Tag: Sraffa

Revisiting J. H. Clapham’s ‘Empty Economic Boxes’

This blog post revisits the economic historian J. H. Clapham’s1922 classic paper ‘Of Empty Economic Boxes‘ published in The Economic Journal, and raises some critical questions about the continued use of constant returns to scale (CRS hereafter) assumption in marginalist (or neoclassical) microeconomics and macroeconomics. In 1926, Piero Sraffa took Clapham’s 1922 paper as a starting point to mount a more devastating logical critique of Marshallian notions of increasing returns and the representative firm; this was published as part of a symposium in the Economic Journal.

What is returns to scale’ According to marginalist economics, the technique of producing a commodity may be represented by a functional relationship between inputs (say, k’and l) and output (say, y): y’= f(k,l). If all the inputs are multiplied by a positive scalar m, and the resultant output is expressed as mr’y, then r’represents the magnitude of the returns to scale. If r = 1, the technique exhibits CRS, if r < 1, it exhibits diminishing returns to scale (DRS), and if r’> 1, it exhibits increasing returns to scale (IRS).

Despite the ‘advances’ in mainstream economics research, the marginalist theory of value and distribution still requires the CRS assumption (and the diminishing returns to a factor assumption) to make several key claims. The aggregate production function employed in the Solow growth model is assumed to exhibit CRS. And the Solow growth model forms the core of supply-sidegrowth accounting exercises which are used to make policy prescriptions (for a critique of one such exercise for the Indian economy, see Joshi & Thomas 2013).

The central argument in Clapham’s article is that the categories of diminishing returns, constant returns, and increasing returns industries are ’empty economic boxes’. In other words, from the standpoint of actual economies, these categories lack empirical and historical content. Consequently, industries cannot be classified into one or the other box a priori.

Clapham asks: what does AC Pigou (in his Economics of Welfare) mean when he writes ‘when conditions of diminishing returns prevail’ (p. 305)’ According to Clapham ‘constant returns…must always remain a mathematical point, their box an empty one’ (p. 310). He acknowledges that different kinds of returns have a ‘logical’ and ‘pedagogic value’ which ‘goes so prettily into graphs and equations’ (p. 312). How can we then use this framework to draw policy conclusions given the inability to classify industries a priori into constant, diminishing, and increasing returns’

The following observation by Clapham is insightful and worth thinking about further. He writes that diminishing returns must be balanced with increasing returns to arrive at constant returns (p. 309). Surely, this makes no conceptual sense and neither does it have any basis in empirical reality. As Clapham puts it, with CRS ‘the conception of the balance of forces, man’s organization versusNature’s reluctance, was worked out’ (p. 309). In other words, is CRS an expression of the balancing of the symmetrical forces of IRS (‘man’s organization’) and DRS (‘Nature’s reluctance’)’ For a visual representation, see the images below. If so, it would add to the symmetrical concepts found in the marginalist toolbox, most notably that of supply and demand. However, beyond the ease of exposition symmetry provides us, is it really how the actual world works’

Source: meritnation.com

CRS, DRS, and IRS posit an a priori functional relationship between labour (L) and capital (K), the ‘factors of production’ and output (Y) for an individual firm and for an economy: Y=f(L,K). While the idea underlying the production function, whether industry-level or aggregate-level, that outputs are produced by inputs is commonsensical and intuitive, its expression as a mathematical function isn’t as benign. Since marginalist economics requires continuous functions (often, of a monotonic nature) to ensure the existence of equilibrium, the ‘f’ is able to map infinitesimal combinations of Land Kto a unique Y. This ‘one-way street’, to use Sraffa’s phrase in his 1960 classic Production of Commodities by Means of Commodities(see my blog post Sraffa), between ‘factors of production’ and output is conceptually unsatisfactory because it misses a fundamental aspect about modern economies: the structural interdependence between inputs and outputs. In addition, it assumes that capital goods (K) are infinitely divisible, a very difficult assumption to uphold.

