This is most of the first chapter of a book I'm writing (which may never be finished). Working title is "Eight Great Debates in the History of Economic Thought, and What We Can Learn From Them Today." I hope you enjoy my preliminary footnotes.
Worldly Philosophers
Sometime in the 4
th
century BCE, somewhere on a rocky outcrop near Athens, a man wrote, “A shoe
is used for wear,
and is used for exchange; both are uses of the shoe.
He
who gives a shoe in exchange for money or food to him who wants one,
does indeed use the shoe as a shoe, but this is not its proper or
primary
purpose, for a shoe is not made to be an object of
barter.”
That man was
Aristotle, and those words, according to some, were the first ever penned in
economics.
How appropriate that the dismal
science should have begun with the contemplation of a shoe. Greek and Roman
philosophers generally agreed that the state was the most proper object of study,
but in practice no subject was too trivial, too simple, or too ordinary to escape
notice. This was the age of
empiricism, when books had not yet attained the authority that centuries now
lend the classics, and when the wise acquired knowledge through reflection on
worldly experience alone. Aristotle
mused about value and exchange, but he also wrote about ethics, physics, logic,
and medicine, and devised his own system to classify the plants and animals he
encountered. His contemporaries theorized about the causes of disease, the
movements of the stars, and building blocks of the universe, with no
instruments to aid them but eyes and ears, and no frameworks to guide them but
common sense and imagination. Most of the time they were wrong, but when they
were right, they were astounding.
Aristotle’s evaluation of his
shoes contributes to a larger argument in Book I of his
Politics about the “nature” of things, an argument that juxtaposes
gems like “man is by nature a political animal” with terrifying statements like
“from the hour of their birth, some
are marked out for subjection, others for rule,” and “silence is a
woman's glory.”
Aristotle
recognized that every element in society can serve multiple purposes, but for
every element he decided that one purpose was better, or more natural, than the
others. Slaves are meant to serve masters, women are meant to mind households,
and shoes are meant to wear. By criticizing
the exchange of shoes for money, Aristotle established a standard of value for
goods and services based on potential for use, not on price, or any other
attribute.
Some modern scholars argue that
Aristotle’s criticism of commerce reflected an attachment to the status quo, which
at the time was threatened by the growth of trade and markets in ancient
Greece, and others praise his characterization of life as larger than
economics.
Whatever his motivation, Aristotle
introduced an intriguing question: what determines value? Other early philosophers reflected on
the same question and came to similar or different conclusions, and Aristole
himself used different standards of value in different passages. No definitive definition was reached. Not too long after Aristotle, philosophers
turned their scrutiny towards the heavens, and for many centuries focused their
energies on distinctly unworldly subjects. With a few exceptions, they did not
return to earth until the 17
th century and the dawn of the age of
enlightenment.
John Locke, one of the greatest
empiricists of the new age, stumbled upon an entirely different standard of
value his chapter
On Property in his
Second Treatise of Government: “...it is
labour indeed that puts the difference of value on every thing; and let any one
consider what the difference is between an acre of land planted with tobacco or
sugar, sown with wheat or barley, and an acre of the same land lying in common,
without any husbandry upon it, and he will find, that the improvement of labour
makes the far greater part of the value.”
[4] Men
value nature mixed with labor more than nature untouched, Locke observed, and
therefore labor must create value. By
extension, shoes are valuable not because you can wear them, nor because you
can sell them, but because the shoemaker made them.
Contemporary philosophers continued to reach different conclusions, and,
like Aristotle, Locke used different standards of value in different passages,
but the idea of labor as a basis for value became particularly popular in the
early modern world. Benjamin Franklin, American scientist,
politician, and commonsense
philosopher, expressed similar ideas in his
Modest
Inquiry into the Nature and Necessity of a Paper Currency.
Francis Quesnay, the leader
of the influential French Physiocrats, agreed but emphasized the importance of nature
mixed with labor, arguing that value is built on agricultural output
particularly.
