Labour, Scarcity and Techniques of Production

Value ‘ is of utmost importance to all paradigms in Economics (Neo-classical, Classical Political Economy, Austrian Economics, Marxian Economics, etc) because the theory of value is the fundamental proposition or the foundation on which subsequent theories are built. Therefore, it is crucial to understand the various theories of value.

The problem of value has different features. The aim could be to find the source of value, a standard of value for inter-temporal comparisons between and across countries and determination of exchange values in theoretical problems.

Through an example pertaining to ‘value’, this post tries to bring out the distinction between the Neo-classical and Classical paradigm in terms of the source of value. As students of economics, all of us have come across the Diamond-Water paradox. This paradox is a commonplace in economic literature, even before Adam Smith. This is how Smith refers to the paradox:

The things which have the greatest value in use have frequently little or no value in exchange; and, on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarce anything; scarce anything can be held in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.

For the classical economists, value of a commodity means the value in exchange. And prices of commodities are believed to reflect its ‘value’. Value in exchange is determined by the conditions of reproduction of the economic system. The economic system is one where a number of firms using labour, land and capital (machinery, tools, etc), produce commodities (goods produced with the intention of selling them) by using commodities produced by the economic system (the firms within it). The conditions of reproduction would include the technology available (which would tells us in what proportions the labour and capital need to be mixed; in neo classical terminology, it would give a fixed proportions production function) Moreover, the classical economists did not consider value in use as a measurable quantity.

Before the ‘marginalist revolution’, utility had an objective sense as the capacity of a good to satisfy some need, and not as the subjective evaluation on the part of one or more individuals. It is worth noting that, in a capitalist economy a good or service is produced only because it can be sold. According to Marx, it is commodity production which forms the fundamental tenet of Capitalism. So, any commodity in a capitalistic economy does have utility. To clarify my argument, let me modify the definition of a commodity. A commodity is a good or service which is produced or offered only because it has a use value. Rather, it can be put for sale only if it has utility for someone or the other. The market does not produce commodities which has no demand or that which has no use/utility for any one.

Thus, it is clear that in a capitalistic economy (all economics theories, namely neoclassical, classical and Marxian tried to understand the working of a capitalist mode of production) the proposition that a commodity has a use value is a truism. So, because all commodities had a use value which they believed could not be measured, the value of a commodity was seen as the exchange value of it.

Since, labour was considered to occupy a central position in the economy, Adam Smith put forth the view that ‘labour commanded’ could be used as a standard to measure exchange value. In Marx, it takes the form of ‘labour embodied’ which then gives rise to the labour theory of value. For Marx, it is labour which provides value to the commodity by engaging in the production of that particular commodity.

Thus when the paradox is viewed through the classical and Marxian lens, it seems as if the paradox is only an illusion. The production of diamond is a costly affair and thereby requires a lot of labour (in today’s world, a lot of capital as well) due to which the value (exchange value) of diamond is high and thereby it commands a high price. More the labour needed for producing a commodity, more will be its value. So, because of the higher production costs, diamond is priced high.

For the neoclassical economists, the price of a commodity is determined by its marginal utility. Marginal utility is based on a subjective theory of value. Let me put forth two snippets from neoclassical economics as to how the paradox is resolved.

The more there is of a commodity, the less the relative desirability of its last little unit becomes, even though its total usefulness grows as we get more of the commodity. So, it is obvious why a large amount of water has a low price.‘ ‘ Paul Samuleson, the first American to receive a Nobel Prize in Economics.

In the blogosphere, I came across this piece from Michael Stastny, who blogs at Mahalnobis.

A better answer to the paradox why diamonds are more expensive than water would be that since water is so plentyful, the marginal utility (= the derivative of U(x) with respect to x, i.e. (approx.) the extra satisfaction of wants and needs obtained from consuming one additional unit of good) of water is is relatively low. An extra liter of water provides very little additional satisfaction. To the contrast, diamonds are very scarce and the marginal utility is therefor relatively high.

The study of economics is aimed at discovering the laws prevailing in the economic sphere. This helps in understanding the inter relationships within an economy. This further helps in policy purposes, by trying to increase investment rates, saving rates, GDP, etc.

The reasons provided for the paradox above assume that prices of commodities arise from their scarcity. Capitalism ensures a constant supply of the commodities which have utility (objective or subjective). It is to understand how prices come about, that economists theorize on values. For neoclassical economics, prices are indices of scarcity.