John Eatwell (2008; first published in 1987), in his entry on ‘returns to scale’ published in The New Palgrave Dictionary of Economics, also notes the apparent symmetry between IRS and DRS but points out its spuriousness. While there is no evidence of functional relationships in Adam Smith and David Ricardo, Smith’s discussion of division of labour, capital accumulation, and economic growth indicates that he recognised scale-enabled technological progress and Ricardo recognised diminishing returns to land, a non-reproducible input in production. Subsequently, Alfred Marshall, in his Principles of Economics, ‘attempted to formulate a unified, symmetric, analysis of returns to scale which would provide the rationale for the construction of the supply curve of a competitive industry, derived in turn from the equilibria of the firms within the industry’ (Eatwell 2008, p. 140). This point was initially noted by Sraffa 1926, and later much more thoroughly investigated also by Krishna Bharadwaj (1978).

It is well understood that the question of returns to scale is important in the construction of the supply curves which are integral for the marginalist price theory. Therefore, a thorough critical study of mainstream price theory and a renewal in the interest in rival price theories (found in Ricardo, Marx, Sraffa, and Kalecki, among others) are warranted. This is crucial because it is value or price theory which provides us with the economic possibilities a competitive economy generates. If it generates unemployment and worsens inequality, we know that intervention of a particular kind is necessary. However, if it generates full employment and reduces inequality, then it supports the idea of making markets more competitive and reducing government intervention.

REFERENCES

Clapham, J. H. (1922), “Of Empty Economic Boxes.”‘The Economic Journal,’vol. 32, no. 127, pp. 305-14.

Eatwell, John (2008), ‘Returns to Scale’. In: Durlauf S.N., Blume L.E. (eds.) The New Palgrave Dictionary of Economics. London: Palgrave Macmillan.

Sraffa, Piero (1926), “The Laws of Returns under Competitive Conditions.”‘The Economic Journal,’vol. 36, no. 144, pp. 535-50.

Acknowledgement

I thank Mohib Ali for his helpful comments.

 

Frank Ramsey and the Rate of Interest

I first came across Frank Ramsey in the preface to Piero Sraffa’s classic Production of Commodities by the Means of Commodities: Prelude to a Critique of Economic Theory (1960). My recent interest in Ramsey is primarily motivated by the following news. Cheryl Misak, a philosopher based at the University of Toronto has recently completed a biography of Ramsey. This blog post provides an introduction to Ramsey’s life and his contribution to the growth theory literature. [It was reassuring to notice that I first blogged about History of Economic Thought (HET) explicitly more than 10 years ago.]

Ramsey was born in 1903. In the year 1920, he read around 45 books, which included Karl Marx’s Capital, Sidney Webb and Beatrice Webb’s The History of Trade Unionism, J. A. Hobson’s The Industrial System, J. S. MiIl, and Alfred Marshall’s Industry and Trade. At the age of 19, he was commissioned to review Ludwig Wittgenstein’s Tractacus Logico-Philosophicus (1922), a significant treatise in philosophy, for the journal Mind; the review was published in 1923. Subsequently, he was commissioned to translate Wittgenstein’s work into English. In Wittgenstein’s later work, Philosophical Investigations, there is an explicit acknowledgement of Ramsey. He was acknowledged for his critique/interventions of Bertrand Russell’s and Alfred Whitehead’s Principia Mathematica in a new introduction by the authors. Sraffa, in his PCMC, had acknowledged Ramsey for mathematical help. In 1929-30, Ramsey met with J. M. Keynes, Sraffa, and Wittgenstein to discuss the theory of probability advanced by Keynes and Ramsey and also to discuss Freidrich Hayek’s theory of business cycles. Ramsey also had a close engagement with AC Pigou, a leading marginalist economist who was also the target of criticism in Keynes’s General Theory. Ramsey died in 1930.’

Under the patronage of Keynes, who was the editor of the’ Economic Journal, Ramsey published in it articles on the ‘theory of taxation’ (1927) and the ‘theory of saving’ (1928). In my 2019 article which critically evaluated the Nobel contributions of Paul Romer and Nordhaus, I had highlighted that Nordhaus employs a marginalist growth model drawing from Ramsey (without further comment). Ramsey’s question was the following: how much should a nation save today for future consumption tomorrow so as to maximise consumption across generations’ Nordhaus employs the optimal growth model with environmental protection as an important constraint. And, the rate of interest is seen as a price which equilibrates the society’s time preference. In other words, the rate of interest equilibrates the society’s preference for the future with that of the present. The policy implication when marginalist economists have a significant say in practical matters is as follows. Since the (actual) rate of interest captures the time preference of the society, this rate can be used to decide how much of current gross domestic product (GDP) should be devoted to environmental protection. In effect, not enough resources are being allocated to mitigate climate change and undertake environmental protection.’

