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Towards an Objective Understanding of Scarcity

Posted by Alex M Thomas on 26th November 2013

When Henry Holt & Co. sent me an advance edition of Sendhil Mullainathan and Eldar Shafir’s Scarcity: Why Having Too Little Means So Much to review, I had presumed it to be another book on the ubiquitous nature of scarcity. However, their book, while acknowledging the phenomenon of scarcity to be omnipresent, argues, in a novel manner, the adverse effects scarcity has on the cognitive resources of individuals. In other words, scarcity (of money, time, etc.) forces people into a scarcity-trap: the poor stays poor; the busy remain busy; and the lonely remain lonely. For, ‘[s]carcity creates a mind-set that perpetuates scarcity.’ The aim of their book, writes Mullainathan and Shafir, is ‘to unravel the scientific underpinnings of scarcity’ in order to make more sense of ‘social and behavioral phenomena’ and is targeted at a ‘wide audience’. Their book is an attempt to present ‘the logic and consequences of scarcity.’

‘Scarcity captures our mind. … It changes how we think. It imposes itself on our minds.’ And, ‘scarcity’s capture of attention affects not only what we see or how fast we see it but also how we interpret the world.’ Hence the authors argue that scarcity ‘is not just a physical constraint. It is also a mind-set.’ The consequence of scarcity, according to Mullainathan and Shafir, is that it makes ‘us less insightful, less forward-thinking, less controlled.’ It reduces our ‘bandwidth’ – our cognitive ability. There is however a positive outcome of scarcity, the ‘focus dividend,’ which makes us more effective in the immediate period but ‘scarcity eventually ends in failure.’ They label the mechanism which reduces our cognitive resources ‘tunneling’. ‘Sometimes when we tunnel, we neglect other things completely.’ ‘Focus dividend’ is a short-term positive outcome of scarcity whereas ‘tunneling’ is a long-term adverse consequence arising from the tax scarcity imposes on our bandwidth. They are, in fact, interdependent phenomena. Based on their experiments, they observe that poor people ‘tunnel’ and therefore do not purchase insurance which would have helped them in the future. For, ‘scarcity taxes bandwidth’ and ‘generates internal disruption’ by lowering ‘fluid intelligence and executive control’. The authors acknowledge the role ‘self-control’ could play in overcoming scarcity, but they note that ‘will-power’ is something which is not yet fully understood. To summarise: ‘[t]he problem is not the person but the context of scarcity.’

Opposite of scarcity is ‘slack’ or ‘abundance’. ‘Slack’, writes the authors, ‘is a consequence of not having the scarcity mind-set.’ Those who have an abundance of resources (money or time) have the luxury not to make trade-offs. Additionally, ‘[s]lack gives us room to fail.’ Scarcity therefore not only leads to ‘greater errors’ due to the bandwidth tax, but also implies that there is ‘less room to fail.’ Marginalist economics treats any unused or underutilised resource as wasteful and inefficient and the authors follow this logic. Although, in the later part of the book, they distinguish between useful and useful slack. Of course, what is useful or wasteful depends on the goals or aims of the individual, organisation or government. The subjective assessment of physical/objective scarcity is also dependent on the goals, and the process of tunneling depends on this subjective measurement of scarcity and the goals. Therefore, the experience of scarcity is in itself conditioned by the goals and they affect each other in a dynamic fashion – reasoning is not limited to the means to achieve the ends, but it also can modify the ends. In the initial chapters, the authors, using results from experiments, quite convincingly argue that the subjective feeling of scarcity generates an objective result – it taxes the bandwidth and lowers the cognitive ability. In fact, the entire book can be seen as an attempt to provide an objective understanding of scarcity (which can be real or imagined or both).

