The Economics Book

ON

50 INTRODUCTION Anne-Robert- Richard Arkwright opens Adam Smith’s classic The American Jacques Turgot a mechanized cotton work, An Inquiry Declaration of argues for the mill in England and later into the Nature Independence exemption of trade introduces machinery and Causes of the Wealth of Nations, is adopted and industry that sets the pace is published. by Congress. from taxation. for industrialization. 1766 1771 1776 1776 1776 1780S 1770S 1774 David Hume Turgot is appointed The first of James Watt’s Smith’s proposals on denounces trade finance minister in steam engines are liberalizing trade protectionism, arguing France and attempts to put into operation in that countries should not reform the tax system are adopted by strive to export more British factories, marking British Prime than they import. by taxing the true beginning of the Minister William wealthy landowners. Industrial Revolution. Pitt the Younger. T oward the end of the 18th had begun to industrialize on to his thesis was the concept of century much of the world an unprecedented scale. A fresh “rational economic man.” Smith was undergoing enormous approach was needed to describe argued that individuals made political change. The so-called and meet the demands of this economic decisions on the basis Age of Reason produced scientists rapidly emerging economic of reason and in their own self- whose discoveries were leading new world. interest, not for the good of society. to new technologies that would When they were allowed to act in transform the way goods were Rational economic man this way in a free society with produced. At the same time The economist who rose most competitive markets, an “invisible political philosophers had inspired successfully to this new challenge hand” guided the economy for the revolutions in France and North was a Scotsman, Adam Smith benefit of all. This was the first America that would have a (p.61). His background in the detailed description of a free profound effect on the social philosophy of British Enlightenment market economy, which Smith structures of both the Old and thinkers, such as John Locke and advocated as the means of the New Worlds. In the field of David Hume (p.47), led him to ensuring prosperity and freedom. economics a new scientific approach the subject initially as It is generally regarded as a approach was overturning the one of moral philosophy. However, milestone in the development old mercantilist view of an economy in his famous book of 1776, The of economics as a discipline. The driven by protected trade and Wealth of Nations, he presented approach to economics that Smith reliant on exports as a means of a comprehensive analysis of the helped to establish is often referred preserving its wealth. By the end market economy and how it to as “classical” economics. His of the Napoleonic wars in 1815, contributed to the economic analysis of a competitive market Europe, and Britain in particular, welfare of the people. Central economy was essentially a

THE AGE OF REASON 51 The storming Edmund Burke Jean-Baptiste Say Jean Charles Léonard de of the Bastille criticizes state proposes Say’s law Sismondi describes prison in Paris involvement in the of markets: there sparks off the regulation of wages can never be a deficiency business cycles and the French Revolution. of demand or a glut of difference between and prices. goods in the economy. long-term growth and short-term ups and downs. 1789 1795 1803 1819 1791 1798 1817 1819 Jeremy Bentham Thomas Malthus David Ricardo lays The US suffers its sets out his theory of warns of the danger of the foundations for first major financial utilitarianism; its goal population outstripping 19th-century classical crisis, which follows economics, advocating is “the greatest resources, and the free trade and the a period of happiness of the suffering that this specialization of labor. sustained growth. greatest number.” will bring. description of what we now know economy of an industrialized gloomy predictions of the suffering as capitalism. However, The Wealth society. In particular Smith that would ensue from a population of Nations was far more than a addressed the place of government growing faster than resources description of the economy as in a capitalist society, arguing for could feed it. Many of Smith’s ideas a whole, or “macroeconomics.” a limited role for the state. were also taken up by the French It also examined issues such as physiocrat school, most notably the division of labor and its Ending protectionism Anne-Robert-Jacques Turgot (p.65) contribution to growth, and what British political economist and François Quesnay (p.45), who factors were involved in giving David Ricardo (p.84) was one of argued for a fair system of taxation, value to goods. The publication the most influential of Smith’s and Jean-Baptiste Say (p.75), who of Smith’s work coincided with the followers. A staunch advocate of first described the relationship start of the Industrial Revolution free trade, Ricardo put the final nail between supply and demand in in Britain, a period of rapidly in the coffin of protectionism when a market economy. accelerating economic growth and he showed how all countries, even prosperity aided by dynamic new those that were less productive, Not everyone agreed with technology and innovation. Smith’s could benefit from free trade. He Smith’s analysis, of course, and ideas found a willing audience, also cast a critical eye over the in the 19th century there was soon eager to understand how the ways that government spending to be a strong reaction against the economy worked and how best to and borrowing affected the notion of a completely free market take advantage of it. His work was economy. Another of Smith’s capitalist economy, but the hugely influential, raising many of followers was Thomas Malthus classical economists of the early the questions that needed to be (p.69), a British clergyman and industrial period raised questions addressed in managing the scholar famous today for his that remain at the center of economics today. ■