Let me illustrate the ignorance of neoclassical economics with an example. In a functioning economy, suppose an inventor discovers/invents a new product/commodity ‘ say a vehicle that runs on air. So, at this point of time, there is only one firm supplying this commodity. It is extremely scarce and according to neoclassical theory, it is rational for the producer to sell the first vehicle at any price because it has the highest value by being the sole product in the market.

So, when the first vehicle is on sale, the demand outstrips the supply. According to the neoclassical theories, the capitalist can ask for a higher price in such circumstances. I conclude by asking: is that how commodities are priced’ Are such prices ethical’ Isn’t it the techniques of production along with the wage rate and profit rate that governs the prices of commodities’

References

1) The Wealth of Ideas: A History of Economic Thought, Alessandro Roncaglia, 2005.

2) Das Kapital, Volume 1, Karl Marx.

3) Economics, 11th edition, Paul A Samuelson, 1980.

On the ‘Invisible’ Adam Smith

This post mainly deals with the common misconception about Adam Smith, whose name is known to all students and professors of Economics; the misconception being the notion that he advocated laissez-faire. Sadly, his works are not as known. (Though the names of his two major works are widely known) So, this post tries to makes visible what is commonly invisible regarding Smith.

In the Indian Schools, textbooks in Economics associate him with the ‘wealth definition’. In Frank ISC Economics, which is authored by D K Sethi and U Andrews, Adam Smith is supposed to have defined Economics as ‘A science which enquires into the nature and causes of wealth of nations.’ Definition is ‘a concise explanation of the meaning of a word or phrase or symbol’. [Dictionary.com] Adam Smith has never defined Economics is the afore mentioned way. Is it ‘right’ to teach such ideas’ Isn’t it against the ethics of academics’ A large number of students are programmed in such a way in school, whereby their notion of economics is constituted only by neoclassical economics. Plurality in economics has been totally done away with. Teachers teach what is printed in the textbooks. No questions are asked.

Also, it is not surprising to see classical economists (Smith, Ricardo, Malthus, etc) being seen as ‘classical’ or rather irrelevant, because of either their naive assumptions or their bad theories.

The primary focus of this blog post is to argue that Adam Smith never advocated Laissez-faire. Let me put forth two instances where such a misconception has been put forth.

The following paragraph was published in The Hindu Young World, a widely read Indian Newspaper.

Adam Smith’s fundamental proposition was that a free market is a self-regulating mechanism and tends to produce the most desirable types and quantities of goods.

The second instance is from Economy professor, an online dictionary of economics.

Adam Smith’s fundamental argument was that individuals should be allowed to pursue their own private economic interests as much as possible and so long as they do not violate basic principles of justice.

Smith called this the invisible hand of the market – although everyone is acting in their own self-interest, they are led to achieve the good of all as if by an invisible hand of economic forces. Therefore, outside interference will inevitably lead to disaster. This became known as laissez-faire economic policy.

Instances like these are numerous. One reason could be that, the only paragraph(s) that such people read by Smith is this (are these):

Every individual…generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry 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.

-The Wealth of Nations, Book IV Chapter II

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 necessities but of their advantages.

-The Wealth of Nations, Book I Chapter II

In fact, there is very little evidence to state that Smith advocated ‘free markets’ through stating the importance of self-interested behaviour. Also, he viewed individuals as a part of the society and not like an individual that is cut off from the society-the Homo economicus. Sen rightly points out that ‘it is precisely the narrowing of broad Smithian view of human beings, in modern economies, that can be seen as one of the major deficiencies of contemporary economic theory.’ [Sen 1987]

To conclude, Adam Smith tried to understand his society and also tried to prescribe ways by which the society could grow-morally and economically through his two masterpieces. In short, he was a great scholar, who ideas are still prevalent; despite what school textbooks and some academicians posit.

References

Sen, A.K. 1987: Economic Behaviour and Moral Sentiments. On Ethics and Economics. OUP.

Further Reading

Prof. Gavin Kennedy’s Blog-a must read for those who want to ‘know’ Adam Smith.

The Prospects of Homo economicus-a scientific American piece which uses behavioural economics.

Myth and Fact about Homo economicus

Is any 'economics' being taught’

Prices- how are they formed’ Economics fundamentally is concerned with the theory of value; wherein prices play a crucial role. Does the mainstream or marginalist (neoclassical theory) explain the formation of prices’ In equilibrium, the forces of demand and supply interact to give the equilibrium prices and quantity purchased and sold. But, in reality, is it so’ Does this theory explain the actual working of any economy’

In school textbooks, I remember being taught the law of demand, factors affecting demand and the exceptions to demand. The law of demand conveniently takes into account only one factor, which is its own price. And economists like Veblen and Giffen who tried to discuss demand were sidelined as exceptions.

