lus of, 14–15 Bentham’s vs. Chad- ment of (natural
Protectionism, List on, wick’s perspective on, monopoly), 250–251
266–267 238 Rational choice, 494, 678
Protestant Ethic and the Chadwick on, 247, Rational expectations the-
Spirit of Capitalism 249–251 ory, 565
(Weber), 94–95 common-pool resources Real-balance effect, Wick-
Protestantism/Protestant vs., 239 sell on, 554–557
theology, 38, 94–98 community demand Recession/depression,
Proto-neoclassical econom- curve for, 598 Veblen on, 489
ics consumer surplus and, Reciprocal demand, 193,
American, 463 411 409, 435
British, 455 demand theory of, Reciprocal velocity, 540
demand theory in, 461 597–600 Regression analysis,
French, 309–331, 459 Dupuit on, 319, 327–329 640–642
German, 336–340, Ghazali on, 27 Regulation
456–457 Mill on, 195 capture theory, 609–610
hegemony of, 454–462 social welfare produced decline in seventeenth-
Italian, 460 by, 319 century England, 66
market equilibrium in, 462 Public interest, Chadwick internal, in English mer-
pre-1870, 454–462 on, 238–239 cantilism, 57–58
predominance of engi- Pure Theory of Foreign local (Elizabethan),
neers in, 462 Trade (Marshall), 444 enforcement of,
price elasticity of Purposive human action, 58–60
demand in, 462 573 median-voter model,
Psychology, relationship 600
with economics, 697 Quantity theory of money modern approaches/the-
Public assistance, Mill on, Cantillon on, 82–83, 577 ories, 54–55, 612
236–237 failure explain mecha- new political economy of,
Public choice/public-choice nism of variations in 606–612
theory value of money, 576 Peltzman model of,
agency problems in poli- favored by the classics, 610–612
tics, 606 535 rent seeking and, 608
bureaucracies and, 604 Hume on, 144–148 Schumpeter on, 613
demand analysis in, 604 Locke–Hume specie-flow Smith’s job as regulator,
empirical, 604–606 mechanism and, 110–111
Lindahl on tax prices/ 50–51, 53 Relative income hypothesis,
equilibrium, 601–602 neoclassical 553–559, 561 665–666
Ekelund-Hebert 6E.book Page 729 Thursday, August 1, 2013 11:03 AM

Subject Index ■ 729

Religion Resource mobility, 59–60 Saint-Simon, Henri de

Azzi–Ehrenberg model of Ricardian Socialists, Proudhon compared
religious participa- 256–257 with, 271–272
tion, 678–679 Ricardo, David Smith compared with,
cults as form of, 678–679 biographical information, 261
economic analysis of reli- 156 utopian vision of indus-
gious behavior, economic method/theory trial society, 259–262
678–681 of, 159–164 vision of Charlemagne,
Feuerbach on, 286 on entrepreneurship, 169 260n
Iannaccone on, 679 on impact of mechaniza- Saint-Simonism, 252
industrial organization tion on labor, 223, 223n Sales, Cournot’s law of, 311
and, 679–681 on income distribution, Sanitation reform, 211,
link with economic devel- 163 242–245, 247
opment, 94–95 land rent doctrine of, Savigny, Frederick Karl von,
medieval church, eco- 156–159 273
nomic impact of, 35–38 marginal productivity Say’s Law
Protestantism/Protestant theory, 385–388 Cournot on, 310
theology, 38, 94–98 Ricardo–Malthus corre- Keynes’s critique of,
Saint-Simon on, 261 spondence, 164–167 533–534
See also Christianity; on stationary-state equi- Malthus’s criticism of,
Roman Catholic librium, 162–164 166–167
Church on supply and demand, Mill on, 186, 192
“Rent of ability,” Mangoldt 165 recent debates about,
on, 425–426
supremacy of Ricardian 263
Rents/rent seeking
economics, 174–175 Ricardo’s defense of,
agricultural protection-
Roman Catholic Church 166–167
ism’s stimulation of,
antagonism against Sismondi’s rejection of,
157
medieval scientists, 262–263
Cantillon on, 82
96–97 underconsumption and,
contemporary, 57
decline of Catholicism/ 166–167
Dupuit on, 322
rise of Protestantism, Scarcity
feudalism and, 113
94–98 Aristotle on, 18
Hufeland and Hermann
doctrine of usury, 33–35, Henry of Friemar on, 31
on, 359
interest groups, 232n 35n, 96 Menger on, 342
Mangoldt on, 361 Holy Inquisition, 90, 92, Odonis on, 32–33
Marshall on, 424–426 97, 97n Ricardo on, 146, 160
medieval, 36–37 industrial organization Roman law and, 21
mercantilism as form of, of, 680–681 Senior on, 172
51, 54–58, 62, 64–66 maintenance of church Scholastic economics
physiocratic explanation monopoly and doctri- Albertus Magnus, 29
of, 87–88 nal manipulations, Henry of Friemar, 31
politics, regulation and, 37–38 Jean Buridan, 31–32
608–612 organization of, 36–37 method of, 28–29
Ricardo on, 164, 190, products of religion Odonis and Crell, 32
385–386 “bought and sold” as precursors/contribu-
Smith on, 124–125 through, 680 tors to value theory,
during Spanish Enlight- reciprocity with civil gov- 11, 28, 31–43
enment, 89 ernment, 680 Thomas Aquinas, 29, 31
See also Land rent Roman contributions to eco- Schumpeter, Joseph A.
“Report to the County of nomics, 21–22 on entrepreneurship, 580
Lanark” (Owen), 268 Romanticism, 257–258 Keynes vs., 543–544
Resource allocation Schmoller’s influence on,
Mangoldt on, 361 Sacred Congregation for the 277n
Marshall on, 423–424 Doctrine of the Faith, Scientific economics,
Wieser on, 352 97n 169–174, 197–198
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730 ■ Subject Index