52 MAN IS A COLD, RATIONAL CALCULATOR ECONOMIC MAN IN CONTEXT As individuals we are M ost economic models self-interested. are underpinned by the FOCUS assumption that humans Decision making We aim to improve are essentially rational, self- our personal well-being by interested beings. This is Homo KEY THINKER consuming goods and services Economicus, or “economic man.” Adam Smith (1723–90) The idea—which applies equally and achieving goals. to men and women—assumes that BEFORE every individual makes decisions C.350 BCE Greek philosopher We make decisions by designed to maximize their personal Aristotle claims that innate collecting information and well-being, based on a level-headed self-interest is the primary calculating which actions will evaluation of all the facts. They economic motivator. choose the option that offers the help us achieve our aims greatest utility (satisfaction) with 1750s French economist without being too costly. the least effort. This idea was François Quesnay claims that first expounded by Adam Smith self-interest is the motivation Man is a cold, (p.61) in his 1776 work, The behind all economic activity. rational calculator. Wealth of Nations. AFTER Smith’s central belief was that 1957 US economist Herbert human economic interaction is Simon argues that people are governed mainly by self-interest. not able to acquire and digest He argued that “it is not from the all available information about benevolence of the butcher, the every topic, so their rationality brewer, or the baker that we can is “bounded” (limited). expect our dinner, but from their regard to their own interest.” In 1992 US economist Gary making rational decisions suppliers Becker receives the Nobel seek to maximize their own profit; Prize for his work on rational the fact that this supplies us with choice in the fields of our dinner matters little to them. discrimination, crime, and human capital. Smith’s ideas were developed in the 19th century by the British philosopher John Stuart Mill (p.95). Mill believed people were beings

THE AGE OF REASON 53 See also: Free market economics 54–61 ■ Economic bubbles 98–99 ■ Economics and tradition 166–67 ■ Markets and social outcomes 210–13 ■ Rational expectations 244–47 ■ Behavioral economics 266–69 who desire to possess wealth, by itself, and some goals may appear Monks who lead a life of fasting and which he meant not just money, but to be quite irrational to most prayer, denying worldly goods in the a wealth of all things good. He saw people. For example, while to expectation of an afterlife, act rationally individuals as motivated by the will most of us it may seem a dangerous within their beliefs, regardless of what to achieve the greatest well-being decision to inject the human body others may think of their goal. possible, while at the same time with unverified performance- expending the least possible effort enhancing drugs, for numerous economists have begun to explore to achieve these goals. athletes—in the context of the ways in which humans act the desire to be the best—the differently from Homo Economicus Costs and benefits decision may be a rational one. when making choices. The idea Today, the idea of Homo of “economic man” may not be Economicus is referred to as Some people have questioned entirely accurate for explaining rational choice theory. This says whether the idea of Homo individual behavior, but many that people make all kinds of Economicus is realistic. They economists argue that it remains economic and social decisions argue that it does not allow for the useful in analyzing the actions of based on costs and benefits. For fact that we cannot weigh every profit-maximizing firms. ■ example a criminal thinking of relevant factor in a decision—the robbing a bank will weigh the world is too complex to collect and benefits (increased wealth, greater evaluate all the relevant facts respect from other criminals) against needed to calculate costs and the costs (the chances of getting benefits for every action. In caught and the effort involved in practice we often make quick planning the heist) before deciding decisions based on past experience, whether to commit the crime. habit, and rules of thumb. Economists consider actions The theory also falters when to be rational when they are taken there are conflicting long- and as a result of a sober calculation of short-term goals. For instance costs and benefits in relation to someone might buy an unhealthy reaching a goal. Economics may burger to stave off immediate have little to say about the goal hunger, despite knowing that this is an unhealthy choice. Behavioral Family economics Parents’ investments in children, US economist Gary Becker (1930– ) believes that investment in especially through education, are an was one of the first to apply a child is motivated by the fact important source of an economy’s economics to areas usually that it often produces a better capital stock, according to Becker. thought of as sociology. He argues rate of return than traditional that decisions relating to family retirement savings. However, life are made by weighing costs children cannot be legally forced and benefits. For example he to take care of their parents, views marriage as a market and so they are brought up with a has analyzed how economic sense of guilt, obligation, duty, characteristics influence the and love, which effectively matching of partners. Becker also commits them to helping their concluded that family members parents. For this reason it can be will help each other, not out of argued that the welfare state love, but out of self-interest in the damages families by reducing hope of a financial reward. He their need for interdependence.

