Review: The Classical School: The Birth of Economics in 20 Enlightened Lives

I bought this 2020 book by Callum Williams after I heard this podcast with him.

I like reading history of economic thought books because it’s interesting to see how economics has evolved over the centuries and useful to compare cumulative misunderstandings with what long-dead thinkers actually said. (That’s why I am reading and blogging on Alfred Marshall’s 1920 Principles of Economics.)

Adam Smith’s 1776 Wealth of Nations (WoN) is widely considered to mark the start of economics, although it was then called “moral philosophy” before changing to “political-economy” in the 1800s and “economics” in the 1900s (roughly).

Overall, I found this book to be interesting, but not nearly as inspiring as the classic Worldly Philosophers: The Lives, Times and Ideas of the Great Economic Thinkers, which has been in print since Heilbroner published it in 1953. Williams has a tough act to follow.

In this review (as usual), I offer thoughts based on highlights and notes I made while reading.

  • Economics — the study of markets, choices, prices, etc. — became a useful topic when capitalism started to displace feudalism. Double-entry bookkeeping was invented during the Renaissance and used by merchants in Italian city-states. The Dutch East India Company was founded in 1602. Economists brought the supply to meet these demands 😉
  • One early school of economics was mercantilist, which believes that it’s best to trade goods for gold rather than other goods. Colbert (1619-1683) imposed this win-lose trade policy on France in the 17th century and made the country much poorer. (Trump has a mercantilist obsession with trade balances.)
  • Mercantilists are right to focus on employment, but they used wasteful and  ineffective tools (high tariffs on imported goods and subsidies to domestic producers) to protect jobs. (Better to boost domestic employment by helping start-ups identify comparative advantages and grow.)
  • 18th century calculations of economic activity (GDP was not invented until the 1930s) were biased in favor of labor over land. The landed classes supported this bias as a way shifting taxes from land onto labor; see my post of property taxes.
  • Theory and data are often at odds. Data can be useful or biased (anecdata, missing variables, bad measurement). Theory can persist long after it has been empirically falsified.
  • Bernard de Mandeville (1670-1733) wrote that the rich created jobs by consuming luxuries in the Fable of the Bees (1705). He also worried that an ultra-capitalist society would have weak morals. He was right.
  • Richard Cantillion (1670-1734) focussed on cause and effect, ceteris paribus (“all other things held equal”) and trade-offs, i.e., opportunity costs. He also raised an important question (“it is better to have a great multitude of Inhabitants, poor and badly provided, than a smaller number, much more at their ease”?) that Jeremy Bentham (“the greatest good for the greatest number“) later flubbed, as there are always tradeoffs [page 38].
  • Cities grow on the productivity that specialization, innovation and competition bring to deeper, broader markets. They fail when the commons (public health, crime, etc.) are weak. Economics did not pay attention to these failures until the 20th century, with the work of Jane Jacobs and Elinor Ostrom, among others.
  • `The Scottish universities were superior to the English ones, where [Adam] Smith complained that “the greater part of the public professors have, for these many years, given up altogether even the pretence of teaching”‘ [page 58].
  • Adam Smith (1723-1790) built the foundation for WoN with his Theory of Moral Sentiments (1759), which focussed on our social (non-market) selves: `“We endeavour”, Smith says, “to examine our own conduct as we imagine any other fair and impartial spectator would examine it.” In invoking this ghostly projection, Smith presents people as fundamentally social beings’ [page 59]. Smith, a member of the Scottish Enlightenment, was implicitly attacking God-given morality, which was not easy back then.
  • `The Wealth of Nations achieves something that no other work had quite done before. It clearly brings out the idea of an “economy” –- a self-regulating system of exchange, which is subject to its own natural laws” (page 66). I say the same of Bitcoin, which I consider a new species.
  • The debate over value vs cost in determining price was not resolved for decades. Marx was not alone in proposing the labor theory of value (a good’s value depended on the embedded labor needed to produce it). The joint-determination of price (as the two blades of scissors) via the interaction of cost (supply) and value (demand) was a real achievement for economics, even if many people today still don’t understand it.
  • Inflation makes it hard to see prices as an indicator of value or cost.
  • Who creates value? Workers, capitalists, landowners? Economists who backed one group (cynically or thoughtfully) would be attacked by the others, since political support went to those seen to be creating value.
  • Poverty is both absolute (are you hungry?) and relative (does your neighbor have better food?). Stop arguing for one definition.
  • Nicolas de Condorcet (1743-1794) wanted people to respect each others’ views and advocated reading novels for this. I agree that people need constant reminders that their subjectivity is not reality.
  • David Ricardo (1772-1823) is credited with defining “rents” as the excess (or unearned) profits derived from possession of a productive resource. He used land as an example, but rents also arise with fossil fuels, minerals, intellectual property, and so on. Monopoly profits are often called “rents” by economists, but Alfred Marshall did not use that term for profits derived from market power that will disappear with deregulation, competition or entry. He reserved “rents” for profits arising from natural scarcity.
  • The first 50-100 years of the Industrial Revolution lowered prices for consumers but most of the profits went to capital, not labor. Under those circumstances, Ricardo wanted to repeal the Corn Laws that protected English farmers from competition and raised bread prices, to help the working classes. (They were repealed in 1846.)
  • Jean-Baptiste Say (1767-1832) is known for “supply creates its own demand” by which he meant that economic imbalances (unsold inventory, unemployed workers) would correct over time. He was wrong, but it took 100+ years before Keynes explained failures in aggregate demand.
  • Thomas Robert Malthus (1766-1834) worried about over-population, but he — like the neo-Malthusian Garrett Hardin — favored self-control over  birth control. Failure #1. Malthus also underestimated potential increases in  agricultural productivity, which was just taking off. Failure #2.
  • I had never heard of Simonde de Sismondi (1773-1842), but I like his ideas, i.e., that human nature (and thus society) is not universal, but different  among places and eras. Capitalism was not inevitable. Workers were not doomed to suffer poverty. Although his nostalgia for (pre-capitalist) feudalism and guilds would not help the masses, Sismondi was right to want to reduce inequality by redistributing profits from capital to labor. Efficiency and fairness are complements, not substitutes.
  • John Stewart Mill (1806-1873) argued that the value of a good depended on how useful it was (demand), not just scarcity (supply) — a perspective that (correctly) undermined those who argued the labor theory of value.
  • Mill argued for a stationary state of the economy and population over endless growth, in what seems (to me) to be the earliest call for a steady-state economy or degrowth. This perspective evokes the pre-industrial era of a century earlier, but Mill “advocates a stationary state in which a stable population maintains itself at some reasonable average level of material comfort, yet most persons also attach more importance to certain ‘higher pursuits’ than to further labour, investment, and exploitation of natural resources” [p 140]. From this, I see a strong claim for quality over quantity. Indeed, Mill worried about inequality and the working classes. He was right to advocate steep inheritance taxes.
  • Mill was raised in books and developed some idiosyncratic ideas, but that didn’t keep him from important insights and opinions (p 140):