Search goods vs. experience on child labor reform, on wealth, income, and
goods, 653 218 productive/unproduc-
Search time, new economics economic method of, tive labor, 128–129
of, 652–653 170–171 Social economics, 265, 346,
Self-alienation, Feuerbach interest-group theory of 350–351
on, 286 economics, 219 Social reform
Self-interest scientific economics of, Chadwick’s approach to,
acquisitive behavior as 169–174 220–226
healthy manifestation on value and costs, economic theory applied
of, 19 171–172 to, 219n
ancient Greek concep- Services, issues concerning laws against child labor,
tion of, 10 quality of, 653–654 217–218
application in contempo- Short-run equilibrium, Mill’s position on,
rary economics, 399–401 221–222
595–614 Simple regression, 641 poor laws and factory
Bentham on, 137, 150 Sismondi, Simonde de acts in Great Britain,
Campomanes on, 91 on capitalism, 263–264 216–219
Cantillon on, 78–80 economic method/theory utility of poverty vs.,
Fourier’s rejection of, 270 of, 264–265 52–53, 220
game theory and, 634 on machinery/technol- Social science/sociology
Hales on, 52 ogy, 263–264 applications of economic
legalists on, 23 Marx compared to, 263 analysis to sociology,
Mandeville on, 65–66 on Say’s Law, 262–263 672–675
medieval, 98 Smith, Adam Comte’s espousal of,
Menger on, 341 biographical information, 184–185
mercantilism and, 59 107–108 resurgence of economics
Parliament’s, 61, 63 on capital, 129–130 as, 671–687
physiocratic, 85 Cournot on method of, sociology of knowledge, 4
process approach to mer- 310 Spanish Enlightenment,
cantilism and, 46 economic development 89–93
Proudhon’s criticism of, theory, 127–130 Social welfare. See Welfare
271–272 on entrepreneurism, economics/theory
public choice theory and, 125–127 Socialism
605 on human nature, Austrian critique of,
regulation and, 54, 58–59, 111–112 586–588
609–611 on inheritance tax, 234 Mill’s sympathy toward
Saint-Simon’s rejection Marx’s criticism of, 292 ideals of, 193–194
of, 261 model of market equilib- socialist calculation the-
Senior on, 219 rium, 116–120 ory, 587
Sismondi’s criticism of, on natural law and prop- utopian, 267–273
264 erty rights, 108–111 Specie flow, and interna-
Smith on, 108, 110–114, on natural value, 120 tional trade, 49–51
136 on profit and interest, Stagflation, 566
Spanish Enlightenment 123–124 Stationary state
economists’, 93 regulatory responsibili- in classical economics,
Stigler on, 702 ties of, 110–111 175–177
Veblen on, 483, 492 on rent, 124–125 equilibrium, 176–177
Walras on, 444 Saint-Simon compared Mill on, 187, 194–195
See also Utilitarianism/ with, 261 progressive state econo-
utility theory on self-interest and eco- mies, 187
Senior, Nassau nomic growth, Ricardo on, 162–164
analysis of Factory Acts, 112–114 stationary-state equilib-
218–219 on wages, 121–123 rium, 176
on capital and interest, water–diamond paradox Statistical science, Jevons’s
173–174 of, 342 work in, 379–382
Ekelund-Hebert 6E.book Page 731 Thursday, August 1, 2013 11:03 AM