THE INVISIBLE HAND OF THE MARKET BRINGS ORDER FREE MARKET ECONOMICS



56 FREE MARKET ECONOMICS IN CONTEXT A ccording to the Scottish Mandeville’s Fable of the Bees thinker Adam Smith, the explored the idea that when people FOCUS West had embarked on act out of self-interest, they benefit the Markets and firms a great revolution before the 18th whole of society, like the self-interested century, with nations changing behavior of bees benefits the hive. KEY THINKER from agrarian, or agricultural, Adam Smith (1723–90) societies to commercial ones. answer. Man, in his freedom, rivalry, During the Middle Ages towns had and desire for gain, is “led by an BEFORE developed, and they were slowly invisible hand to promote an end, 1714 Dutch writer Bernard joined up by roads. People brought which was no part of his intention” Mandeville illustrates the goods and fresh produce to the —he inadvertently acts on behalf of unintended consequences that towns, and the markets—with the wider interest of society. can arise from self-interest. their buying and selling—became a part of life. Scientific innovation Laissez-faire economics 1755–56 Irish banker Richard produced reliable, agreed-upon The idea of “spontaneous order” Cantillon describes a version of units of measurement, along with was not new. It was proposed in “spontaneous order.” new ways of doing things, and 1714 by the Dutch writer Bernard centralized nation-states formed Mandeville in his poem The Fable AFTER from the mix of principalities that of the Bees. This told the story 1874 Léon Walras shows how had dotted Europe. People enjoyed of a beehive that was thriving supply and demand lead to a a new freedom and had begun to on the “vices” (self-interested general equilibrium. exchange goods for their own behavior) of its bees. When the personal gain, not merely for that of bees became virtuous (no longer 1945 Austrian economist their overlord. acting in their own self-interest Friedrich Hayek argues that but trying to act for the good of market economies produce Smith asked how the actions the hive), the beehive collapsed. an efficient order. of free individuals could result in Smith’s notion of self-interest was an ordered, stable market—where 1950s Kenneth Arrow and people could make, buy, and sell Gérard Debreu identify what they wanted without enormous conditions under which free waste or want. How was this possible markets lead to socially without some kind of guiding hand? optimal outcomes. In his great work of 1776, The Wealth of Nations, he provided the Covent Garden Market in London is pictured here in 1774. Smith thought markets were key to making society fair. With the freedom to buy and sell, people could enjoy “natural liberty.”