Adam Smith,
a contemporary of Quesnay’s, wrote, “the
real price of every thing, what every thing really costs to the man who wants
to acquire it, is the toil and trouble of acquiring it,” emphasizing tools
and machinery as well as nature as supplements to human endeavor, to create the
holy triumvirate of classical economics: labor, land, and capital.
Although Smith built his theory of the wealth of nations on the idea of labor
value, he also penned a passage remarkably similar to the one Aristotle had
written nearly two millennia before: “The word value it is to be
observed, has two different meanings, and sometimes expresses the utility of
some particular object, and sometimes the power of purchasing other goods which
the possession of that object conveys. The one may be called 'value in use' the
other, 'value in exchange.'”
[7]
Where Aristotle went on to
declare “value in use” more natural than “value in exchange,” Smith merely gave
an example of something that is extremely valuable in use, but of nearly no
value in exchange, and of something that is extremely valuable in exchange, but
not terribly valuable in use—the famous paradox of water and diamonds. Thus in
one book Smith proposed three contradictory definitions of value:
exchange value, use value, and
labor value.
Smith’s conclusions, like Locke’s and Aristotle’s, were products of empiricism.
Because the same thing can look different from different perspectives,
knowledge based on observation often produces contradictions, and to most of the
worldly philosophers, such contradictions were acceptable. They used philosophy
to spread wisdom by sharing their most interesting interpretations, and they
left us with many simultaneous truths. In the end, multiple sketches from different
angles proved more accurate than single, focused studies; but to understand
why, we must enter the age of science.
The Labors of Ricardo
Adam Smith lived at the dawn of
the industrial revolution. Many of the inventions that set the stage for transformation
were invented during his lifetime, including the flying shuttle, the spinning
jenny, and the threshing machine. He was a personal friend of James Watt, who
perfected the steam engine in 1778, and he saw Glasgow grow from a local
trading hub to a thriving center for industry, and Britain begin the journey
toward economic empire.
New technology disrupted philosophy as well as industry. Science had discovered
universal and exclusive truths; gravity always pulled down, steam always pushed
up, and together the two forces could move mountains of iron and transform
sleepy towns into powerhouses of profit.
If science could be so efficiently applied, why couldn’t economics? What
clear, actionable advice could be drawn from musings on wealth, value, and exchange?
Resolving the inconsistency of the
empiricists took on a new urgency, and David Ricardo rose to the task.
Ricardo was born in London in 1772
to a wealthy Jewish family, but his father cut off his inheritance when he
eloped with a Quaker, Priscilla Anne Wilkinson, at 21. He remade his fortune as a stockbroker,
and by the end of his life had won a seat in the House of Commons and purchased
one of the finest estates in England for his wife and children. Ricardo built
his success on hard work, and everyday made decisions that the markets decided were
either right or wrong. There was no room in his world for simultaneous truths. Ricardo
read the Wealth of Nations in 1799, and,
inspired, embarked soon after on the labors that would produce his magnum opus
in 1817, On the Principles of Political
Economy and Taxation. Where the Wealth
of Nations, wandered, pondered, and suggested, Ricardo followed the method
of mathematical proof, choosing a few key axioms and constructing a consistent
model of the economy on their foundation.
He cut to the heart of the
matter in his first chapter,
On Value.
“The value of a commodity, or the quantity of any other commodity for which it
will exchange, depends on the relative quantity of labour which is necessary
for its production, and not on the greater or less compensation which is paid
for that labour.” Unlike Aristotle, Locke, and Smith, Ricardo did not contradict
his chosen standard, but carefully defended it, arguing that fluctuations in price
unrelated to labor must represent “accidental or temporary” deviations.
In chapter five,
On Wages, Ricardo introduced a second key axiom, declaring that
that wages must always tend towards subsistence, or the minimum price necessary
to feed the laborer and his family. This assumption allowed him to price labor
value by multiplying hours by the subsistence wage, and also reflected the
deeply unequal economic relations of his day. In chapter six,
On Profits, Ricardo formalized a third
axiom: because of the pressures of competition, the profits of industry must
always tend toward a common rate; only land, because of its natural scarcity,
can yield increasing returns.