Subject Index ■ 731

Statistics in empirical eco- Technical coefficients of Tragedy of the commons,

nomics, 638–642 production, 629 681–683
Statues that Walked, The Technical substitution, mar- Treatise (Say), 359
(Lipo & Hunt), 682n ginal rate of, 447 Treatise on Probability
Statute of Artificers, 60 Technology (Keynes), 531
Subjective use value vs. and ceremony, interac- Trust management vs. con-
objective exchange tion of, 484–485 tract management, 150
value, 575–577 classical perspective on, Twenty-first-century eco-
Sumptuary and excise 222 nomics
taxes, Mill on, 235–236 impact on human capital, behavioral science vs.
Sunspots and commercial 224. See also Machin- applied mathematics
activity, Jevons on, ery/mechanization perspectives, 706–708
381–382 Theoretical and Practical danger of doctrinism in,
Superintendence, 202–203, Studies on the Move- 703–704
425–426, 581 ment of Running Water dissemination of eco-
Supply and demand (Dupuit), 318 nomic information,
Jenkin on, 188, 371 Theory of Business Enter- 697–699
Jevons vs. Marshall on, prise (Veblen), 488 ideology and ideas in,
378 Theory of Economic Devel- 701–703
Keynes on, 536 opment, The (Schum- methodology in, 703–706
labor theory of value vs., peter), 543 new “technology” of eco-
172 Theory of Games and Eco- nomics, 697, 700
long-term vs. short-term nomic Behavior, The Nobel laureates, 693–697
supply, Marshall on, (Morgenstern), 634
406–408 Theory of Monopolistic Unanimity, ideal of, 602–603
Malthus on, 166–167 Competition (Chamber- Underconsumption, 166–167,
Malthus vs. Ricardo on, lin), 350, 515, 516n 490
165 Theory of Moral Sentiments, Undertakers and projec-
Marshall on, 398–403, The (Smith), 108–109, tors, Smith on, 126, 202
557–558 126–127 Unemployment
Mill on, 187–190 Theory of Political Economy and inflation, Phillips
neoclassical framework (Jevons), 368, 379–370, curve, 561
of, 462 382 inflation and, 561–562
Proudhon on, 272 Theory of the firm, 329, 370, involuntary, Keynes on,
Scholastics’ view of, 31 383, 516, 625 539
Smith on, 119 Theory of the Leisure Class, Keynes on, 534
Veblen on, 483 The (Veblen), 486 Unemployment equilib-
Walras vs. Marshall on, Time rium, 536, 538–539, 542
439–443 Becker’s allocation the- Unproductive labor, Smith
Wicksell on, 555–556 ory, 649 on, 128–129
Supply-side economics, 118, in demand analysis, Mar- Usury, 26, 33–35, 35n, 96,
564–566 shall on, 409–410 148–149, 680
Sveriges Riksbank Prize in short-run vs. long-run Utilitarianism/utility theory
Economic Science, market conditions, Austrian approach to,
693 399, 401–403 573
System of Logic, A (Mill), Time-period analysis and Bentham’s, 137–140
183, 197 ceteris paribus assump- Buridan thought as pre-
tions, 398–403 cursor to, 32
Taxes/taxation Trade Chadwick’s, 238–251
Ghazali on, 27 Aristotle on, 16–18 Clark’s, 384–385
Hume on, 53 international, and specie doctrine of. See Self-
Mill on, 233–236 flow, 49–51 interest
Schumpeter on, 582 mercantilism and, 49 Dupuit’s, 319–322
Team production, and shirk- Smith on, 113 evaluation of, 139–140
ing in the firm, 657–658 See also Exchange Gossen’s, 338–339
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732 ■ Subject Index