THE AGE OF REASON 57 See also: Economic man 52–53 ■ The division of labor 66–67 ■ Economic equilibrium 118–23 ■ The competitive market 126–29 ■ Creative destruction 148–49 ■ Economic liberalism 172–77 ■ Markets and social outcomes 210–13 not a vicious one. He saw humans Every individual acts out This might lead to a as having an inclination to “truck of self-interest. chaotic mix of products and barter” (bargain and exchange) and to better themselves. Humans, and prices, but… in his view, were social creatures who act with moral restraint, using … other self-interested people provide competition— “fair play” in competition. they take advantage of each other’s greed. Smith believed that If one seller charges If one employer pays wages governments should not interfere too much… that are too low… with commerce, a view that was also held by other Scottish thinkers … another will undercut … another will around him, including the his price, and the first seller’s take his employees, philosopher David Hume (p.47). and his firm will fail. An earlier French writer, Pierre de products will fail to sell. Boisguilbert, used the phrase laisse faire la nature (“leave nature alone”), Businesses fail unless they pay market by which he meant “leave business wages and make products the market demands alone.” The term “laissez-faire” is used in economics to advocate at the price people are willing to pay. minimal government. In Smith’s view government did have an The invisible hand of the important role, supplying defense, market brings order. justice, and certain “public goods” (pp.46–47) that private markets goods that people want. If demand Society, the Austrian economist were unlikely to provide, such for a product exceeds its supply, Friedrich Hayek (p.177) showed as roads. consumers compete with each how prices respond to individuals’ other to drive the price up. This localized knowledge and desires, Smith’s vision was essentially creates a profit opportunity for leading to changes in the amounts optimistic. The English philosopher producers, who compete with each demanded and supplied in the Thomas Hobbes had earlier argued other to supply more of the product. market. A central planner, Hayek that without strong authority, said, could not hope to gather up human life would be “nasty, This argument has stood the so much dispersed information. It is brutish, and short.” British test of time. In an essay in 1945, widely believed that communism ❯❯ economist Thomas Malthus (p.69) titled The Use of Knowledge in looked at the market and predicted mass starvation as a direct result of increased wealth. After Smith, Karl Marx (p.105) would predict that the market leads to revolution. Smith, however, saw society as perfectly functional, and the entire economy as a successful system, an imaginary machine that worked. He mentioned the “invisible hand” only once in his five volume work, but its presence is often felt. Smith described how his system of “perfect liberty” could have positive outcomes. First, it provides the

58 FREE MARKET ECONOMICS collapsed in Eastern Europe because In that case, opportunities for gain Consumption is the central planning failed to deliver the will arise, and prices will increase, sole end and purpose goods that people wanted. Some but only until competition brings criticisms of Smith’s first point have new firms into the market and of all production. been raised, such as the fact that prices fall back to their natural Adam Smith the market might only provide the level. If one industry begins to goods that are wanted by the rich; suffer a slump in demand, prices about competition, although it ignores the desires of the poor. It will drop and wages will fall, but dissenters, such as Austrian- also responds to harmful desires— as a different industry rises, it will American economist Joseph the market can feed drug addiction offer higher wages to attract Schumpeter (p.149), would later and promote obesity. workers. In the long run, Smith say that innovation can also lower says, “market” and “natural” rates prices, even where there appears to Fair prices will be the same: modern be little competition. As inventors Second, Smith said that the market economists call this equilibrium. come forward to provide higher system generates prices that are quality products at lower prices, “fair.” He believed that all goods Competition is essential if they blow away existing firms in have a natural price that reflects prices are to be fair. Smith attacked a storm of creative destruction. only the efforts that went into the monopolies occurring under the making them. The land used in mercantilist system, which Fair incomes making a product should earn its demanded that governments Smith also argued that market natural rent. The capital used in its should control foreign trade. When economies provide incomes that manufacture should earn its natural there is only one supplier of a are fair and can be spent on goods profit. The labor used should earn good, the firm that supplies it can in a sustainable “circular flow,” its natural wage. Market prices and permanently hold the price above rates of return can differ from their its natural level. Smith said that natural levels for periods of time, as if there are 20 grocers selling a might happen in times of scarcity. product, the market is more competitive than if there are just Smith described the ways in which two. With effective competition labor, landowners, and capital (here and low barriers to entry into a invested in the horses and plow) work market—which Smith also said together to keep the economic system was essential—prices tend to be moving and growing. lower. Much of this underlies mainstream economists’ views