Scarcity leads to borrowing. Borrowing, according to the authors, is a ‘simple consequence of tunneling.’ Although, it is conceivable that scarcity can lead to borrowing, it certainly cannot be maintained that all borrowing is because of tunneling. The phenomenon of a debt-trap is nothing new. ‘Scarcity leads us to borrow and pushes us deeper into poverty.’ Scarcity, writes the authors, causes the poor to focus more on immediate (short-term) goals and they overlook long-term goals. The focus on several short-term goals is termed juggling, and is a ‘logical consequence of tunneling.’That is, the poor resort to ‘short-term fixes.’ Can one get out of scarcity? Without some external intervention, the authors argue, it is highly unlikely. For, getting out of the scarcity-trap requires a (long-term) plan but since the goal is not immediate, the scarcity mind-set does not accommodate it. ‘Planning requires stepping back, yet juggling keeps us locked into the current situation.’ Also, ‘future planning requires bandwidth, which scarcity taxes heavily.’ To state the obvious, the authors note that ‘[a]ll this is complicated by the lack of slack.’ Scarcity implies a lack of slack. Similarly, slack implies a lack of scarcity. Owing to the objective effects of scarcity on cognitive resources, getting out of a scarcity-trap is extremely difficult, be it those who lack money or time.

Chapters 7 and 8 are devoted to understanding (income) poverty and some suggestions are offered for improving the lives of the poor. The authors rightly argue that the extant explanation of poverty is largely ‘piecemeal.’ Their major contribution, I think, to studies on poverty is that the poor ‘lack not only money but also bandwidth’ as a consequence of their income poverty. As they ask: ‘Why not look at the structure of the programs rather than the failings of the clients?’ This bandwidth tax is something the designers of social programmes ignore. Therefore, ‘strong incentives’ do not often function well. The authors call for social programmes which are ‘fault tolerant’ given the already taxed bandwidth of the poor. A limit ‘penalises but fails to motivate’ the poor and according to the authors such limits/penalties on incentives are flawed because they do not take into account the cognitive effects of scarcity. ‘Limits create scarcity, the logic goes, which might lead to better management of how the resource is “used.” This almost relies on the psychology of scarcity. But it is flawed.’ A better solution, according to Mullainathan and Shafir, would be ‘to create smaller but more frequent limits.’

A greater focus on the creation of dependable jobs and stable incomes for the poor across the world could be psychologically transformative.

All this is a radical reconceptualization of poverty policy. … Now, rather than looking at education, health, finance, and child care as separate problems, we must recognize that they all form part of a person’s bandwidth capacity.

A powerful and political conclusion emerges from the authors: social engineering should be built on better foundations, in this case, that of the psychology of scarcity.

Chapter 9 is titled ‘Managing Scarcity in Organizations’ wherein the importance of slack is stressed, in contrast to the views espoused by the ‘efficiency experts.’ Organizations should ‘explicitly manage and ensure the availability of slack.’ In other words, the quality of the workplace must be improved – less surveillance, adequate leaves, reduced working hours, etc. For, as the authors note:

Increasing work hours, working people harder, foregoing vacations and so on are all tunneling responses, like borrowing at high interest. They ignore the long-term consequences.

In line with the optimizing story told by marginalist economics, Mullainathan and Shafir emphasise the need to ‘maximize our limited cognitive capacity.’ They call for a greater focus on the ‘cognitive side of the economy’ and even go as far as to suggest the creation of a ‘Gross National Bandwidth’ index!

Despite the authors adopting some static concepts employed in marginalist economics of a very subjective nature, their research points towards a very dynamic and objective understanding of scarcity. Moreover, the adverse consequences of scarcity on cognitive resources highlight the extreme importance of careful social engineering, especially in the reduction of poverty.

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Posted in Behavioral Economics, Book reviews, Economics, Marginalist economics | No Comments »

Two Fundamental Objections to Marginalist Economics

Posted by Alex M Thomas on 31st October 2013

In the past, several posts on this blog have raised dissatisfactions and have expressed discontent with the prevalent orthodoxy in economics – neoclassical economics (more accurately, marginalist economics). This post is similar in intent as the previous posts, but it chooses to focus on, what I deem to be, the two most theoretically and empirically inadequate tenets of marginalist economics: (1) the marginal productivity theory of (income) distribution and (2) the supply-side growth theory.