Ramsey’s optimal growth theory also underlies Thomas Piketty’s position on economic growth. In his 2015 article in the American Economic Review, he writes that in the standard model ‘where each individual behaves as an infinitely lived family, the steady-state rate of return is well known to be given by the modified ‘golden rule’ r = ‘ + ‘ g (where ‘ is the rate of time preference and ‘ is the curvature of the utility function)’ (p. 2). The reciprocal of ‘ is the intertemporal elasticity of substitution which captures how much the representative family wishes to smoothen consumption over time. He uses this to point out that in general (marginalist) economic theory, we arrive at the r>g result–the focal argument in his book Capital in the Twenty First Century (2015; for a critical assessment see Thomas 2017). Furthermore, ‘in steady-state each family only needs to reinvest a fraction g/r of its capital income in order to ensure that its capital stock will grow at the same rate g as the size of the economy, and the family can then consume a fraction 1 ‘ g/r‘ (p. 3). To a marginalist (or neoclassical) economist, as Joseph Stiglitz wrote in an article in 1974, ‘interest rates are just intertemporal prices’ (p. 901).’

Therefore, for both Nordhaus and Piketty, interest rates are ‘intertemporal prices’ which allocate today’s income between today’s consumption and tomorrow’s consumption (today’s saving). As Ramsey (1928) writes, ‘The more we save the sooner we shall reach bliss, but the less enjoyment we shall have now, and we have to set the one against the other’ (p. 545). It is also interesting to note that their use of optimal growth models yields vastly different policy suggestions. While Nordhaus is conservative in his proposals for environmental protection, Piketty is progressive in his proposals to tax wealth.’

The rate of interest in Ramsey, as in Alfred Marshall, is a reward for waiting. Therefore, inequality in Ramsey necessarily arises from the heterogeneity of tastes or preferences; if a family is (relatively) more patient, it saves more than the (relatively) impatient one, and ends up owning all the capital stock (Attanasio 2015). How does this conception differ from the notions of interest rate found in Marx and Keynes’ For Marx, the rate of interest is the part of surplus value which is expropriated by the financial capitalist; the source of it is from the value added by labour. Keynes views the rate of interest as an expression of the preference for liquidity. To conclude, is the conception of the rate of interest found in Ramsey satisfactory for understanding a competitive economy’

REFERENCES

Attanasio, Orazio P.’ (2015), ‘Frank Ramsey’s Mathematical Theory of Saving’, The Economic Journal, 125 (March), pp. 269’294. https://doi.org/10.1111/ecoj.12229

Duarte, Pedro (2017), ‘Frank Ramsey’, In: Robert Cord (ed.) The Palgrave Companion to Cambridge Economics, Palgrave Macmillan, vol. 2, pp. 649’671.

Monk, Ray (1990), Ludwig Wittgenstein: The Duty of Genius, London: Vintage Books.’

Stiglitz, Joseph E. (1974), ‘The Cambridge-Cambridge Controversy in the Theory of Capital; A View from New Haven: A Review Article,’ Journal of Political Economy, vol. 82, no. 4, pp.’ 893‘903.

Further reading

Collard, David (2011), ‘Ramsey, saving and the generations’, Generations of Economists, London: Routledge.’

[Most of the contents of this post was informally discussed with my Economics colleagues at Azim Premji University on 19th February 2020.]

 

A Case for Pluralism in ‘Microeconomics’

[My return to blogging is motivated by the extremely warm response I’ve received in person – in the last 6 months – from several people who have been readers of this blog. I’m also happy to announce the publication of my co-edited book on the history of economic thought.]