These axioms, which became
known respectively as the labor theory of
value, the iron law of wages, and
the common rate of profits, set the
scene for the rest of his theory.
Put in motion, the three characters act out a very tragic play. As the
population grows, new land is cultivated, but because marginal land is
necessarily inferior, it requires more labor to cultivate, driving up the price
of food, raising the subsistence wage, and cutting into to profits of industry.
To maintain profits, industrial capitalists introduce machines into the process
of production, decreasing the amount of labor necessary to produce goods and
decreasing the wages they must pay, until the competition kicks in to lower
profits back to the common rate. Agricultural prices tend to rise, industrial
prices tend to fall, and the only party who can possibly benefit in the long
term is the landowner.
Ricardo used his theory to
successfully advocate for the repeal of the Corn Laws, which by placing tariffs
on imports of grain increased the price of food, and therefore, according to Ricardo,
kept wages artificially high and profits artificially low. Thus before he died
Ricardo was able to taste the fruit of his labors; he had constructed an
internally consistent, scientific system that could be applied to the real
world to forward the cause of progress.
He also had the good fortune to see his economics embraced by his
countrymen. As John Maynard Keynes, wrote one hundred years later, “Ricardo
conquered England as completely as the Holy Inquisition conquered Spain. 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.”
On the Principles of Political Economy
and Taxation remained the standard text in economics until John Stuart Mill
published his
Principles of Political
Economy in 1848, which improved little on Ricardo’s reasoning but greatly
on Ricardo’s style.
Karl Marx, born two years after
the publication of
On the Principles of
Political Economy and Taxation, lived his entire life under the shadow of
Ricardian economics. As a young man at the University of Bonn in Berlin, Marx
studied the grandiose but often abstract theories of Gottfried Wilhelm Leibnez,
Ludwig Andreas von Feuerbach, and most importantly Georg Wilhiem Friedrich
Hegel, whose philosophy of history painted progress as the evolution of
collective human reason. At the
beginning of the 19
th century and the height of the German
philosophy, Bonn scholars paid little attention to the primitive mutterings of
the barbarians across the northern sea, but as Marx grew older, whispers of a
bold new English system grew louder.
Friedrich Engels, his friend and primary collaborator, fed him socialist
ideas from France, and he continued to discuss Hegel’s ideas with an
enthusiastic cohort of German students, but Marx remained unsatisfied. In 1843, at the age of 25, Marx decided
that to answer his philosophical questions, he needed to master Ricardian
economics.
Marx took Ricardo’s skeleton
theory and dressed it in rags. Ricardo may have declared that the wages of
labor must always tend towards subsistence, but he never took the time to
imagine what subsistence would look like. Engaged in the European socialist
movement, and later living among factory workers in London’s slums, Marx saw
subsistence at every turn; children covered in soot, mothers with fingers twisted
from textile mills, and fathers weary from 18 hours of hard labor.
Ricardo’s science said it must be so, but Marx’s soul cried that it could
not. And so he united Hegel’s
ideas about the evolution of history, Engel’s ideals of an equal society, and Ricardo’s
axioms on value, wage, and profit to conclude that revolution must rewrite the
rules of science.
Marx did not follow Ricardian
economics exactly. He tweaked the labor theory of value to create the concept of
socially necessary labor time,
partially fusing use value and labor value as the marginalists would later
do. He embedded the iron law of wages
in the social relations of the proletariat and the capitalist, and the common
rate of profit became the
tendency of the
rate of profit to fall. In Marxian economics, surplus value accrues not to
land, but to something much more subtle: hoarding.