Equilibrium prices and quantities of commodities and factors of production (such as labour and ‘capital’) are determined simultaneously in marginalist economics. Distribution is endogenously determined according to the relative scarcity of factors, i.e., based on the demand and supply of factors. Under conditions of perfect competition, in equilibrium, the wage rate equals the marginal product of labour and the profit rate equals the marginal product of ‘capital’. That is, there is no surplus in the marginalist theory of value and distribution. The origin of the marginal principle is to be found in Ricardo’s discussion of intensive rents. This principle has been illegitimately extended to labour and to ‘capital’. In marginalist production theory, labour is freely substitutable with ‘capital’. The famous Cobb-Douglas production function is based on the substitutability of the two factors of production. The use of the aggregate production function has been shown to be logically unsound (due to problems of not just measurement but also aggregation of ‘capital’) and therefore its applicability in empirical analysis is severely undermined. But, this logical critique, famously known as the Cambridge Capital Controversies, remains ignored.

Underlying the supply-side theory of growth is the marginal productivity theory of distribution. Relative scarcities of the factors induce changes in their prices such that the demand for factors equals their supply. This implies that, in equilibrium, all factors are employed. The real wages are assumed to be sufficiently sensitive to disequilibrium in the labour market such that they adjust in order to render the labour demand equal to its supply. And, the aggregate production function states that a growth in the factors will lead to a growth in output. In other words, if the labour and ‘capital’ endowments are increased, there will be higher growth. Aggregate demand adapts to aggregate supply and the possibility of an aggregate demand deficiency is ruled out. Slight modifications have been made to this theory in order to explain the presence of unemployment. These modifications take the form of rigidities of the real wage, which cause labour unemployment. In marginalist theory, one of the explanations for the presence of unemployment is labour market rigidities. If these rigidities are absent, labour will tend to be fully employed. Such theories have come under severe criticism and rightly so.

To conclude, marginalist economics is unsatisfactory on logical grounds. Moreover, it does not perceive the possibility of an aggregate demand deficiency. Lastly, unemployment is seen to be a consequence of imperfections or rigidities and not as permanent feature of competitive economies.

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Posted in Economic Growth, Economics, Marginalist economics, Neoclassical Economics | 1 Comment »

Understanding India’s Economic Growth and Development

Posted by Alex M Thomas on 28th July 2013

This post is a review of the recent book by Jean Drèze and Amartya Sen titled An Uncertain Glory: India and Its Contradictions. An earlier post in this blog has dealt with the vexed relation between economic growth and development and elsewhere, I have discussed the need to focus on the structure of economic growth. Drèze and Sen’s book contains 10 chapters including the introduction (‘A New India?’) and the conclusion (‘The Need for Impatience’); the main text spreads across 287 pages. Their argument is buttressed with comparative exercises between Indian states, international comparisons, historical facts, surveys, published data sources and contemporary events apart from ample secondary literature. However, this review does not engage with their empirical findings.

For Drèze and Sen, the aim of any society should be the expansion of human capabilities. And, institutions such as markets and democracy are a means to that end. Similarly, economic growth ‘generates resources’ which can be used to improve human capabilities. As they write in the preface, ‘the achievement of high growth must ultimately be judged in terms of the impact of that economic growth on the lives and freedoms of the people’ (p. viii). Human capabilities, as is to be expected, refer to a spectrum of endowments and the ability to access all of them. For instance, it includes, in no particular order, nutrition (pp. 157-162), education (see ch. 5), health (see ch. 6), clean environment (pp. 41-44), access to energy (pp. 84-87), transportation, communication and banking infrastructure. The ability to access them, however, is severely constrained by caste (pp. 218-223). And some of them are also constrained by gender (pp. 224-239) besides other power relations.

