G601, IO I Eric Rasmusen, erasmuse@indiana 7 September 2006 SMITH-MARSHALL-SCHUMPETER

1. G601, IO I Eric Rasmusen, erasmuse@indiana.edu 7 September 2006 SMITH-MARSHALL-SCHUMPETER This is for one 75 minute session .

2. Readings • 7 September, Thursday. Classics-- The Big Picture • Adam Smith, Wealth of Nations , Book I chapters 1, 2, 3, 9, and 10. Alfred Marshall, chapters 10 to 12 of Book IV of his Principles of Economics (8th edition, 1920).Alfred Marshall'sletter to Bowley on mathematics and economics. Joseph A. Schumpeter, "The Fundamental Problem of Economic Development," The Theory of Economic Development, tr. Redvers Opie, pp. 57-94 (Oxford: Oxford University Press, 1934, 1st edition in German, 1911). Two parts in large files: 1 and 2. Judith Lachman,``Knowing and Showing Economics and Law,'' (A review of An Introduction to Law and Economics, A. Mitchell Polinsky (1983)) Yale Law Journal, 93: 1587, 1598-1605 (July 1984). Reader 12.

3. NEXT TIME • Accounting and Data • Just skim Lilly report, except for the financial tables. • Problem Set 2 (due next Tuesday): 3.4, 3.5, 3.8.

4. Handouts • PS answers

5. History of Thought in Economics • Stigler story—required course • My 8 Great Economists Course at Yale. Who are they?

6. Question: Which of the three—Smith, Marshall, or Schumpeter, was the most worth reading for you personally? (write it down, pass to X, let X count and announce towards the end of class)

7. Adam Smith • Wealth of Nations (1776) • The Theory of Moral Sentiments • An excellent writer---still worth reading • No diagrams or equations yet, but good verbal analysis • Project Gutenberg, http://promo.net/pg/

8. The Pin-Maker An unpractised skilled blacksmith can make 300 bad nails in a day. A practised boy can make 2,300 good ones. (concrete, specific, empirical evidence) 1 person: 20 pins 10 people plus machines: 48,000 pins Why? 1. Increase of dexterity from practice 2. Time savings from not switching 3. Specialized machines Leonard Read, "I, Pencil," The Freeman (December 1958). http://www.econlib.org/library/Essays/rdPncl1.html.

9. 2nd Paragraph: IO In those great manufactures, on the contrary. which are destined to supply the great wants of the great body of the people, every different branch of the work employs so great a number of workmen, that it is impossible to collect them all into the same workhouse. We can seldom see more, at one time, than those employed in one single branch. Though in such manufactures, therefore, the work may really be divided into a much greater number of parts, than in those of a more trifling nature, the division is not near so obvious, and has accordingly been much less observed.

10. Sauntering “A man commonly saunters a little in turning his hand from one sort of employment to another. When he first begins the new work, he is seldom very keen and hearty; his mind, as they say, does not go to it, and for some time he rather trifles than applies to good purpose.”

11. Innovation In the first fire engines, a boy was constantly employed to open and shut alternately the communication between the boiler and the cylinder, according as the piston either ascended or descended. One of those boys, who loved to play with his companions, observed that, by tying a string from the handle of the valve which opened this communication to another part of the machine, the valve would open and shut without his assistance, and leave him at liberty to divert himself with his play-fellows. One of the greatest improvements that has been made upon this machine, since it was first invented, was in this manner the discovery of a boy who wanted to save his own labour.

12. Other Sources of Innovation All the improvements in machinery, however, have by no means been the inventions of those who had occasion to use the machines. Many improvements have been made by the ingenuity of the makers of the machines, when to make them became the business of a peculiar trade; and some by that of those who are called philosophers, or men of speculation, whose trade it is not to do any thing, but to observe every thing, and who, upon that account, are often capable of combining together the powers of the most distant and dissimilar objects.

13. Advantage • The corn of Poland, in the same degree of goodness, is as cheap as that of France, notwithstanding the superior opulence and improvement of the latter country. • The corn of France is, in the corn provinces, fully as good, and in most years nearly about the same price with the corn of England, … • The corn-lands of England, however, are better cultivated than those of France, and the corn-lands of France are said to be much better cultivated than those of Poland. • But though the poor country, notwithstanding the inferiority of its cultivation, can, in some measure, rival the rich in the cheapness and goodness of its corn, it can pretend to no such competition in its manufactures; at least if those manufactures suit the soil, climate, and situation of the rich country. • Absolute vs. comparative advantage (Ricardo, rent)

14. Joseph Schumpeter • Theory of Economic Development (1912) • Capitalism, Socialism and Democracy (1942) • The famous joke. Founding the Econometric Society, advising Samuelson. • Innovation idea. • Finance minister in Austria

15. Schumpeter onThe Entrepreneur I “When he swims with the stream in the circular flow which is familiar to him, he swims against the stream if he wishes to change the channel. What was formerly a help becomes a hindrance. What was a familiar datum becomes an unknown. Where the boundaries of routine stop, many people can go nofurther, and the rest can only do so in a highly variable manner.” “...every man would have to be a giant of wisdom and will, if he had in every case to create anew all the rules by which he guides his everyday conduct.”