    The real reason Mill loved free trade was not because it made the economy more efficient but because it encouraged people of different backgrounds to talk to one another. “It is hardly possible to overrate the value, for the improvement of human beings, of things which bring them into contact with persons dissimilar to themselves, and with modes of thought and action unlike those with which they are familiar.” Mill continued: “There is no nation which does not need to borrow from others.”

  • Karl Marx (1818-1883) “either did not know about the clear improvements in living standards that were happening all around him or chose to ignore them: From 1849, when Marx moved to London, to 1883, when he died, the average working week fell from 64 hours to 58 hours. Over the same period the average wage did not stay at subsistence level, as Marx predicted. In fact it rose by fully 35% in real terms” p 170.
  • My favorite footnote: “Marxist economists have developed a whole new set of economic terms, none of which is used by mainstream economists. This makes it almost impossible for Marxist and non-Marxist economists to discuss the use of empirical data” (p 278).
  • Friedrich Engels (1820-1895) came from a rich industrial family, so he knew that technology would help produce the food that Malthus thought impossible, but he (and Marx) took Hegelian dialectics too seriously. That’s why the duo predicted an inevitable triumph of communism, why Lenin et al. stubbornly ignored failures, and why millions died needlessly.
  • William Stanley Jevons (1835–1882) preferred “economics” to “political economy,” which differed:

    It is often said that political economy has more sociological and historical elements than dry old economics. The examples of Ricardo and Say, two of the archetypal political economists, undermine that idea. In my view the clearest distinction between political economy and economics is in the use of mathematics. Jevons argued passionately in favour of the systematic incorporation of maths into economic inquiry. (Note that today the term “political economy” tends to refer either to economic analysis with a bit of politics thrown in, or to a more left-leaning sort of economic analysis. Only economists really use this term.) p278.

    A few years ago, I started to call myself a political economist to emphasize my interest in history, institutions and the distribution of surplus. I see too many examples of “economics” depending on mathematical theories and predictions that deviate too far from reality.