Given India’s high growth rate, the authors pose one major question: why has the ‘pace of change … been excruciatingly slow’ for majority of the Indian populace (p. 29)? According to Drèze and Sen, the major cause for this is the abysmal situation of public education and health in India. (There are some Indian states which have done relatively better.) This is because of issues relating to accountability and also due to insufficient public spending. Moreover, the authors harshly criticize the Indian media for their ‘excessive focus on a relatively small part of the population whose lives and problems are much discussed’ (p. 261; see also pp. 262-267). This wide gap in public discourse provides their motivation in writing the book. Hence, they point out the ‘importance of enlightened public reasoning’ as ‘a central part of the general thesis of this book’ (p. 239). Furthermore, they state that ‘this book is aimed much more as an attempted contribution to public reasoning, including discussion in the media, than at giving professional advice to the government in office’ (p. 253).

Is their account of economic growth and development entirely satisfactory? Their second chapter is about ‘Integrating Growth with Development’. First, what determines economic growth? According to mainstream (neoclassical) economics, a growth in physical capital, human capital (educated and healthy workforce) and technological progress causes economic growth. This is known as the supply-side view of economic growth. If we accept this growth account, then clearly an improvement in the quality of life directly contributes to faster economic growth. Drèze and Sen do not have theoretical dissatisfactions with mainstream economics, as is made very clear in the following passage written in the context of a discussion on markets.

Relying solely on the market has become a strongly advocated theme in India on the basis on highly exaggerated expectations, often based on a misreading of the conclusions of mainstream economics, which includes much scepticism of the performance of markets in the presence of externalities, public goods, asymmetric information and distributional disparities. We do not have to look for any “alternative economic paradigm” to see what the market cannot do, in addition to what it can do – and do very well. (p. 184; emphasis added)

They also approvingly cite Joel Mokyr and Elhanan Helpman who emphasize the importance of ‘accumulation of knowledge’ and ‘total-factor productivity’ through education in economic growth respectively (p. 35). This is the supply-side production function approach in understanding the growth determinants. No one denies their significance. However, if one is convinced by such a theory/view of economic growth, the popular version of it being the Cobb-Douglas production function in various clothes, then, theoretically, physical capital can be substituted with human capital. And, this would entail a very different method of attaining economic development from that mentioned in the book. Moreover, aggregate demand does not play a role in this growth account; as the authors write in the preface, the ‘expansion of human capability, in turn, allows a faster expansion of resources and production, on which economic growth ultimately depends’ (p. x). That is, economic growth is entirely determined by the growth of aggregate supply, without considering the problems which can arise from aggregate demand deficiency (such as a fall in wage income or decrease in government spending). Without getting into the details of the argument, it appears that their conception of economic growth and development sits more comfortably with the economics of the classical economists (such as Adam Smith, David Ricardo and Karl Marx) combined with the effective demand theories of Michal Kalecki and John Maynard Keynes.

The surplus generated from economic growth can be utilized for societal needs which is further determined through socio-political movements and economic considerations of the entrepreneurs as well as the state. To put it differently, ‘the fruits of growth’ need to be allocated intelligently – based on our physical, economic, environmental, social and cultural needs (p. 9; cf. p. 14, p. 18, p. 38). There are two very different kinds of distribution that takes place – income distribution between wage-earners and profit-earners and the expenditure of the government from the revenue they collect as taxes and duties. They also observe,

The impact of economic growth on the lives of the people is partly a matter of income distribution, but it also depends greatly on the use that is made of the public revenue generated by economic expansion. (p. 37)

They mention the importance of collective bargaining (p. 141) and point out that the NREGA ‘strengthened the bargaining power of rural workers’ (p. 201). But their focus in the book is how to utilize public revenue in improving the quality of life (p. 269). Since this public revenue can be utilized in a variety of ways, Drèze and Sen assert ‘the constructive role of the state for growth and development’ (p. 39; italics in original). Hence, the organs of the state need to be made more accountable (ch. 4).

