Economic Analysis for Business

Economic Analysis for Business Chapters 10 An Interlude on the History of Economics

Value of the History of Economics • Why look at the history of economics in studying economics: • to make textbook and mainstream theory easier to follow • to recognise that the development of economic theory is achieved by particular individuals in particular circumstances • a matter of general cultural awareness

Wealth of Nations • Adam Smith and his Inquiry into the Nature and Causes of the Wealth of Nations changed the entire way economic issues have been conceived ever since • The book was published in 1776 and became in immediate sensation • It has never been out of print

Self Interested Individuals and Economic Prosperity • Smith argued economies were institutions that could be left to run themselves • At its centre is the argument that individuals, if left to act in their own best interests, will create a world of wealth more efficiently and with more certainty than any other possible way of arranging a nation’s affairs

The Metaphor of the Invisible Hand • business people do what they do to make money • but in going about making money, they actually do a great deal of social good although it was not their actual intention to do so • business people are only trying to become more wealthy themselves • but in acting in their own best interests, they are led by an invisible hand to act in ways that often turn out to be very good socially • indeed, had these business people actually decided to do things with the intention of benefiting society, it is uncertain whether they could have done so as effectively as they have by just building their own businesses and running their own firms

The Invisible Hand “[A merchant] generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it…. 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.... By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”

Business Motives “It is not from the benevolence of the butcher the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages.”

View of Merchants “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

View of Governments “It is the highest impertinence and presumption ... in kings and ministers, to pretend to watch over the œconomy of private people…. They [governments] are themselves always, and without any exception, the greatest spendthrifts in the society. Let them look well after their own expence, and they may safely trust private people with theirs. If their own extravagance does not ruin the state, that of their subjects never will.”

The Need for Saving “Whatever a person saves from his revenue he adds to his capital … or enables some other person to do so, by lending it to him for an interest, that is, for a share of the profits. As the capital of an individual can be increased only by what he saves from his annual revenue or his annual gains, so the capital of a society, which is the same with that of all the individuals who compose it, can be increased only in the same manner.”

Benefits from Trade “It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy.... What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.”

David Ricardo • David Ricardo Principles of Political Economy and Taxation, published in 1817 • Ricardo was narrow and deeply logical • The first of the analytical abstract economists

Comparative Advantage • The central idea of comparative advantage is that it is not whether one country is absolutely more productive than another that allows trade to occur. What matters is whether one country is relatively better at producing one good rather than another

Simple Example • Suppose in Country A, in one hour it can produce either one car or 1000 shirts • And suppose in Country B, in two hours it can produce either one car or 500 shirts • Country B is therefore not as good at producing either cars or shirts since in one hour it can only produce half a car and 250 shirts • But note this. In Country A the cost of one car is 1000 shirts since every time a car is produced 1000 shirts could have been produced instead • Using the same reasoning, in Country B the cost of one car is only 500 shirts

Trade Makes Both Better Off • Country A is better at producing both products, but is relatively better at producing shirts • Country B is not as good at producing either good, but is relatively better at producing cars • According to the theory of comparative advantage, Country A should produce only shirts which it should sell to Country B and use the money received to buy cars. • Country B should produce only cars and sell these to Country A and use the money it received to buy shirts • Both countries are better off since both will have more of both products since each is concentrating on what it does comparatively better than the other

Jean-BaptisteSay • His Treatise on Political Economy was published in 1803 to acquaint the French public with Adam Smith’s ideas • Not merely a restatement of Smith but had a number of innovations of his own

Say and the Entrepreneur • It was Say who first recognised the crucial importance of the entrepreneur as the initiator and organiser of the production process • It was through the entrepreneur that value adding activity was able to take place

Say’s Law • Say’s Law: demand is created by value adding production and by nothing else • For goods to be bought not only must goods be produced, but precisely those goods that others will be willing to buy are the ones that need to be produced • It was the rejection of this principle in 1936 that became known as the Keynesian Revolution

Thomas Robert Malthus • Wrote one of the most sensational and influential books of all time • In 1798, he published On Population • He argued that population rose more rapidly than food production • Darwin reached his conclusions on evolution by natural selection after reading On Population • Only the fittest would survive because there was not enough food to go around

Malthus and “General Gluts” • Principles of Political Economy published in 1820 • Commenced a debate on the causes of recession • Malthus argued that recessions were caused by a deficiency of demand • Too much was being saved and not enough was being spent to employ the entire working population of England

Ricardo and “General Gluts” • Ricardo led the opposition to Malthus on general gluts • Debate in part carried on through correspondence • Corresponded over was the question of overproduction and demand deficiency • It was this correspondence that a century later would lead to the Keynesian Revolution

John Stuart Mill and the General Glut Debate • General Glut debate ended with the publication of John Stuart Mill’s Principles of Political Economy in 1848 • The overwhelming view of the entire mainstream of the economics profession was that Say’s Law was valid • Demand deficiency or overproduction was never an actual cause of recession

Mill’s Conclusion • In opposing Malthus Mill wrote: “A theory so essentially self-contradictory cannot intrude itself without carrying confusion into the very heart of the subject, and making it impossible even to conceive with any distinctness many of the more complicated economical workings of society.”

Adam Smith and the Labour Theory of Value “Labour ... is the only universal, as well as the only accurate measure of value, or the only standard by which we can compare the values of different commodities at all times and at all places.”