  • The “Jeavons Paradox” states that a gain in efficiency in providing a good (e.g., lighting) will lead to more, not less, use of that good. I don’t see much of a paradox when an outward shift in the supply curve (making lighting more affordable) results in higher quantity demanded (the demand curve doesn’t move).
  • Jeavons said if economics “is to be a science at all, then it must be a mathematical science” (p 186). This aspiration is admirable but autistic, since humans do not behave in mathematical (predictable) ways, which means that math-centric models often fail to work. Williams’s summary of this discussion (pp 186-7) is worth quoting:

    Why did the political economists not use much maths [despite having math skills]? … In 1803, [Jean Baptiste] Say referred to “our always being misled in political economy, whenever we have subjected its phenomena to mathematical calculation”. The thinking goes that people are too unpredictable and unreliable for their actions to be reduced to simple equations. Political economy, in Say’s words, is “subject to the influence of the faculties, the wants and the desires of mankind” and therefore is “not susceptible of any rigorous appreciation, and cannot, therefore, furnish any data for absolute calculations”. The question, of course, is how representative were Say’s views. John Elliott Cairnes, a contemporary of Jevons who was a paid-up political economist, rather than an economist, reckoned that many of the data necessary to the mathematical solution of economic problems were too unreliable. Cairnes also worried that mathematics could not be applied to the development of economic truth, “unless it can be shown, either that mental feelings admit of being expressed in precise quantitative forms, or, on the other hand, that economic phenomena do not depend upon mental feelings”. In other words, you cannot quantify feelings like hunger, desire or love. But Jevons came to economics with a different philosophical background. For one thing he was a science nerd.

    … and many science nerds, physicists and engineers have tried — and failed — to reproduce economic dynamics in mathematical, statistical, game theoretic, or mass-balance models. (Today, they are pursuing big data, machine learning and agent-based simulations.) They have failed, in ways large and small, due to an inability to capture chaotic, complex human interactions. Maybe they are not wasting their time, but I worry that  misleading advice and predictions can lead to mistaken actions and policies. I prefer humble assumptions and robust (anti-fragile) policies that work with a range of potential behaviors.

  • Jeavons thought the labor theory of value was misleading: Something that costs £10 to make may only be worth £8 (to the marginal consumer) in the market.
  • Jeavons (and other marginalists) resolved the “diamond-water paradox” thus:

    Adam Smith was exercised by the question of why water is so much cheaper than diamonds, despite the fact that it is so much more useful. Smith reckoned that the paradox showed how useless questions of utility were in determining value. Jevons has another answer. He accepts that water is more useful than diamonds. But then the marginal stuff comes back in. The Jevons theory says that the marginal utility of water is far lower than the marginal utility of diamonds. As Ellen Frankel Paul says, “[w]hile water has great utility, it is so abundant that final increments of it, which is all that one is concerned about in the normal market situation, are worth little or nothing to people already in possession of all they need.” An extra diamond, by contrast, offers massive extra utility to someone. But imagine if there was a drought. Then, the marginal utility of water would be very high–people would be willing to trade diamonds for a glass of water, since it would stave off death for a few more hours (p 191).

  • Dadabhai Naoroji (1825-1917) is another new name to me. This Indian economist called attention to — and calculated — the loss and extraction from colonial India to Britain, from poor to rich. I first appreciated this “drain theory” when I read Era of Darkness two years ago, and it’s still upsetting to me how many Brits claim that Empire helped India when the opposite was true. The damages from those 300+ years of exploitation are still visible; the dysfunction of inherited weak institutions still harms.
  • Rosa Luxemburg (1871-1919) claimed that capitalism could only grow with colonialism, since the metropole needed others to exploit. While I agree that colonialism is about exploitation, I don’t see how capitalists need it, since they can also thrive with voluntary trade in free markets.
  • The book ends with Alfred Marshall (1842-1924), the subject of my Marshall 2020 project. Marshall departed from Malthus and Ricardo’s pessimism over the Industrial Revolution because he had more data. At the beginning of the 19th century, wages, productivity and quality of life were rising very slowly but real-wage growth was much faster in Marshall’s time, which meant that workers were gaining relative to capital. We must note that these gains were not automatic, but the result of fights in the press, the streets and legislatures.
  • Marshall also developed Smith’s ideas (diversification increases with the size of the market) into theories of innovation-intensive industrial clusters.
  • Most important, Marshall found a middle way between scientistic plodding (paradoxical proofs promoting pessimistic predictions) and grand but groundless claims of inevitability. Marshall was skeptical and pragmatic. His facts were limited, his caveats numerous. I prefer this humble perspective, as did others. Marshall was influential in his time;  contemporary economists should follow his example in humility over “stylized facts.”
  • I became an instant fan of Marshall (even if it took me 15 years to get ’round to reading his work!) while in graduate school:

    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 (p219).