interdependent func- Austrian economic theory of economy-wide

tions of, 666 approach to, 571–588 institutional change,
Jevons’s, 368, 372–376, Böhm-Bawerk’s, 354, 356 484–485
376n, 378–379 Clark on, 384–385 theory of pecuniary emu-
Kahneman–Tversky integration with mone- lation, 486
emphasis on “experi- tary theory, 578 Veblen effect, 487–488
enced” utility, 665 Jevons’s, 370–377 Veblen good, 487
labor as a utilitarian pol- John Crell and Gerald Veblenians, second-genera-
icy issue, 220 Odonis on, 32–33 tion, 494–496
marginal. See Marginal Magnus on, 29 Velocity, 75, 540
utility Marx’s, 293–300 Von Thünen, J. H.
Marshall on, 395 Menger’s, 341–344 biographical information,
Mill’s, 232–237 Mill’s, 187–190 337
neoclassical contribu- Mises on, 575–578 location theory of,
tions to, 455, 458, neoclassical contributors 337–338
460–461, 465 to, 454–468 Voting process, impact of
of poverty, 52–53 Petty on, 75 economic rationality
prospect theory as, physiocratic sense of, 88 on, 684–685
661–664 Ricardo’s, 160–162
proto-neoclassical contri- Scholastic contributors’ Wages-fund theory/doc-
butions to, 461–462 list, 34 trine, 121
Senior’s, 171 Senior’s, 171–172 Böhm-Bawerk’s affini-
twenty-first-century revi- Smith’s, 114, 116, ties with, 357
sions to, 661–667 119–125 long-run adjustments,
Veblen on, 664 Walras on, 435 201–202
Wieser’s, 348–349 Wieser’s, 346–349 Marx on wage and capi-
Utility of poverty, 52–53, “Variation of Prices and the tal, 294
220 Value of the Currency Mill on, 186, 199–202
Utility maximization Since 1782” (Jevons), Ricardo’s, 176
Cabarrús’s, 92 380–381 short-run model,
Chadwick on, 221 Veblen, Thorstein Bunde 200–202
constrained optimization American institutional- Smith on, 121–123, 129,
as, 625 ism of, 479–494 198–199
Gossen on, 339 assessing the economics “utility of poverty” idea
Menger on, 341 of, 492–493 in, 220
modern alternatives to, biographical information, Walras, Léon
664–665 480–481 biographical information,
neoclassical theory on, on conspicuous con- 437–438
584–585 sumption, 485–488 construction of a mathe-
Schumpeter on, 351 on economic change and matical system in eco-
Wieser on, 350 the future of capital- nomics, 436
Utopian socialism, 267–273 ism, 488–492 impact of his correspon-
Fourier’s, 269–270 on human nature and dence on economics,
historical determinism economic method, 448–449
vs., 284–302 481–482 on market adjustment
Proudhon’s, 270–273 on interaction of ceremo- mechanism, 439–444
Robert Owen’s, 268–269 nial and technological Marshall compared with,
institutions, 484–485 433–437
Value/value theory on “matter of fact” vs. partial/general-equilib-
Aquinas’s, 30 animistic preconcep- rium analysis,
Aristotle on, 17–18 tions, 482–484 434–435, 571
attempts to integrate rationality postulate of, Wants
with monetary theory, 664 advertising’s manipula-
552, 555, 557–558, 578 theoretically inclined fol- tion of, 499, 512
Augustine on, 22 lowers of, 494–497 and costs, 33
Ekelund-Hebert 6E.book Page 733 Thursday, August 1, 2013 11:03 AM

Subject Index ■ 733

human, nonsatiability of, Mill on, 194–195, 233–235 Wicksell, Knut

486 production, rent-seeking aggregate demand/aggre-
individual vs. aggregate, mode of. See Rents/ gate supply analysis,
32 rent seeking 556
Menger’s ten classes of, Smith on, 128–129 aggregate demand/aggre-
343 Wieser on, 348 gate supply frame-
and price, connection See also Rents/rent seek- work and price
between, 30 ing change, 555–556
subjective, Mises on mar- Wealth of Nations (Smith), integrating monetary
ginal utility of, 107, 109–110, 112, 114, theory with value the-
525–577 116, 123, 127, 149 ory, 555, 557
superiority of present Welfare economics/theory Wieser, Friedrich von
goods over future aggregate utility and biographical information,
goods in satisfying, social welfare, 413 345
343, 358 Bentham’s, 138–139 social economics of,
See also Indigentia Dupuit on, 319, 321–325 350–351
Water supply and public felicific calculation of, theory of imputation,
health conditions in 139 351–353
London (natural impact of monopoly on, theory of social economy,
monopoly), 251 520 350–351
Water–diamond paradox, Marshall on, 416–417 value theory of, 346–349
Smith’s, 342 Pareto on, 446–447, 447n, Women, changing cultural/
Wealth 448 familial values for, 674
Industrial Revolution’s welfare maximization, Workhouses, 216–217
impact on English lev- equimarginal princi-
els of, 213–214 ple of, 343–344