The subject matter of microeconomics is enshrined in the economics curriculum at all levels – school, undergraduate, postgraduate, and doctoral. The central objective of microeconomic theory is to provide a solution for equilibrium price and quantity in both the commodity (say, apples or coconuts) and factor (wage and ‘capital’) markets. Indeed, questions of what is the source of value and what is the exchange value of two commodities have been posed much earlier. You can find answers in Kautilya, Aquinas, Petty, and Cantillon – all of them writing prior to Adam Smith’s foundational treatise on political economy.

 

Kautilya’s Arthashastra contains discussions of a fair price. Aquinas, drawing inspiration from Aristotle and Christianity, tries to arrive at the notion of a just price. One of the founders of political economy, William Petty, derives the distinction between necessary price and political price and possesses a rudimentary labour theory of value. Following Petty, Cantillon distinguishes between ‘intrinsic value’ and ‘market price’ based on a land-cum-labour theory of value. The contributions of Smith, Ricardo, Marx, and Sraffa to value theory follow this tradition of objectively determining value.

 

The dominant theory of value in contemporary economics is not the objective theories of value found in Ricardo, Marx, or Sraffa but the subjective theories of value whose pioneers are Jeremy Bentham, William Stanley Jevons (whose son taught at Allahabad University), Alfred Marshall, AC Pigou, and Paul Samuelson. The value theory (or microeconomic theory, as it is now called more fashionably) found in the textbooks of Hal Varian or Gregory Mankiw take the following as data when solving for equilibrium prices and quantity: (i) preferences, (ii) technology, and (iii) endowments. On the other hand, Piero Sraffa’s value theory, found in his Production of Commodities by Means of Commodities (1960), takes the following as given when arriving at a solution for prices and one distributive variable: (i) size and composition of output, (ii) technology, (iii) the real wage or rate of profit.

 

How do you measure the data listed above’ While technology, endowments, and real wage can be measured in terms of the commodity-mix, the rate of profit is a pure number. However, how are preferences measured (or ordered)’ They are measured in a subjective manner. This is one of the core differences between the dominant marginalist theory of value and the Classical/Sraffian objective theory of value. Given this core difference, it is incorrect to treat the objective theory of value found in Ricardo or Marx as a precursor or rudimentary version of modern subjective theory of value. And therefore, it is important that students of economics learn about different value theories in microeconomics.

 

I shall end by drawing your attention to the practical implications of believing in the marginalist conception of the labour market vis-a-vis that of the classical economists (see an earlier post on wages). Under conditions of perfect competition, the equilibrium real wage is determined by the marginal product of labour. Any intervention, such as a minimum wage legislation or collective bargaining by the workers, results in imperfections and consequently leads to unemployment. However, in classical economics, real wage is exogenously determined though historical and social factors. If you believe in the marginalist conception, the logical policy recommendation is to eliminate any intervention/imperfection (such as minimum wage legislation or collective wage bargaining) whereas if you believe in the classical conception, you would treat collective wage bargaining and minimum legislation as legitimate ways of improving workers’ conditions.

 

This post argues that value theory matters for both contemporary politics and policy. And consequently, the teaching of microeconomics needs to become pluralistic. Moreover, as pointed out earlier, the politics of microeconomics ought to be made explicit. It is, as Keynes, said that we are the ‘usually the slaves of some defunct economist.”

 

Sraffa: Production as a Circular Process

This is the second in the series of posts on Sraffa. The objective of this post is to clarify the assumption of scarce resources made frequently in neoclassical economics. This is then contrasted with the notion of mass-production in capitalist economies. This facet of capitalism is understood by concepts such as ‘circular production’ and ‘production of commodities by means of commodities’ in Classical Economics.

A brief look at the history of micro and macroeconomics becomes essential. Elements of Marshall and Walras are found in modern microeconomics. Specifically, partial equilibrium analysis comes from Marshall; whereas, Walras contributed ‘general equilibrium analysis’ to economics. Usually, emergence of macroeconomics is considered to have originated with the work of Keynes. This has been contested and it has been shown with considerable evidence that William Petty (1623-1687) was the first macroeconomist. [See Murphy 2009] And that economists like Adam Smith, David Ricardo and Karl Marx were talking about macroeconomics when they discussed production, distribution and accumulation. Neoclassical macroeconomics can be loosely said to comprise New Classical Economics, Neo-Keynesian Economics, variants of Computable General Equilibrium Models (CGE), etc. One of the unifying features of the above mentioned neoclassical schools/models is the assumption of ‘scarce factors’. It is owing to the assumption that factors are scare, that optimization is carried out.