And with those 2,500+ words, I come to this one-handed conclusion: (Political) economists, from undergraduate to PhD, should read this book (and books like it) to understand where we came from, where we made mistakes, and how individuals and personalities affected our thinking. It is only with knowledge and humility that we can offer good advice on the everyday business of life. For others, I am not sure if this will be quite the page-turner as Heilbroner’s classic. FOUR STARS.

Here are all my reviews.

Marginal costs in relation to urban values

Book 5, Chapter 11

§1. If demand for the land’s produce is growing, then it will still be worth applying additional labor and capital to the land, despite diminishing returns. Urban areas that can — due to density, specialization, etc. — produce more, of greater value, can bring this demand whereas agricultural or “low density” agglomerations cannot.

§2. The development of agricultural land into urban use is expensive, but it will can raise land values by enough to repay investment. It’s for these reasons that some land owners tax themselves to build improvements, railways, drainage, etc. Success and profits are not guaranteed.

§3. The discounted value of land and its discounted ground rent differ due to time, since rental terms are agreed at the beginning of a period (e.g., 20 years) but values are calculated from the end of a period.

§4. Up or out? Build up if land is dear and out if it’s cheap. That’s why we see skyscrapers in urban areas and sprawling ranch homes in rural areas.

§5. Land use will change as value per unit area increases, going from farming to garden crops to factories to (cheap then expensive) shops and housing.

§6. Shops and traders competing for scarce urban space will either need to sell high volumes at low prices profits or low volumes at high profits.

§7. The value of a location to a renter will rise or fall with its natural and artificial amenities and their price. A factory running on water power will get value from its location as well as its water power, but an increase in the price of either can make the site unattractive, which can lead to problems if different landlords set different prices for land and water power.

This post is part of a series in the Marshall 2020 Project, i.e., an excuse for me to read Alfred Marshall’s Principles of Economics (1890 first edition/1920 eighth edition), which dominated economic thinking until Van Neumann and Morgenstern’s Theory of Games and Economic Behaviour (1944) and Samuelson’s Foundations of Economic Analysis (1946) pivoted economics away from institutional induction and towards mathematical deduction.

Marginal costs in relation to agricultural values

Book 5, Chapter 10

§1. The price of agricultural produce depends on the interaction of supply and demand. If there’s an increase in demand, then higher prices encourage the addition of inputs and effort. Rents from land are not part of this calculation, as they are an inherent return on fertility.

[This chapter, recall, is part of seven “technical” chapters that Marshall advises lay readers to skip. I didn’t because I want to see his thought process. What occurs to me, in comparing these chapters (and the whole book) to contemporary economics books, is that Marshall spends much more time on whatifs, caveats and conditions than “modern” books, which can over-simplify to the point of losing touch with reality.]

§2. Marshall discriminates between monopoly profits (e.g., via collusion) and rents that accrue due to (natural) scarcity. He gives a water example:

It is, indeed, true that if there were more than enough land, all of about the same fertility, to enable everyone to have as much of it as was needed to give full scope to the capital he was prepared to apply to it, then it could yield no rent. But that merely illustrates the old paradox that water, when abundant, has no market value: for though the services of some part of it are essential to support life, yet everyone can get without effort to that margin of satiety at which any further supplies would be of no service to him. When every cottager has a well from which he can draw as much water as he needs, with no more labour than is required at his neighbour’s well, the water in the well has no market value. But let a drought set in, so that the shallow wells are exhausted, and even the deeper wells are threatened, then the owners of those wells can exact a charge for every bucket which they allow anyone to draw for his own use. (p 356)

So rents due to natural scarcity are part of anyone’s profit-loss calculations when starting business, settling “virgin” lands, and so on. Thus frontier settlers endure hardship because they expect to be rewarded in the future, e.g., by selling their appreciated land claims.

[In a later footnote, Marshall quotes Adam Smith’s Wealth of Nations: “High or low wages and profit are the causes of high or low price: high or low rent is the effect of it” p 364, my emphasis.]

§3. A farmer can expand on intensive or extensive margins, e.g., working existing land harder or adding more land, respectively. But this individual decision does not scale, as more land for one farmer means less for others. Thus it’s more socially productive to add effort on the intensive margin. The same is true to a factory owner deciding to increase the effort from workers and machines versus adding more of either.

§4. This section on land taxes is tricky, but I see it as an exploration of elasticity. Marshall says that an increased tax on agricultural output will reduce profits on a farmer earning decent profits because the farmer cannot pass along that tax on consumers (they go elsewhere) whereas a farmer making small profits must pass the tax on to consumers because the alternative is to cut back on production. In terms of elasticity and incidence, I’d translate these scenarios as inelastic and elastic, respectively, on the producers side, i.e., farmers paying a larger or smaller share of the taxes, respectively.