Thorstein Veblen talked of ‘social factors’ like status symbol, conspicuous consumption etc which affected demand. His book The Theory of the Leisure Class explains how interdependent individuals in an economy are, and how the individual is very much a part of the society unlike the ‘rationalist atomistic individual’ as assumed by the mainstream theory.

In Marshall’s Principles of Economics, he mentions Giffen effect- a rise in the price of bread results in a large drain of resources which force them to curtail the consumption of relatively expensive items like meat; and they consume more of bread as it is still the cheapest food they can get. In India, with more than 60% percent of the populace being poor [Guruswamy and Abraham], Giffen effect is the norm rather than the exception!

This post discusses some of the microeconomic concepts taught across schools and colleges.

Scarcity

I was taught that the central problems in economics were that of scarcity, of unlimited wants and how one chooses the best option. And here optimization (a mathematical apparatus) comes to the aid of economics- in finding the optimum. But are resources really scarce’ If resources were really scarce, how could an economy grow’ Land, of course is scarce; but the availability of land can be increased through reclamation, deforestation etc. Economics ought to be concerned about wants that are backed by purchasing power; otherwise the theory will be trying to reconcile dreams and scarce resources.

Equilibrium

Equilibrium is reached when the demand and supply curves intersect in the graph having quantity demanded and supplied on the x axis and price on the y axis. Joan Robinson (1973) wonders why one uses a metaphor based on space to explain a process which takes place in time.

This approach has for quite some time disturbed me. Why is it that we take ‘equilibrium’ to be favorable’ Equilibrium is a thing very commonly found in Physics. One of the meanings is that ‘it is a state of rest’ and this is precisely the meaning economists provide. For, in equilibrium, the quantity demanded will be equal to quantity supplied and all is well. Coming to think of it more, why would a stagnant economy be favorable’ What is more frightening is that, we are taught that it is what economic policies should aim at!

Prices

Prices, according to the mainstream neoclassical theory are determined based on the intersection of demand and supply; that too in a static set up. Prices, in today’s world is certainly not fixed in the before said manner. The producers decide the price based on the cost of raw materials and other items needed for production, wages and salaries of employees, advertising costs, existing taxes, etc. So this means, prices in an economy has more correspondence to the supply side than the demand side.

What is the significance of the demand side’ One of the reasons could be to point out the importance consumers have in deciding the prices in a ‘perfectly competitive’ economy. It would signify consumer sovereignty in such an economy. Again, this belief of ‘consumer sovereignty’ is something one would like to have, but is absent totally.

Perfect Competition

No student of economics graduates without studying ‘perfect competition’. It is very much entrenched in economic theory as taught today. Why’ The answer given is that it is the ideal state for an economy. Or rather, as the name suggests, it is ‘perfect’. Then we are taught about imperfect competitions keeping in mind what is good or ideal-perfect competition.

One of thoughts one could have is ‘why is it considered perfect’. The price is assumed to be given or it is said that the firm is the price taker. Another query would be- is perfect competition possible’ The main driving force behind corporations and businesses is money or precisely speaking, profits. Would firms like an atmosphere where they are unable to fix prices and hence unable to earn more profits’ It reeks of Orwell’s Animal Farm. Why would there be any competition at all’ Aren’t differences that lead to competition’ Would there be any incentive to produce or to diversify’

Conclusion

This post ends on a skeptical note. Is the current mainstream economics helping the economy by tailoring productive and progressive economic policies’ Is they are not, why are they still being taught as compulsory topics’ Is there an alternative approach’

I would like to put forth a question regarding the notion of prices.

50 years ago, one could buy a book for a rupee; but now, a book’s average cost would be about 100. This follows for all other goods and services too. What is that which accounts for this sustained rise in prices’ Is it inflation alone’

On Neo-classical economics

This post is the first in the series- On Neoclassical Economics. This series attempts to look at the basic concepts of Neoclassicalism or Marginalism. The concepts that this series will cover are that of man being rational, measurement of utility, equilibrium from demand and supply, Micro and Macro economics and notion of perfect competition.

Remind yourself that what we (mostly) see in textbooks is Neoclassical economics (In India). Is there another approach to Economics which these textbooks fail to talk about’ The answer is yes. It is known as ‘Classical Political Economy’.

Classical Political Economy

The concern of the classical economists from Adam Smith to David Ricardo was the laws governing the emerging capitalist economy, characterized by wage labour, an increasingly sophisticated division of labour, the coordination of economic activities via a system of interdependent markets in which transactions are mediated through money, and rapid technical, organizational and institutional change. In short, they were concerned with an economic system in motion. [Kurz and Salvadori 1998]

This approach does not break economics into monetary, fiscal, international trade, microeconomics, macroeconomics etc. Nowadays, economics has got lot many divisions and specialties, that I feel the essence is getting compromised. [Thomas 2006] Classical Political Economy does not make such compartments like the ‘mainstream economics’ and is also dynamic in nature.