Since democracy offers ‘significant opportunities’ for improving the quality of life as well as its pace, the authors are ‘contingently optimistic’ (p. xii). In fact, the issues addressed by the authors are intended to be a contribution to a wider debate on how to construct a better society. Thus, the book aims to provide ‘reasoned solutions to the problems’ (p. 3). They also write that ‘economic reforms, even when appropriate, require informed public debate’ (p. 28). In sum, there ought to be a ‘greater use of informed reasoning in the practice of democracy’ (p. 181). As they observe, and correctly, I think, that daily troubles are ‘less spectacular and less immediate – [and hence] provide a much harder challenge’ to politicize (p. 14). The book is primarily about these issues and since they cover a vast terrain, there have been some omissions. Two very varied issues come to my mind: the influence of public debt on economic growth is only addressed briefly (p. 18) and the gap between English and non-English speakers get barely one paragraph (pp. 215-6). In addition, there is no mention of freedoms relating to sexuality. To conclude, the book is an excellent contribution in so far as it provides an accessible introduction to several social concerns such as armed conflicts, child mortality, corporate power, corruption, land ownership, minimum wages, nutrition, open defecation, pollution and sanitation.

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Posted in Adam Smith, Book reviews, Classical Economics, Development Economics, Economic Growth, Economics, GDP, India, Macroeconomics, Marginalist economics, Neoclassical Economics, Supply side economics | 1 Comment »

Reflections on Chayanov’s The Theory of Peasant Economy

Posted by Alex M Thomas on 17th February 2013

Alexander Vasilevich Chayanov, the Russian agricultural economist published the essay ‘On the Theory of Non-Capitalist Economic Systems’ in 1924 and Peasant Farm Organization in 1925, both in Russian. This blog post presents a selective summary of the English translations of these two works, one of the aims being to comment on Chayanov’s method of doing economics. He wrote around 60 books and essays during his lifetime. This blog post, it must be noted, is not an exhaustive survey of the essay and the book.

I

Chayanov’s essay on non-capitalist economic systems questioned the dominant approach of economic theorising which is conducted in the framework of capitalism. One of the characteristic features of the capitalist system is the presence of wage labour. So, how does such a theoretical framework understand peasant economies, where wage labour is non-existent? This is Chayanov’s question. Since labour is entirely provided by the peasant family, there exists no labour market and therefore no concept of wage labour. Moreover, the peasant family undertakes agricultural production (and engages in simple manufacturing) with the family labour and the surplus (or net product) arising from production cannot be resolved into wages and profits. The notions of profitability present in a family run enterprise, according to Chayanov, is very different from a capitalist enterprise. Chayanov terms the returns from the enterprise as the net product.

The required consumption of each family member is set by custom and habit. Chayanov computes an ‘internal equilibrium for the well-being of the family’ which is given by the intersection of their well-being and drudgery functions (p. 5). The gross product can be increased if more land is cultivated and/or an increase in labour intensity; remember, that the number of workers are given for any peasant farm organization. (This can change, perhaps in the very long-run, if the birth rate of the family is greater than its death rate.) The net product is arrived at by deducting the necessary consumption of the family and necessary consumption of the capital equipment from the gross product. The increase in labour intensity has definite physical limits; according to Chayanov, the family as a farm unit will increase labour intensity (drudgery) until the point when the net product is sufficient to meet the consumption needs of the workers and their dependants (children, parents and grandparents). The family’s access to land will depend on the land price and their ability to buy/lease more land will be constrained by their net product.

After laying out the basic relationships prevalent in a peasant farm, Chayanov concludes the essay by listing the various economic systems (p. 25). The extreme forms are capitalism and communism. In between, he introduces the family economy, slave economy and the feudal system (comprising landlord economy and peasant economy). Chayanow wishes for multiple economic theories catering to the needs of different economic-systems, as his last sentence in the essay shows:

…we have no doubt that the future of economic theory lies not in constructing a single universal theory of economic life but in conceiving a number of theoretical systems that would be adequate to the range of present or past economic orders and would disclose the forms of their coexistence and evolution. (p. 28)

 II

In Chayanov’s 1925 work entitled Peasant Farm Organization, his team carries out a detailed analysis of the agricultural situation in various districts of Russia based on zemstvo statistics, state statistics, independent research and budget studies (p. 38). At the outset, Chayanov points out the ‘coexistence and evolution’ of the capitalist and non-capitalist forms. When the peasant as worker-entrepreneur is unable to make sufficient earnings (owing to a bad harvest, increased input cost or some other factor), he temporarily abandons his undertaking and becomes a wage-labour in order to avoid being unemployed (p. 40). A peasant farm, to reiterate, does not make use of hired labourers.