In his 30 years of intensive study at the British Museum, Marx actually created
a system much closer to the truth than Ricardo, but, written in the language of
insurrection and peppered with innumerable convoluted German expressions,
Das Kapital remained unpalatable or
unintelligible to most. A small but devoted set of disciples would carry
Marxian economics to St. Petersberg, Bucharest, Havana, and Beijing, but in
London and in the majority of the rest of the world, Marx never threatened Ricardo.
Indeed, Ricardian economics
became so ingrained in 19th century thought that only one force proved
powerful enough uproot it: time. For
in the end, very few of Ricardo’s conclusions came true. Profits deviated from
the “common rate” too often and for too long to excuse fluctuations as
“accidental and temporary.” Prices
of industrial goods rose, and prices of agricultural goods fell, and landowners
found their relative place in society challenged by urban capitalists. Wages increased, Marx’s slums gradually
cleared, and at the turn of the 20th century English society was, if
still extremely unequal, working well above subsistence. And as time wore on, Ricardo’s
disciples uncovered problems that his economics simply could not explain. Luckily for them, the seeds of an
alternative system had already been planted, not in science, but in moral philosophy.
The Utilitarian Project
Morality in the age of
enlightenment was a sensitive business. In the 16th century the
Protestant Reformation discredited Catholic ethics, but offered nothing
definite to replace it; new prophets rushed to fill the void, some offering slight
amendments to traditional values, others preaching brave new interpretations of
the Bible, and still others declaring radical moral codes that claimed no
dependence on the authority of God.
Prophets preached against prophets, kings chose sides and started wars,
and bewildered citizens clung fanatically to new creeds or chose to operate
without a moral code at all. Chaos bred discord, but, for the worldy
philosophers, it also made room for creativity.
In the early 18
th
century, a number of thinkers began to reexamine an ancient and powerfully
simple moral philosophy: hedonism, the belief that behavior should endeavor
only to maximize pleasure, and minimize pain. One was Francis Hutchinson, Chair
of Moral Philosophy at the University of Glasgow and favorite professor of Adam
Smith, who argued that action should be judged by its effect on the general
welfare of mankind.
Another was John Gay, a Vicar of Wilshampstead,
who proposed something he called “the greatest happiness principle” in his
Dissertation Concerning the Fundamental
Principle of Virtue or Morality. A third was the English philosopher and reformer Jeremy
Bentham, who in addition to his moral philosophy is today remembered for his passionate
defense of animal rights, gender equality, and the charging of interest, his
advocacy for the construction of a circular prison called the Panopticon, and
his fulfilled wish to be mummified after death.
In 1780 Bentham rebranded
hedonism as “utilitarianism” in his
Introduction
to the Principles of Morals and Legislation. He defined “utility” as “that property in any object, whereby
it tends to produce benefit, advantage, pleasure, good, or happiness, (all this
in the present case comes to the same thing) or (what comes again to the same
thing) to prevent the happening of mischief, pain, evil, or unhappiness to the
party whose interest is considered.”
If utility sounds familiar, it should. Bentham’s
utility was essentially the same as Smith’s value in use, described only four
years earlier in the
Wealth of Nations, and
more than two millennia before that by Aristotle by way of his shoes.
Through moral philosophy, Bentham
proposed a standard of value where the unit of relevance is not an hour of
labor, nor a piece of currency, but single unit of utility, later infamously dubbed
“the util.” However, despite his avid interest in economics and personal
acquaintance with Ricardo, Bentham never used utility to directly challenge the
labor theory of value. The problem
was measurement. Ricardo measured
value by counting labor hours, but utils are not so easy to count. Bentham feebly proposed that
individuals might report the intensity of pleasure received from goods and
services as numbers, an idea rightly ridiculed by his contemporaries and
successors. Even if you could rely
on the integrity of self-evaluation, how could you possibly compare the
subjective utility of one individual to the subjective utility of another?
Price presented a second problem; Ricardo translated labor value into exchange
value by multiplying labor hours by the subsistence wage, but utilitarianism
suggested no such obvious mechanism.