§5. Delving further into crop mix choices and tax elasticities, Marshall explains that farmers will choose the mix of crops (in coverage and rotation) based on profit maximization. If a tax is applied to a particular crop (he uses hops), then its production will fall if profits fall (elastic demand) but not if most of the tax can be passed to consumers (inelastic demand).

§6. Royalties in the case of a depleting mine are not the same as (ongoing) rents, since the royalties represent a fee based on the mine’s falling resource — and thus value.

This post is part of a series in the Marshall 2020 Project, i.e., an excuse for me to read Alfred Marshall’s Principles of Economics (1890 first edition/1920 eighth edition), which dominated economic thinking until Van Neumann and Morgenstern’s Theory of Games and Economic Behaviour (1944) and Samuelson’s Foundations of Economic Analysis (1946) pivoted economics away from institutional induction and towards mathematical deduction.

Marginal costs in relation to values. General principles, continued

Book 5, Chapter 9

§1. The relative contributions of various inputs to intermediate and then final goods is hard to calculate. Thus, “unbalanced” taxes on various inputs might unbalance their mix and flow. Local taxes will fall on immobile inputs if mobile inputs can flee. Taxes on capital goods will not affect the marginal price of goods until those goods must be replaced. That step will be delayed in proportion to the tax, delaying implementation of innovations.

§§2-3. The price of an input depends on how easily it can be produced as well as the price of substitute and complementary inputs. If the input is hard to replace or displace, then it will attract a “critical” (higher) price, i.e., rents. If the opposite, then its price will be supported by the prices of replacement or substitute inputs. Those prices — given their total depreciation into final goods — will reflect the cost of financing the delay between production and sale.

§4. The relative contributions of inputs will reflect a mix of their separable (“additive, in a mechanical fashion”) and commingled (“multiplicative, as if by chemical transformation”) contributions.

§5. An input of superior quality will attract lower rents when other, inferior inputs are available as substitutes. In Marshall’s time, some claimed that the existence of inferior goods increased rents to superior goods (perhaps by highlighting the gap?), whereas today we’d say their existence reduced prices (or rents) via competition. Marshall was right, there.

This post is part of a series in the Marshall 2020 Project, i.e., an excuse for me to read Alfred Marshall’s Principles of Economics (1890 first edition/1920 eighth edition), which dominated economic thinking until Van Neumann and Morgenstern’s Theory of Games and Economic Behaviour (1944) and Samuelson’s Foundations of Economic Analysis (1946) pivoted economics away from institutional induction and towards mathematical deduction.

Marginal costs in relation to values. General principles

Book 5, Chapter 8

§1. “And again this demand [for an input], because it is so derived, is largely dependent on the supply of other things which will work with them in making those commodities [final goods]. And again the supply of anything available for use in making any commodity is apt to be greatly influenced by the demand for that thing derived from its uses in making other commodities: and so on. These inter-relations can be and must be ignored in rapid and popular discussions on the business affairs of the world. But no study that makes any claim to thoroughness can escape from a close investigation of them. This requires many things to be borne in mind at the same time: and for that reason economics can never become a simple science” [p 334 emphasis added].

§2. The demand (=price) of inputs that can be substituted for each other (e.g., steam vs horse-power) will depend on relative efficiencies, with exceptions for laws, custom and other frictions. A horse that produces 10% of a machine’s output will attract offers equal to 10% of that machine’s price.

§3. Businessmen are always experimenting with the mix of inputs required to get a desired output. Although accounting for marginal and capital costs (and depreciation) is not easy, prices and costs will, over time, tend to reflect each input’s value added.

§4. The balance among inputs of capital, labor and materials will tend to equate, at the margin, with their marginal products (i.e., ratios of values to costs). An over-application of any input is wasteful due to decreasing marginal returns (on that input) and opportunity costs (not using other inputs).

In a long footnote, Marshall argues against those who see any given input as “essential” in that a small reduction in its use (e.g., a worker who labors one hour less) will have dramatic effects on the productivity of other inputs.  While this might be true in the short run, Marshall argues that changes here  can be balanced by (continuous) adjustments elsewhere. This appeal to continuity underpins the use of calculus (finding minima and maxima by taking derivatives of functions), which makes sense in many circumstances. I disagree with the continuity assumption when it comes to constraints (an 8 hour shift) or innovations (the shift is eliminated). I assume Marshall would have agreed but modern (=mathy) economists may have forgotten those important caveats and exceptions.

§5. The decision to add/subtract inputs is made “at the margin” in terms of weighing additional profits (or value) vs costs. That calculation takes existing levels of inputs as given, which also means that removing a unit at the margin has a far smaller effect than removing an “inframarginal” unit. In this way, we can see how it might be ok to, say, skip another hour of sanding down a chair while it might be a bad idea to skip an hour of adding legs to that chair. Order matters.