THE AGE OF REASON 59 in which money paid in wages Demand in a market can change for many reasons. As it does so, circulates back into the economy the market responds by altering supply. This happens spontaneously— when the worker pays for goods, there is no need for a guiding hand or plan in a market that encourages only to be paid back out in wages competition among self-interested people. to repeat the process. Capital invested in production facilities helps During a rainy summer… to increase labor productivity, which means that employers can … demand … demand for afford to pay higher wages. And if for umbrellas sunglasses employers can afford to pay more, drops. they will because they have to soars. compete with each other for workers. As prices As prices drop, so do Turning to capital, Smith rise, so do profits. said that the amount of profit that capital can expect to earn through profits. investments is roughly equal to the rate of interest. This is because Umbrella firms Self-interested employers compete with each other employ more employers let to borrow funds to invest in profitable people and go of staff. opportunities. Over time the rate enjoy profits of profit in any particular field until other Staff go to work falls as capital accumulates and in the booming opportunities for profit are exhausted. firms enter the umbrella business. Rents gradually rise as incomes market, forcing rise and more land is used. prices back to a “natural level.” Smith’s realization of the interdependence of land, labor, and labor (pp.66–67). Economists It is not from the capital was a real breakthrough. He call this “Smithian growth.” As benevolence of the butcher, noted that workers and landowners more products are produced and tend to consume their incomes, consumed, the economy grows, the brewer, or the baker while employers are more frugal, and markets also grow. As markets that we expect our dinner, investing their savings in capital grow, there are more opportunities stock. He saw that wage rates vary, for specialization of work. but from their regard depending on different levels of to their self-interest. “skill, dexterity, and judgment,” The second engine of growth is and that there are two forms of the accumulation of capital, driven Adam Smith labor: productive (engaged in by saving and the opportunity for agriculture or manufacturing) and profit. Smith said that growth can what he called “unproductive” be reduced by commercial failures, (supplying services needed to back a lack of resources required to up the main work). The highly maintain the fixed capital stock, unequal outcomes of today’s an inadequate money system market system are a long way (there is more growth with paper from what Smith envisioned. money than with gold), and a ❯❯ Economic growth Smith claimed that the invisible hand itself stimulates economic growth. The source of growth is twofold. One is the efficiencies gained through the division of

60 FREE MARKET ECONOMICS high proportion of unproductive There is no art which invisible hand would be socially workers. He claimed that capital is one government sooner beneficial. Kenneth Arrow and more productive in agriculture than learns of another than Gérard Debreu (pp.208–11) showed in manufacturing, which is higher that of draining money how free markets do this, but they than in trade or transport. also showed that the conditions Ultimately, the economy will grow from the pockets needed were stringent and did not until it reaches a wealthy, stationary of the people. bear much relation to reality. state. In this, Smith underestimated Adam Smith the role of technology and This was not the end of the innovation—the Schumpeterian their returns. Later, free market story. After World War II the idea growth described earlier (p.58). theory took a different, of laissez-faire was in hibernation. “neoclassical” form with general However, from the 1970s, Keynesian Classical legacy equilibrium theory, which sought policies, which advocated state Smith’s system was comprehensive. to show how a whole economy’s intervention in economies, seemed It considered small (microeconomic) prices could reach a state of stable to break down, and laissez-faire details and the large (macroeconomic) equilibrium. Using mathematics, enjoyed a strong resurgence. The picture. It looked at situations in economists such as Léon Walras seeds of this flowering can be both the short and long run, and its (p.120) and Vilfredo Pareto (p.133) found in works on the market analysis was both static (the state reframed Smith’s claim that the economy by Milton Friedman of trade) and dynamic (the economy (p.199) and the Austrian School, in motion). It looked in detail at the notably Friedrich Hayek (p.177), class known as workers, who were skeptical about the good distinguishing entrepreneurs such that interfering governments can as farmers and factory owners from do and argued that social progress suppliers of labor. In essence it would be attained through established the parameters for unfettered markets. Keynesians, “classical” economics, which too, recognized the power of focuses on the factors of production markets—but for them markets —capital, labor, and land—and needed to be nudged to work best. The free market approach enjoyed an important boost from theories in the 1960s and 70s based on the role of rationality and rational expectations (pp.244–47). Public choice theory, for example, depicts government as a group of self- seeking individuals who maximize their own interests and extract money without regard to the social good (“rent-seeking”). New classical macroeconomics uses Smith’s assumption that markets always sort themselves out and adds the point that people can see the future implications of any government actions and understand the Localized markets such as this one in Kerala, India, exhibit all the hallmarks of Smith’s free market and demonstrate the natural way in which supply and price adjust to demand.