The peasant farm is an organization that makes use of family labour and receives a single labour income. And, the trade-off between physical effort and material results (already noted in the previous section) is re-emphasised (p. 41). Responding against criticisms against their employing the method of marginalist economics, Chayanov maintains that the trade-off between family member as consumer and as labourer (labour-consumer balance) determines the volume of family economic activity but he does ‘not at all consider it possible to deduce from this a whole system of the national economy’ (p. 46). His objective is not, in modern terms, macroeconomics. The concept of a family has its basis in ‘the purely biological concept of the married couple, living together with their descendants and the aged representatives of the older generation’ (p. 54). Moreover, the gross product of the labour farm includes income from ‘agriculture’ as well as ‘crafts and trades’ (p. 70).

Given the trade-off between manual work and well-being, ‘the annual intensity of labor declines under the influence of better pay, because to remain the same it is absolutely essential that the productivity of the year’s labor (and equally the standard of well-being) should grow in proportion to the increase in the pay of a unit of labour’ (p. 80). In conclusion, as Chayanov states:

Thus, any labor farm has a natural limit to its output, determined by the proportions between intensity of annual family labor and degree of satisfaction of its demands. (p. 82)

One of the problems of such a principle is the exclusion of the relationship between labour intensity and consumption needs of the labourers. For instance, when income increases, there might arise a heightened demand to consume more of luxury products. The consumption needs certainly have a lower limit or a floor, but it is not bounded from above. In other words, labour intensity and consumption needs are interrelated factors.

One final observation before we move to conclusions. Chayanov, with a view to aiding practical policy, was interested in finding the ‘optimal farm size’ because ‘the optimal combination gives the highest income, and any deviation from it gives the proprietor a reduced profit rate’ (p. 91). In part, and by large, the combination is based on the technical relations between inputs and outputs. Therefore, ‘[a]ny excess of production means available to labor or of land above the technically optimal level will be an excessive burden on the undertaking’ (p. 92). It is also on account of the technological relationship that  the ‘volume of agricultural activity is not a simple arithmetic derivative of the size of area used’ (p. 94). Some of these technological relationships can be better grasped by taking recourse to ‘the basic laws of contemporary agricultural science’ (see especially pp. 138-47 for a rich account of crop rotation, manuring, etc).

III

First, Chayanov is dissatisfied with economic theory studying capitalist systems alone. But, (neoclassical) microeconomics can perhaps explain certain features of the peasant farm, especially the trade-off between drudgery and well-being (the backward bending labour supply curve is a good example). Also, the search for the optimal farm size can also be conducted by certain microeconomic procedures. One does not need to accept the marginal productivity theory of distribution which is a central feature of microeconomics. To put it differently, the ‘science of choice’ can explain the trade-offs which Chayanov is talking about by making appropriate changes in the parameters.

Secondly, treating the farm output as being ‘determined by the proportions between intensity of annual family labor and degree of satisfaction of its demands,’ as noted earlier, assumes them to be independent of each other which need not be the case. But in his credit, Chayanov undertakes a very detailed analysis of the farm households which provides content to the maximization problem. Also, the tabular and visual representation of the data is remarkable.

Finally, the co-existence of different economic organizations like capitalist and peasant farms is characteristic of economies like India. Often, they are called a dual economy. Self-employment, as opposed to wage employment is a significant feature of the Indian labour force; so is informal versus formal employment. Understanding their innate dynamics as well as their interrelationships is of much use. They require a combination of good theory, data collection methods, statistical analysis and an understanding of the socio-economic history of the particular locality.

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Posted in Agricultural sector, Communism, Development Economics, Economic Thought, Economics, History of Economic Thought, India, Informal Sector, Marginalist economics, Neoclassical Economics | 1 Comment »