Neoclassical economics began as a project to fashion an economic model in the image of Newtonian mechanics, one in which economic agents could be treated as if they were particles obeying mechanical laws, and all of whose behaviour could, in principle, be described simultaneously by a solvable system of equations. [www.paecon.net ]

This post delves into the origin and the importance utility enjoys in Microeconomics aka ‘the pet of Neoclassicalists‘.

Economists are subject to many vices, and one of them has been to talk about ‘utility’, which is a quantitative conception that there is no known way of measuring. [Robinson 1979] Still, hours and hours are dedicated to the task of measuring Utility and ‘Marginal’ Utility in colleges and universities. It forms the basis of Microeconomics and also helps in bringing more mathematics into the realm of economics.

Bernard Guerrien writes in Issue 12 of the Post-Autistic Economics Review that ‘The French students’ movement against autism in economics started with a revolt against the disproportionate importance of microeconomics in economics teaching. The students complained that nobody had really proved to them that microeconomics was of any use; what is the interest of going through ‘micro1’, ‘micro2’, ‘micro3’, etc., using lots of mathematics to speak of fictitious households, fictitious enterprises and fictitious markets”

Can economic policies be made based on such ‘fictitious’ measurements’ Is economics a policy science or an intellectual game’ One becomes a skeptic when wondering about why ‘Microeconomics’ has come to dominate economics learning. Is it to make economics more mathematical’

A digression: Economy

The concept of the ‘economy’ is of utmost importance in this regard. Does the ‘economy’ occupy a separate existence from that of the community and the state’ Very often, the headlines in the media say so, but it is not so. And economics is not tantamount to money.

According to C. T. Kurien, Economy is a structure of relationships among a group of people, in terms of the manner in which they exercise control over resources, use resources and labour in the production of goods, and define and settle the claims of the members over what is produced, emphasising that while the economy is concerned with goods and services, it should be recognised essentially as a set of social relationships.

The economy consists of two realms, namely the community and the market. Community refers to real, on-the-ground associations and to imagined solidarities that people experience. [Gudeman 2001] Gudeman goes on to say that ‘Neoclassical economics focuses on one value domain, the market, which is modified as a separate sphere making up the whole of economy in which all goods are priced and available for exchange.’

On Utilitarianism

Bentham played a crucial role in the development of ‘utility measurement’. He proposed the ‘felicific calculus’, namely the quantitative evaluation and the algebraic summation of pleasures and pains stemming as consequences from any given course of action. ‘Good’ is whatever gives as its result an algebraically positive felicific magnitude, and hence increases the ‘amount of happiness’ within human societies; ‘bad’ is whatever gives as its result a negative quantity, and as a consequence decreases the amount of social happiness. [Roncaglia 1999]

But, Mill in his Utilitarianism (1987) criticizes this notion of measurement of utility by stating that ‘Utility is an uncertain standard, which every different person interprets differently, and even ‘in the mind of one and the same individual, justice is not some one rule, principle, or maxim, but many.’

If there is an intellectual field where the utilitarian attitude-namely, looking at the consequences of human actions-dominates, to the point of being identified with the scientific attitude tout court, this is economics‘ [Roncaglia 1999](Italics added)

Utility, when taught to students, appears very logical and thus is easily comprehended and imbibed. Of course, no individual would do any activity if it didn’t give him or her pleasure or rather, ‘utility’. As a philosophical concept, it does make sense. But when it is introduced into the realm of economics, it fails miserably. The demand function which is built on utility along with the supply is what determines the equilibrium price and quantity in neoclassical economics. But if one stops to think and to try and relate it to the real world, one would fail. Think of how prices are determined; and are prices based on demand and supply functions’

Conclusions

What has neoclassical theory taught us’ That individuals do what they do because they get ‘utility’ out of it’ And that this helps in calculating the demand of an economy which further helps in the determination of prices’ Does it tell us anything about the working of the economy’

References

1) Kurz, H and Salvadori, N (edited), The Elgar companion to classical economics (A-K), 1998.
2) Robinson, Joan, Collected Economic Papers, 1979.
3) Kurien, C T, Rethinking Economics, 1995.
4) Gudeman, Stephen, The anthropology of economy, 2001.
5) Thomas, A M, Undergraduate Economist, The fellowship of economics, 2007.