Most citizens of the 18th
century flat out rejected utility as a guide for moral behavior, and Bentham’s
alternative beliefs and radical reputation certainly did not add to his moral credibility. He needed help to convince the wider
public that utilitarianism meant anything more than the unabashed celebration
of an irresponsible, indulgent lifestyle.
Ironically, the man most
responsible for popularizing utilitarianism was John Stuart Mill, also
remembered as the author of the authoritative resource on Ricardian economics for
the second half of the 19th century. With a series of essays penned
in his characteristically beautiful prose, Mill teased utilitarianism from a thoughtful
restatement of self-indulgence into a widely accepted system that scholars
still discuss today. But like Bentham, Mill never fully applied moral
philosophy to economics, and today those two fields view him not as a key
contributor, but as a genius of interpretation.
Instead, in one of history’s
great coincidences, three different men in three different countries independently
realized how to measure and price utility: William Stanley Jevons in Britain,
Carl Menger in Austria, and Leon Walras in Switzerland.
Although seemingly miraculous at the time, in retrospect their simultaneous innovation
was actually quite understandable. Ricardo gave the world a glimpse of what
economics could accomplish, and, like Marx, hundreds of idealistic men turned
to his theory for guidance and found it wanting. Bentham “planted a tree” that no one could ignore, but he
left the utilitarian project unfinished.
The task of the next generation
was to incorporate the utility into Ricardian economics, and to so lay the foundations
for the construction of a new and greater science.
Marginal Revolution
Jevons, Menger, and Walras each approached the problem of
measurement in a different way. In his
Brief
Account of a General Mathematical Theory of Political Economy, Jevons began
with a Benthamite exposition of pleasure and pain and stumbled awkwardly toward
a numerical ratio. In his
Principles of
Economics, Menger abandoned any attempt to calculate, and instead rigorously
constructed a system based on ranked preferences, also known as ordinal utility.
Walras discovered the topic during
an attempt to build a mathematical model of the entire economy, and actually
worked backwards to deduce the theory of value behind his equations.
Eventually, all three arrived
at the same conclusion: prices are determined on one hand by
marginal utility, or the amount of utility
the consumer expects to receive from the last unit bought, and by
marginal cost on the other, or the increase
in total cost required to produce the last unit sold. When marginal utility is greater than marginal cost, the
quantity of utility bought and the its price will increase, and when marginal
cost is greater than marginal utility, the quantity of utility sold and its price
will decrease, until the two equilibrate. Walras aptly called this process “tâtonnement” or literally,
groping.
Importantly, all three also noted that marginal utility tends to diminish with
quantity; we are willing to pay less for our fifth apple less than our first. Marginalism solved the problem of
measurement by allowing economists to price utility without counting utils
through the mechanism of tâtonnement, and finally allowed economists to
formally explain Smith’s paradox of water and diamonds: while the total utility
of water is greater than the total utility of diamonds, the marginal utility of
one more diamond is greater than the marginal utility of one more drink.
For the most part, marginalism
remained highly abstract and quite inaccessible to all but a select few until
Alfred Marshall, a Cambridge don and student of Jevons, published his
Principles of Economics in 1890
. Marshall interpreted marginal utility
and marginal cost as curves that intersect at equilibrium, and emphasized that
both marginal cost and marginal utility play an equally important role in
determining quantity and price, like the bottom and the top blade of a pair of
scissors.
Thus with simple graph and a simpler metaphor, supply, demand, and neoclassical
economics were born. Marshall’s
exposition cleared the way for a golden age; finally free from the fallacies of
Ricardian economics and the contradictions of the worldly philosophers, a new
generation of the mathematically minded men, including Vilfredo Pareto, Francis
Edgeworth, and Eugene Slutsky, set out to reduce the world to a series of
graphs and equations. All modern
students know these names, for they decorate the models we use in
microeconomics today.