Lionel Robbins defined economics as ‘the science which studies human behaviour as the relationship between ends and scarce means which have alternative uses.’ Here, scarce means refers to scarce factors of production ‘ land, labour and capital. Yes, land can be considered scarce in an economy where the pressure of population is high (or for environmental reasons). But, wouldn’t labour be scarce in some countries and abundant in others’ Now for the tricky ‘capital’. Capital is understood as produced means of production. That is, tools, machinery, plants, conveyor belts, electrical appliances, tractors, etc are ‘capital goods’. Are they scarce’ They would be scarce if nobody produced them. Usually, in a capitalist or quasi-capitalist economy, capital goods are produced by the private sector, the government and often, imported from abroad. Therefore, a priori, we have no reason to maintain that capital is a scarce factor. Or for that matter, even labour.

Marshall provided a theoretical partition through which one could say that factors are scarce. He introduced the concept of ‘short period analysis’. Till Marshall, the early classicals and neoclassicals analysed economies using the ‘long period method’. Through the short period, Marshall introduced an imaginary period wherein one factor is fixed (usually, capital) and the other factor (labour) is variable. In this period, it is as if one factor is scarce. In a later post, it will be shown that this sort of analysis is an improper generalisation of Ricardo’s theory of rent.

Sraffa’s Production of Commodities by Means of Commodities deals with ‘value and distribution’. That is, he focuses on the relationship between relative prices, wages/profits and technique of production. Throughout the whole analysis, output/quantity is treated as given. This is in tune with the ‘sequential analysis’ of classical economics. Value & distribution is one level of analysis or the ‘core’, as was popularised by Garegnani. Once, the foundation is well-established, the next level is growth & accumulation. In the first level, quantities are treated as given and in the second level, prices are assumed to be given. This is done keeping in view the complexity of the economic processes. Whereas, as we know, in neoclassical theory of general equilibrium, there is a simultaneous determination of quantity, price, wage rate, employment, rate of interest and quantity of capital. That is, all kinds of prices and quantities are simultaneously determined.

A set of equations from classical and neoclassical production theory is given below. This is so as to bring out the differences in a clear way.

Production function: Ya = f(La, Ka)

Sraffa’s equations:
(AaPa + BaPb + … + KaPk) (1 + r) + LaW = APa
(AbPa + BbPb + … + KbPk) (1 + r) + LbW = BPb
. . . . . .
(AkPa + BkPb + … + KkPk) (1 + r) + LkW = KPk

where A, B …. K are the output produced in various industries, L is the labour employed in each industry, Pa refers to price/value of output A and Pk refers to value of output K, r is the rate of profit. [As these are for purposes of illustration alone, some conditions have not been mentioned]

In the first case, it represents the transformation of inputs ‘ labour and capital into an output Y. Let me reproduce what Sraffa writes about his particular conception of production: ‘It is of course in Quesnay’s Tableau Economique that is found the original picture of the system of production and consumption as a circular process, and it stands in striking contrast to the view presented by modern theory, of a one-way avenue that leads for ‘Factors of production’ to ‘Consumption goods’.’ [Sraffa 1960, 93]

The concept of circular production also brings to the fore the web of connections between different production structures. Both classical and neoclassical economics attempts at reducing the complexity of economic phenomena. Neoclassical economics, at the outset abstracts away from interrelated production structures through the concept of ‘representative firm’ in microeconomics. In a similar way, in the area of consumption, man as a social being is reduced to man as an individual whose utility does not depend on that of others. Classical economics carries out its analysis by taking prices as given so as to analyse interrelated production structures.

References

Sraffa, P (1960), Production of Commodities by Means of Commodities, Cambridge: Cambridge University Press.

Murphy, A (2009), The Genesis of Macroeconomics: New Ideas from Sir William Petty to Henry Thornton, New York: Oxford University Press.