§6. The rents (or interest) returned to “free floating” capital versus “invested” capital varies with the longevity and idiosyncrasies of investments, but they tend to converge.

This post is part of a series in the Marshall 2020 Project, i.e., an excuse for me to read Alfred Marshall’s Principles of Economics (1890 first edition/1920 eighth edition), which dominated economic thinking until Van Neumann and Morgenstern’s Theory of Games and Economic Behaviour (1944) and Samuelson’s Foundations of Economic Analysis (1946) pivoted economics away from institutional induction and towards mathematical deduction.

Prime and total cost in relation to joint products. Cost of marketing. Insurance against risk. Cost of reproduction

Book 5, Chapter 7

Marshall, like many of his contemporaries, used long titles. 

§1. How should one price two goods that share common elements in their costs (e.g., a machine or management time) but are sold into different markets (e.g., passengers and freight on ships). Pricing from the cost side is tricky. Pricing from the demand side (“what the market will bear”) makes more sense, but it’s ultimately linked to costs, since competing firms selling similar goods and services must also cover their costs.

§2. A manufacturer will want to allocate marketing expenses among goods in proportion to their marketing “needs” but that manufacturer may cut that allocation in the most competitive markets (e.g., for loss leaders). Manufacturers who achieve economies of scale will have falling per unit costs but rising marketing costs based on trying to differentiate similar goods (e.g., cola advertising).

§3. Insuring against risk is often wise but allocating those costs can be difficult when they rise and fall with other actions. The price of fire insurance, for example, will fall if a building is built to reduce fire risks. Are those additional building costs part of construction or insurance?

§4. Marshall points out that risk aversion (the loss of bad outcomes outweighing the gains from good outcomes) is more prevalent than risk seeking behavior (p332):

It is true that an adventurous occupation, such as gold mining, has special attractions for some people: the deterrent force of risks of loss in it is less than the attractive force of changes of great gain, even when the value of the latter estimated on the actuarial principle is much less than that of the former… But in the large majority of cases the influence of risk is in the opposite direction; a railway stock that is certain to pay four per cent. will sell for a higher price than one which is equally likely to pay one or seven per cent. or any intermediate amount.

Kahnemann and Tyversky rediscovered these principles in the 1980s.

§5. In some cases, the cost of reproducing a good will be similar to its cost of production, with both closely tracking its price, but that relation weakens if production technologies or input prices have changed, and it breaks down if demand races ahead of supply (e.g., “quinine on a fever-stricken island”).

Marshall ends the chapter with the advice that non-economic readers skip the next seven chapters (!), but I won’t. Fasten your seatbelts!

This post is part of a series in the Marshall 2020 Project, i.e., an excuse for me to read Alfred Marshall’s Principles of Economics (1890 first edition/1920 eighth edition), which dominated economic thinking until Van Neumann and Morgenstern’s Theory of Games and Economic Behaviour (1944) and Samuelson’s Foundations of Economic Analysis (1946) pivoted economics away from institutional induction and towards mathematical deduction.

Joint and composite demand and supply

Book 5, Chapter 6

§1. A consumer demanding a good from a producer thereby creates derived demand for the inputs to produce that good. In most cases, inputs are not interchangeable (100% substitutes), which means they are joint (or complementary) with other inputs, with all supplied in stable proportions. Thus, the absence of one input can halt overall production, e.g., trying to make beer without hops.

§2. A missing factor (production input) will lead to increased prices for that factor if (1) the factor cannot be replaced (no substitutes), (2) consumers cannot do without that good (thus, they will pay more rather than go without), (3) the missing input plays only a small part in the price (meaning producers able to find some of that input can pay more for it without raising the product’s final price by much), and (4) other inputs can be acquired for lower prices, leaving extra space to pay for the scarcer input. In sum, a scarcer input will still be used if it’s an essential but small part of the production process.

§3. Composite demand for an input results from the summation of demands from all producers using that input for their consumer products.

§4. A joint product produces different goods for different markets (e.g., oil can be cracked into gasoline and lubricants). If the price of one product is significantly higher than that of the other, then producers will focus on it over the other. If demand for the more valuable product collapses, then the less-valuable one will be more scarce, driving up its price.

§5. Marshall uses many figures and mathematical logic to explain joint and separate contributions to supply and demand, but I find these uninteresting. It’s important to understand complements and substitutes on the supply or demand side, but I think it’s quite difficult to work out their exact (financial or mathematical) relations, even with the best data.

§6. Those who demand or supply one input might benefit from lower (or higher) demand or supply for substitutes or complements, and they will lobby for laws and regulations to favor themselves, thereby distorting broader markets.