THE AGE OF REASON 61 workings of the economic system, Smith didn’t foresee the kinds of Adam Smith so state intervention will not work. inequalities that can arise from free Even so, most economists today markets in their present form. In stock The founder of modern believe that the market can fail. exchanges and money markets notions economics, Adam Smith was They focus on disparities in of “fairness” become almost irrelevant. born in Kirkcaldy, Scotland, information, held by various in 1723, six months after his participants in a market. George rationality (pp.266–69), and see father’s death. A reclusive, Akerlof referred to this in his The the non-rationality of humans as absentminded scholar, he Market for Lemons (pp.274–75). a reason for markets to fail. went to Glasgow University at Behavioral economists have the age of 14, then studied at questioned the whole notion of The issue of laissez-faire Oxford University for six years economics divides economists before returning to Scotland Human society, when along political lines. Those on the to take up a professorship in we contemplate it in a political Right embrace laissez- logic at Glasgow University. certain abstract and faire; those from the Left align In 1750, he met and became themselves with Keynesian close friends with the philosophical light, intervention. This remains a philosopher David Hume. appears like a great, central debate in economics today. an immense machine. In 1764, Smith resigned The financial crisis of 2007–08 his post at Glasgow to travel Adam Smith has added fuel to this dispute. The to France as tutor to the Duke free marketeers felt vindicated in of Buccleuch, a Scottish their theories about the business aristocrat. In France, he cycle, while Keynesians pointed met the physiocrat group of to market failure. US economist economists (pp.40–45) and the Nouriel Roubini (1959– ), who philosopher Voltaire, and he predicted the crash, was speaking began writing The Wealth of of those who had distorted Smith’s Nations. He devoted 10 years ideas when he said that “decades to the book before accepting a of free market fundamentalism laid position as Commissioner of the foundation for the meltdown.” ■ Customs. He died in 1790. Key works 1759 The Theory of Moral Sentiments 1762 Lectures on Jurisprudence 1776 An Inquiry into the Nature and Causes of the Wealth of Nations

62 THE LAST WORKER ADDS LESS TO OUTPUT THAN THE FIRST DIMINISHING RETURNS IN CONTEXT F renchman Anne-Robert- Péravy, had said that for each extra Jacques Turgot (p.65) was worker on the land, the amount of FOCUS one of a small group of additional output is constant; in Markets and firms thinkers known as the physiocrats, other words each extra worker adds who believed that national wealth the same to production as the last. KEY THINKER was created from agriculture. But in 1767, Turgot pointed out that Anne-Robert-Jacques unprepared soil produces very little Turgot (1727–81) Turgot’s twin interests in tax and when sowed. If the soil is plowed the output of land led him to develop once, output increases; plowed BEFORE a theory that explains how the twice, it might quadruple. Eventually, 1759 French economist output of each extra worker changes however, the extra work begins to François Quesnay publishes as successive workers are added to increase output less and less, until Economic Table—a model that the production process. A fellow additional workers add nothing demonstrates the physiocrats’ physiocrat, Guerneau de Saint- further to production, because the economic theories. fertility of the soil is exhausted. 1760s French physiocrat The earth’s fertility The role of technology Guerneau de Saint-Péravy’s resembles a spring that is Turgot’s idea is that adding more of essay on the principles of being pressed downward… a variable factor (workers) to a fixed taxation argues that the ratio the effect of additional weights factor (land) will lead to the last of outputs to inputs is fixed. will gradually diminish. worker adding less to output than the first. This has become known AFTER A R J Turgot as “diminishing marginal returns,” 1871 Austrian Carl Menger and it is one of the most important argues in Principles of pillars of modern economic theory. Economics that price is It explains not only why it costs determined at the margin. more to produce more, but also why countries struggle to get richer if 1956 In A Contribution to the their population expands without Theory of Economic Growth, improvements in technology. ■ US economist Robert Solow applies the idea of diminishing See also: The circular flow of the economy 40–45 ■ Demographics and marginal returns to the growth economics 68–69 ■ Economic growth theories 224–25 prospects of countries.

