Econ 309: Capitalism as Complexity

1. Econ 309: Capitalism as Complexity July 13th

2. Capitalism as complexity • The supply-and-demand model is a fairly simple model of how markets work • Macroeconomic models of the economy tend, if anything, to simplify still more radically • Yet Adam Smith’s ideas about the division of labor link growth to complexity, suggesting that theories which rely on simplification may miss the point

3. Disclaimer: Austrian verbosity Not all the eloquence and erudition of mid-20th-century public intellectuals like Schumpeter and Hayek is relevant today. There are occasional insights and a lot of fog.

4. General equilibrium theory • GE models are “static,” atemporal • GE models tend to work better for understanding allocation than production • GE models tend to predict no trade in equilibrium • GE models that involve production typically depend on an implicit assumption of constant returns to scale

5. Adam Smith’s Big Ideas • Economic improvement is a result of the division of labor. • Division of labor emerges not by design, but through the self-interested independent actions of millions of people (the “invisible hand”). • The division of labor is limited by the extent of the market.

6. Adam Smith: Self-interest • We appeal to the self-interest of the butcher, baker, etc. to supply our needs • A person’s friends (“social capital,” as Robert Putnam calls it) are too few in number to provide for large scale division of labor • The great irony: people are individually selfish, yet their pursuit of selfish ends benefits the greater good! • Compare: Schumpeter’s self-interested “bourgeoisie” • How often do we rely on (a) markets, (b) social capital, (c) government to supply our needs?

7. Friedrich Hayek: The failure of planning • Hayek emphasizes the importance of local knowledge (as opposed to scientific knowledge) in running an economy • Decisions must be left to the people who have the local knowledge • Central planners can never assemble all the needed information

8. Freidrich Hayek: GE theory and the price system “The economic calculus proper [i.e., formal mathematical models of general equilibrium] helps us, at least by analogy, to see how this problem [of allocating resources] can be solved, and in fact is being solved, by the price system… It is indeed the great contribution of the pure logic of choice that it has demonstrated conclusively that even [a central planner] could solve this kind of problem only by constructing and constantly using rates of equivalence (or “values,” or “marginal rates of substitution”), i.e., by attaching to each kind of scarce resource a numerical index which cannot be derived from any property possessed by that particular thing, but which reflects, or in which is condensed, its significance in view of the whole means-ends structure.” (Hayek, 525)

9. Hayek vs. Coase • Both Coase and Hayek generally want to leave allocation decision to the market • But Coase, who emphasizes incentives of private actors, wants the state to allocate property rights in order to maximize efficiency • Whereas Hayek, who emphasizes information, casts doubt on whether a central planner (e.g., a judge) will have the knowledge to do this • The public choice school (we’ll discuss them next week) would question whether incentives of public actors will give them reason to do it

10. Adam Smith: The division of labor is limited by the extent of the market • A simple principle: the more people, the more division of labor! • But what is “the extent of the market?” • A large town is a larger market than a small town • Access to the sea increases the size of the market • A maritime theory of comparative development • Water transport is far cheaper than land transport • Industry and cash-crop cultivation progress first along the coasts and navigable rivers • Africa, with little access to the sea and few navigable rivers, is underdeveloped

11. Wolf: History of globalization • Long-run globalization: spread of religions, languages, diseases, empires, technologies, and crops has been going on for millennia • One great age of globalization occurred in the 19th century, but collapsed in the time of the world wars • Since WWII, another era of globalization has been underway

12. Wolf: Effects of globalization • Enemies of globalization: • Social security vs. immigration: When people’s citizenship becomes their greatest asset, they want to restrict access to it • Protectionism leads to imperialism by creating a need to secure markets • Socialist economies tend to be closed because a central planner needs to control the economy

13. Wolf: Dimensions of (economic) globalization • Trade • Trade-to-GDP ratios are generally higher today than during the first era of globalization • WTO has brought tariffs down to low levels • “Splitting up the value chain” is more sophisticated today

14. Wolf: Dimensions of globalization • Capital • The world’s leading power today, the US, is a huge importer of capital, whereas the UK c. 1900 was a huge exporter • Globalized capital markets tend to be among rich countries, whereas c. 1900 they channeled capital from rich to poor countries • Possible explanation: imperialism facilitated rich-to-poor capital flows

15. Wolf: Dimensions of globalization • Migration • Large migrant flows occurred in the 19th century, e.g. • Indians to Africa, Guyana • British to Canada, Australia, Africa, America • Europeans to USA, Chile, Argentina • Chinese to Southeast Asia • Japanese to US, Latin America • French to North Africa • European Russia to Siberia • Migrant flows as a share of world population have not regained their 19th- and early 10th-century peaks

16. Wolf and Smith • Globalization and growth go together • This confirms Smith’s principles that: • Growth is driven by division of labor • Division of labor is limited by the extent of the market • See tables on p. 107, p. 108 • Post-WWII, a strong correlation between openness and growth in developing countries

17. Increasing returns • Smith’s arguments (supported by Wolf’s evidence) point to increasing returns at the macro level • But increasing returns at the macro level probably require increasing returns at the micro level… • … and increasing returns at the micro level create problems for competition theory (e.g., a prediction of generalized monopoly)

18. Monopoly and Competition: The entry game • If there are constant average costs, the monopolist cannot deter entry (result: perfect competition) • If there are fixed costs (but not sunk) and constant marginal costs, the monopolist can deter entry (result: “contestable monopoly”) • If there are sunk costs and constant marginal costs, the monopolist can deter entry

19. Example of pro-social monopoly: Patents • Innovating firm faces: • Substantial fixed development costs • Sizeable profits if an initial monopoly position can be retained, i.e., if entry can be prevented • Losses if new entrants can produce and sell the goods • Solution: Patents • If an innovator has the prospect of patent protection, temporary monopoly profits pay the costs of innovation

20. The Concept of “Monopolistic Competition” • Most firms enjoy a certain degree of monopoly power, e.g., due to location, loyal customers, unique features • (Exception: many agricultural markets fit the description of “perfect competition”) • Another way of putting it: most firms probably face downward-sloping demand curves • But they are face competitors with related products that are partial substitutes

21. Schumpeter on the classical economists • Endorses their vision but finds their theory deficient • Marshall and Wicksell preserve classical doctrines of competition but “in the process of being more correctly stated and proved, the [classic] proposition [that in the case of perfect competition the profit interest of the producer tends to maximize production] lost much of its content– it does emerge from the operation, to be sure, but it emerges emaciated, barely alive.” (Schumpeter, 77)

22. Schumpeter: Creative destruction • Perfect competition is the exception, not the rule • Instead, competition in the real world is best understood as “Creative Destruction” • Effective competition comes from new goods, processes, forms of business organization, etc. • Capitalism is an evolutionary process (Hayek called this “competition as a discovery process”)

23. Schumpeter: Monopolistic practices • Various practices identified as monopolistic are ways of dealing with the uncertainties of the “gale of Creative Destruction” • They result in under-utilization of resources at any given time but can increase the rate of growth in the longer term (as brakes make cars go faster) • Many competitive situations are analogous to the case of patents

24. Conclusions: Complexity and Policy • What does complexity imply for policy? • On the one hand, is a “simple” policy like laissez-faire inadequate to deal with a complex world? • On the other hand, a powerful “law of unintended consequences” applies to any state intervention.

25. Politics and Public Choice • The traditional approach: greedy people, beneficent states • May result from economists’ role as presumptive policy advisers • The public choice approach: apply the rational agent assumption to public-sector actors, e.g., voters, elected officials, bureaucrats, special interests • Are governments appropriate recipients of advice that favors the public interest?