This post is part of a series in the Marshall 2020 Project, i.e., an excuse for me to read Alfred Marshall’s Principles of Economics (1890 first edition/1920 eighth edition), which dominated economic thinking until Van Neumann and Morgenstern’s Theory of Games and Economic Behaviour (1944) and Samuelson’s Foundations of Economic Analysis (1946) pivoted economics away from institutional induction and towards mathematical deduction.

Equilibrium of normal demand and supply, continued, with reference to long and short periods.

Book 5, Chapter 5

§1. “Normal” prices in markets for goods, services, labor, etc. can be pushed up or down to “abnormal” levels by technology, time, changes in season or tastes.

§2. Economists gain insights by via “ceteris paribus” (holding all other things equal) analysis that allows them to ignore complexities while focussing on the most important causal factors. Results are “cleaner” with more controls but less realistic. Marshall cautions against abuse (p 306):

But nothing of this [the world standing still] is true in the world in which we live. Here every economic force is constantly changing its action, under the influence of other forces which are acting around it. Here changes in the volume of production, in its methods, and in its cost are ever mutually modifying one another; they are always affecting and being affected by the character and the extent of demand. Further all these mutual influences take time to work themselves out, and, as a rule, no two influences move at equal pace. In this world therefore every plain and simple doctrine as to the relations between cost of production, demand and value is necessarily false: and the greater the appearance of lucidity which is given to it by skilful exposition, the more mischievous it is. A man is likely to be a better economist if he trusts to his common sense, and practical instincts, than if he professes to study the theory of value and is resolved to find it easy.

§3. Marshall recommends starting with a stationary state before introducing “partial perturbations,” which is now known as partial equilibrium analysis.

§4. He then explores how the prices of fish might vary in the short, medium and long terms. In the short term (day-to-day), prices rise and fall with weather, “meatless Fridays,” etc. When looking at the medium term (~2 years), these fluctuations might cancel out and they can be should be ignored while examining the impact of, e.g., a fall in demand for beef due to a multi-year plague that increases demand for fish. In such a case, prices will rise and stay there (should people permanently change their taste for beef) until long-term adjustments (e.g., more boats and fishermen) increase supply.

§5. Producers will consider time when responding to abnormal prices. In the short run, marginal producers will work harder to add more quantity to the market while incumbents enjoy excess profits from above-average prices. If abnormal prices look set to endure, then producers will alter their capital mix to fit the “new normal.”

§6. Producers will sell at a loss in the short run (e.g., when higher production costs cannot be recovered in prices), but not without considering impacts on the market, competition and their long-run (capital) costs. Marshall cautions: “he [the producer] regards an increase in his processes of production [VC and FC], rather than an individual parcel of his products [VC], as a unit in most of his transactions. And the analytical economist must follow suit, if he would keep in close touch with actual conditions” [p 312]. Economists should not let their theory stray too far from reality. In modern industrial organization, it’s “continue to produce while pq>c(q) — even if pq-c(q) < fc — but shut down if pq<c(q).”

§7. In the long run, investments in production capacity depend on the expectation of profits. Changes in those perceptions thus impact changes in long run supply, in terms of prices and quantities.

§8. Thus, Marshall concludes, short-run supply depends on current capacity whereas long-run supply allows for changes in capital and thus capacity. In both cases, prices also depend on changes in demand (tastes) as well as technology, which affects both supply (more efficient production) and demand (via the appearance of competing substitutes).

This post is part of a series in the Marshall 2020 Project, i.e., an excuse for me to read Alfred Marshall’s Principles of Economics (1890 first edition/1920 eighth edition), which dominated economic thinking until Van Neumann and Morgenstern’s Theory of Games and Economic Behaviour (1944) and Samuelson’s Foundations of Economic Analysis (1946) pivoted economics away from institutional induction and towards mathematical deduction.

The investment and distribution of resources

Book 5, Chapter 4

§1.Marshal begins with a simple example of a man building his own house, which he uses to explain how present costs must be less than (expected) future benefits, which are “normalized” (discounted to net present value) via a “sort of compound interest.” I find this beginning quite interesting, since I am now teaching students about cost-benefit analysis and discount rates!

§2. Expanding to the example of a businessman incurring costs now for potential (risk-adjusted) future benefits, Marshall explains how present values are “aggregated” to future values, whereas future values are “discounted” to present values, with the net benefit being calculated at the same point in time.

§3. Competing businessmen will change their mix of inputs in an attempt to find a cheaper means to the same end. Their profit-seeking searches increase efficiency and thus deliver “progress.”