David Ricardo and the Labour Theory of Value “It is not by the absolute quantity of produce obtained by either class, that we can correctly judge of the rate of profit, rent, and wages, but by the quantity of labour required to obtain that produce.”

Karl Marx • Two major works • Communist Manifesto published in 1848 • Capital (volume 1) published in 1867 – two additional volumes came later • Capital dealt with capitalist exploitation of the worker

Karl Marx and the Labour Theory of Value • Marx is seen as part of the classical tradition of Smith and Ricardo • The Labour Theory of Value embedded in Marx • Source of worker exploitation if all value comes from labour but others share in the proceeds • In market oriented economies little penetration of Marxist thinking into economic theory

Breakdown of the Classical School • LTV could not explain value and relative prices • massive industrial structures destroyed basis for laissez-faire • could not remotely consider leaving economic activity to the market without detailed government involvement and regulation • a theoretical structure was sought that would preserve the role of the entrepreneur while guiding economic regulatory policy • provide a theory which explained the role of profit which showed profits were not exploitation but a return for value adding input • settle conflicts of interest • externalities

William Stanley Jevons and the Marginal Revolution • Where did value come? Why were diamonds expensive but almost useless while water cost nothing but was necessary for life? • William Stanley Jevons published his Principles of Political Economy in 1871 • Jevons wrote: “value depends entirely upon utility” • Subjective theory of value based on demand

Spread of Marginal Analysis • with incomes, it was argued that each person receives the value of their marginal product • capitalists receive the value of their addition to total output – answer to Marx’s Labour Theory of Value • distribution of income based on contribution to production • most important consequence was that the focus was concentrated onto individual decision making rather than the theory of national wealth and prosperity • microeconomics

The Theory of the Business Cycle • Economies were cyclical in their level of activity • There were periods of prosperity followed by periods of recession, often deep recession • theories of the cycle had developed with intention of first explaining causes of recessions • eventual aim to devise programme to limit depth and duration of the downward phase

Ricardo on the Business Cycle “Men err in their productions, there is no deficiency of demand.” • This statement sums up the classical version of Say’s Law – “no deficiency of demand” • Also provides the briefest statement of the classical theory of recession – “men err in their productions”

Say’s Law in the 1920s – Fred Taylor “Among the fallacious notions in popular thinking that have gained very wide currency are to be found a number which grew out of misconceptions as to the real source of the general or total demand for goods, and as to the methods by which that demand is increased or diminished. Several types of these fallacious notions may be cited. Thus, governmental improvements of all kinds, including even those of questionable value, are often supported by business men and others on the ground that such improvements increase the total demand for goods.”

Defining Say’s Law in the 1920s “Principle – Say’s Law. The Ultimate Identity of Demand and Product. “In the last analysis, the demand for goods produced for the market consists of goods produced for the market.”

Keynesian Revolution • The next major revolution in economics was the overturning of Say’s Law • Responsible for this change in direction was the English economist John Maynard Keynes • He, like Malthus, at the time he wrote was the single most famous economist in the world having written The Economic Consequences of the Peace at the end of World War I

Malthus’s Letters to Ricardo • His reading of Malthus’s letters to Ricardo during the depths of the Great Depression in late 1932 that turned Keynes’s thoughts towards the possibility of recessions occurring as a result of a failure of demand • Keynes made no secret that he was recommencing a debate that had last been active during the first half of the nineteenth century

Keynes on Malthus and Ricardo “The idea that we can safely neglect the aggregate demand function is fundamental to the Ricardian economics, which underlie what we have been taught for more than a century. “Malthus, indeed, had vehemently opposed Ricardo’s doctrine that it was impossible for effective demand to be deficient; but vainly. “For, since Malthus was unable to explain clearly (apart from an appeal to the facts of common observation) how and why effective demand could be deficient or excessive, he failed to furnish an alternative construction; and Ricardo conquered England as completely as the Holy Inquisition conquered Spain.

Keynes on Malthus and Ricardo continues • “Not only was his theory accepted by the city, by statesmen and by the academic world. • “But controversy ceased; the other point of view completely disappeared; it ceased to be discussed. • “The great puzzle of Effective Demand with which Malthus had wrestled vanished from economic literature.”

Implications of Belief in Say’s Law, According to Keynes • full employment guaranteed by the operation of the market • “supply creates its own demand” • everything produced automatically finds a buyer • aggregate demand always equals aggregate supply • recessions would never occur and full employment would always be a certainty

Conclusions from Keynes • economies are not self regulating but require constant economic management to keep them on course • economies if left to themselves will fall into prolonged periods of recession with high rates of unemployment • aggregate demand the major driver of economic activity • the role of economic management is to maintain the level of aggregate demand at a sufficiently high level to maintain economic activity at a level that will employ the entire workforce

Demand and Saving • the cause of too little demand was, according to Keynes, too much saving • withdrawals from the spending stream caused by decisions to save were greater than the level of injections that would arise through private investment • interest rates could not be expected to adjust to allow the supply and demand for savings to equilibrate • to bring an economy out of recession required someone to utilise the savings that private investors were refusing to borrow

Keynesian Policy • A “Keynesian” solution is to increase level of public spending during an economic downturn • The aim is to maintain the level of aggregate demand

Economic Analysis for Business