Supply and demand did not cleanly
replace the labor theory of value with the utility theory of value. Demand and marginal utility clearly
referenced Bentham’s calculus of pleasure and pain, but supply and marginal
cost did not. Thinking about cost,
or the price of additional production, made perfect sense to businessmen, but using
price to define marginal cost and marginal cost to define price created a
confusing and circular definition of value. Because all costs can be interpreted as backdated wages,
some contemporary economists simply understood supply as labor value
reincarnated, but this too did not quite fit, because Ricardo’s mechanical method
of pricing labor by multiplying labor hours by the subsistence wage clashed
with the idea of tâtonnement.
Jevons articulated supply more
accurately, if less clearly, than Marshall: “Labor will be exerted both in
intensity and duration until a further increment will be more painful than the
increment of produce thereby obtained is pleasurable. Here labor will stop, but
up to this point it will always be accompanied by an excess of pleasure
.”
Jevons framed equilibrium as the
equality of the marginal utility of consumption and the
marginal disutility of labor, or as some would later call it, the
laborer’s
marginal utility of income,
and so eliminated the need for the troublesome concept of cost. Importantly, Jevons noted that marginal
disutility tends to increase with quantity: we mind our seventh hour of labor
more than our second. Still, to avoid tongue-twisting
terminology, to explain economics easily to practical men, or perhaps simply
out of the force of habit, economists continued to speak about tâtonnement in
terms of cost, and still do today.
Beyond disutility, supply hid
an even deeper relationship between labor value and use value. If it were
possible to decrease the incremental pain of labor by reducing the duration or
intensity of labor required to create utility, would not quantity increase, or
price decrease? In other words, equilibrium
ultimately depends on productivity, or
the rate at which labor can produce utility. Productivity was the missing link between labor value and
use value in Ricardian economics. In the Wealth
of Nations, Smith noted that education, experience, and other characteristics
can differentiate labor, but in order to squeeze philosophy into science,
Ricardo made labor a uniform, homogenous good; an hour of labor was an hour of
labor was an hour of value. Bentham devised a theory of value, but could do nothing with
it. Marginalism incorporated labor value into use value by means of
productivity, and both into exchange value by means of tâtonnement. Instead of choosing one standard to
hold above the others, marginalism defined a relationship between the
three.
Marginalism proved that, after
all, the worldy philosphers were right. All goods and services have three types
of value: use value, labor value, and exchange value. Just
as the eye needs multiple perspectives to understand form, to understand value
economics needed simultaneous truths.
However, the marginalists never truly answered Aristotle’s question. By
shifting emphasis from value itself towards the relationship between different
kinds of value, marginalism divorced economics from larger ideas about what we
care about and why. Today other branches of academia ask Aristotle’s question
more directly; psychology, sociology, and of course, modern day moral
philosophy. Ricardo set economics on the path towards a cold and mathematical
science, and after the marginal revolution, there was no turning back. Marginalism
also explained why Ricardo predicted so gloomy a future. Value based on the
hour cannot grow, because no matter how much we try to stretch it, save it, or
slow it, time will always be our ultimate constraint. Utility, however, has no
limit. We will always be able to cook
food a little tastier, weave clothes a little finer, build houses a little
grander, and tell stories a little better. We do so not by increasing time, but by increasing productivity.
Neglecting productivity was Ricardo’s greatest mistake.
For the immediate heirs of the
marginal revolution, however, productivity presented something of a
puzzle. Economics had spent the
last century denying its existence, and reliance on the language of cost to
describe supply left a simple concept surprisingly poorly defined. Businessmen
unanimously sought to reduce their costs, certainly, by purchasing additional
machinery for the factory, by reducing wages, or by trying to source raw
materials, like coal, wood, or wool, more cheaply. But which, if any, of these
actions could be said to increase efficiency? The rest of Part I will focus on the slow discovery of the
determinants of productivity by 20th century economics. Parts II and
III will examine demand, supply, and the process of tâtonnement more in depth. We will find that, in all cases, equilibrium
is infinitely messier than the models of the marginalists suggested.
Capital, Capital, Residual