§4. Marshall gives examples of a housewife or house builder changing their mixes of products and inputs, to maximize net benefits. These substitutions are mathematically equalized via “marginal products” that both implicitly understand as if solving equations.

§5. A businessman must recover both “prime” (variable) and “supplementary” (fixed) costs when pricing products for sale.

§6. In the short run, a product’s price need only cover variable costs, but revenues total sales must cover fixed costs in the longer run, if the business is to continue.

This post is part of a series in the Marshall 2020 Project, i.e., an excuse for me to read Alfred Marshall’s Principles of Economics (1890 first edition/1920 eighth edition), which dominated economic thinking until Van Neumann and Morgenstern’s Theory of Games and Economic Behaviour (1944) and Samuelson’s Foundations of Economic Analysis (1946) pivoted economics away from institutional induction and towards mathematical deduction.

Equilibrium of normal demand and supply

Book 5, Chapter 3

§1. What determines supply in the market? An individual trader considers a  host of factors (p 281):

Dealers take account of the areas sown with each kind of grain, of the forwardness and weight of the crops, of the supply of things which can be used as substitutes for grain, and of the things for which grain can be used as a substitute… If it is thought that the growers of any kind of grain in any part of the world have been losing money, and are likely to sow a less area for a future harvest; it is argued that prices are likely to rise as soon as that harvest comes into sight, and its shortness is manifest to all. Anticipations of that rise exercise an influence on present sales for future delivery, and that in its turn influences cash prices.

From this, we can see how the market price depends on the mix of opinions from dealers, buyers and sellers, and how price volatility reflects differences in these opinions.

§2. The cost of producing a good depends on a mix of labor and capital costs (money paid), as well as their opportunity cost at the margin (money not paid). This formulation disagrees with Marx’s Labor Theory of Value because it evaluates capital costs not in terms of the embedded labor it took to produce that capital but in the capital’s alternative uses.

§3. The price for a good will depend on the cost of inputs needed to bring it to customers. Thus, a tree is cheap when it’s bought from the logger, but furniture made from that tree reflects the costs of transportation, transformation, design, retail rents, etc.

All market participants will change the mix of inputs as relative costs shift, to maximize profits. Thus Marshall introduces the Principle of Substitution.

§4. Most market participants watch each other, making it possible to assume a “single price” for a given good that changes with time and circumstances. The price will move up (or down) as demand exceeds (or trails) supply. Better run firms will expand faster (or contract slower) than worse run firms.

§5. The price of goods usually increases as quantity sold increases, due to the need to attract increasing quantities of inputs. Economies of scale (spending more capital to shift to larger machines) can lower costs at higher volumes, but that’s discussed later.

§6. Marshall describes “equilibrium” in price and quantity, before explaining how that equilibrium is moving more randomly than “a disturbed stone on a string returning to rest,” i.e.,

In an age of rapid change such as this, the equilibrium of normal demand and supply does not thus correspond to any distinct relation of a certain aggregate of pleasures got from the consumption of the commodity and an aggregate of efforts and sacrifices involved in producing it… We cannot foresee the future perfectly. The unexpected may happen; and the existing tendencies may be modified before they have had time to accomplish what appears now to be their full and complete work. The fact that the general conditions of life are not stationary is the source of many of the difficulties that are met with in applying economic doctrines to practical problems.

§7. Marshall gives one of his enduring metaphors for the relative importance of demand (value) versus supply (cost) in determining market equilibrium (p290):

We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production. It is true that when one blade is held still, and the cutting is effected by moving the other, we may say with careless brevity that the cutting is done by the second; but the statement is not strictly accurate, and is to be excused only so long as it claims to be merely a popular and not a strictly scientific account of what happens.

In the same way, when a thing already made has to be sold, the price which people will be willing to pay for it will be governed by their desire to have it, together with the amount they can afford to spend on it. Their desire to have it depends partly on the chance that, if they do not buy it, they will be able to get another thing like it at as low a price: this depends on the causes that govern the supply of it, and this again upon cost of production. But it may so happen that the stock to be sold is practically fixed. This, for instance, is the case with a fish market, in which the value of fish for the day is governed almost exclusively by the stock on the slabs in relation to the demand: and if a person chooses to take the stock for granted, and say that the price is governed by demand, his brevity may perhaps be excused so long as he does not claim strict accuracy.

…and with scissors and fish in hand, the chapter ends.

This post is part of a series in the Marshall 2020 Project, i.e., an excuse for me to read Alfred Marshall’s Principles of Economics (1890 first edition/1920 eighth edition), which dominated economic thinking until Van Neumann and Morgenstern’s Theory of Games and Economic Behaviour (1944) and Samuelson’s Foundations of Economic Analysis (1946) pivoted economics away from institutional induction and towards mathematical deduction.