16. Schumpeter onThe Entrepreneur II “In the breast of one who wishes to do something new, the forces of habit rise up and bear witness against the embryonic project.” “It is no part of his function to “find” or “create” new possibilities. They are always present, abundantly accumulated by all sorts of people. Often they are also generally known and being discussed by scientific or literary writers.” “For its success, keenness and vigor are not more essential than a certain narrowness which seizes the immediate chance and nothing else.”

17. 5 Types of Innovation 1. new goods (product innovation) 2. new methods of production (process innovation) 3. new markets 4. new sources of inputs 5. new organization

18. Alfred Marshall • Principles of Economics (1st edition 1890, 8th edition 1920) • Supply and demand curves • A mathematician, but he wanted to be accessible, so technical stuff like diagrams are in footnotes and appendix • Hugely influential • Stimulating, but not as worth reading as Adam Smith

19. Marshall on Math Marshall, spelled out more fully his position on the uses of mathematics in economics in a letter to Bowley of 27 February 1906: . . . 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 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.

20. INDUSTRIAL ORGANIZATION, CONTINUED. BUSINESS MANAGEMENT …we have to inquire how it occurs that, though in manufacturing at least nearly every individual business, so long as it is well managed, tends to become stronger the larger it has grown; and though primâ facie we might therefore expect to see large firms driving their smaller rivals completely out of many branches of industry, yet they do not in fact do so.

21. Marshall on Location But there is also the convenience of the customer to be considered. He will go to the nearest shop for a trifling purchase; but for an important purchase he will take the trouble of visiting any part of the town where he knows that there are specially good shops for his purpose. Consequently shops which deal in expensive and choice objects tend to congregate together; and those which supply ordinary domestic needs do not

22. Marshall on National Income Accounting But in recent years a rapid growth of the use of steam power in the fields has coincided with the increased importation of farm produce. The coal-miners who supply these steam-engines with fuel, and the mechanics who make them and manage them in the fields are not reckoned as occupied on the land, though the ultimate aim of their labour is to promote its cultivation. The real diminution then of England's agriculture is not so great as at first sight appears; but there has been a change in its distribution.

23. Marshall on Managerial Diseconomies of Scale On the other hand the small employer has advantages of his own. The master's eye is everywhere; there is no shirking by his foremen or workmen, no divided responsibility, no sending half-understood messages backwards and forwards from one department to another. He saves much of the book-keeping, and nearly all of the cumbrous system of checks that are necessary in the business of a large firm; and the gain from this source is of very great importance in trades which use the more valuable metals and other expensive materials.

24. Marshall on Honesty It is a strong proof of the marvellous growth in recent times of a spirit of honesty and uprightness in commercialmatters, that the leading officers of great public companies yield as little as they do to the vast temptations to fraud which lie in their way. If they showed an eagerness to avail themselves of opportunities for wrong-doing at all approaching that of which we read in the commercial history of earlier civilization, their wrong uses of the trustsimposed in them would have been on so great a scale as to prevent the development of this democratic form of business. Chapter 12

25. Industrial Organization In remote villages in almost every county of England agents of large undertakers come round to give out to the cottagers partially prepared materials for goods of all sorts, but especially clothes such as shirts and collars and gloves; and take back with them the finished goods. … There is a continual contest between the factory and the domestic system, now one gaining ground and now the other:

26. Managers and Entrepreneurs … the manufacturer who makes goods not to meet special orders but for the general market, must, in his first rôle as merchant and organizer of production, have a thorough knowledge of things in his own trade. He must have the power of forecasting the broad movements of production and consumption, of seeing where there is an opportunity for supplying a new commodity that will meet a real want or improving the plan of producing an old commodity. … But secondly in this rôle of employer he must be a natural leader of men. He must have a power of first choosing his assistants rightly and then trusting them fully; of interesting them in the business and of getting them to trust him, so as to bring out whatever enterprise and power of origination there is in them; while he himself exercises a general control over everything, and preserves order and unity in the main plan of the business.

27. The Education of the Childrenof Entrepreneurs “He himself [the entrepreneur] was probably brought up by parents of strong earnest character; and was educated by their personal influence and by struggle with difficulties in early life. But his children, at all events if they were born after he became rich, and in any case his grandchildren, are perhaps left a good deal to the care of domestic servants who are not of the same strong fibre as the parents by whose influence he was educated.”

28. Moral Hazard and Adverse Selection … under the scheme of Profit-Sharing, a private firm while retaining the unfettered management of its business, pays its employees the full market rate of wages, whether by Time or Piece-work, and agrees in addition to divide among them a certain share of any profits that may be made above a fixed minimum; it being hoped that the firm will find a material as well as a moral reward in the diminution of friction, in the increased willingness of its employees to go out of their way to do little things that may be of great benefit comparatively to the firm, and lastly in attracting to itself workers of more than average ability and industry

30. Course Website A link to the course website http://www.rasmusen.org/g601/0.g601.htm