THE AGE OF REASON 63 WHY DO DIAMONDS COST MORE THAN WATER? THE PARADOX OF VALUE IN CONTEXT I n 1769, Anne-Robert-Jacques from important—feeding himself— Turgot (p.65) noted that to trivial—feeding birds. If he loses FOCUS despite its necessity, water a bag of wheat, he will merely stop Theories of value is not seen as a precious thing feeding the birds. Even though the in a well-watered country. Seven farmer needs wheat to feed himself, KEY THINKER years later Adam Smith (p.61) the price he is willing to pay to Adam Smith (1723–90) took this idea further, noting that replace the fifth bag of wheat is low, although nothing is more useful because it only generates a small BEFORE than water, hardly anything can amount of pleasure (feeding birds). 1691 English philosopher be exchanged for it. Although a John Locke connects a diamond has very little value in Water is abundant, but diamonds commodity’s value to its utility terms of use, “a very great quantity are scarce. One extra diamond has (the satisfaction it affords). of other goods may frequently be a high marginal utility and so had in exchange for it.” In other commands a much higher price 1737 Swiss mathematician words, there is an apparent than an extra cup of water. ■ Daniel Bernoulli poses the contradiction between the prices “St Petersburg Paradox,” of certain commodities and their examining how players can importance to people. evaluate options involving chance. The paradox is Marginal utility Diamonds are worth more than resolved by applying the This paradox can be explained water because each one is extremely concept of marginal utility. with the help of a concept known valuable no matter how many you have, as marginal utility: the amount of while water becomes less valuable, per AFTER pleasure gained from the last unit unit, as quantities increase. 1889 Austrian economist of the commodity consumed. In Eugen von Böhm-Bawerk 1889, the Austrian economist develops the subjective Eugen von Böhm-Bawerk explained theory of value (the value it through the example of a farmer of an object depends on a with five bags of wheat. The person’s needs rather than farmer’s use of the wheat ranges the object itself), using the idea of marginal utilities. See also: The labor theory of value 106–07 ■ Utility and satisfaction 114–15 ■ Opportunity cost 133

64 MAKE TAXES FAIR AND EFFICIENT THE TAX BURDEN IN CONTEXT W ho bears the burden of from prices and profits to amounts tax? The key question of goods consumed and incomes FOCUS of “tax incidence” received. Changes in these can Economic policy intrigued the gifted economist ripple through the economy in Anne-Robert-Jacques Turgot, who surprising ways. The “burden” of KEY THINKER was the French Minister of Finance a tax—which is taken to mean a Anne-Robert-Jacques from 1774–76. The question is not decrease in happiness, welfare, or Turgot (1727–81) as simple as “who should pay tax?” money—can be shifted from one because taxes affect many things, person or group to another. If you BEFORE 1689–1763 Expensive wars, They must fall Taxes They must be together with an inefficient mainly on those should… collected tax system that exempted effectively. landowners and unions, lays able to pay the ground for French financial the most. crisis and the Revolution. They must fall … be … be They must AFTER equally fair. efficient. maximize 1817 In his Principles of welfare while Political Economy and upon similar raising sufficient Taxation, British economist people. David Ricardo argues that revenue. taxes should fall on luxuries. They must fall Make taxes They must 1927 British mathematician on those fair and distort markets Frank Ramsay emphasizes the efficient. importance of price elasticity. most likely as little as to benefit. possible. 1976 Economists Anthony Atkinson and Joseph Stiglitz suggest uniform commodity taxes are optimal in The Design of Tax Structure.

THE AGE OF REASON 65 See also: The circular flow of the economy 40–45 ■ Efficiency and fairness 130–31 ■ External costs 137 ■ The theory of the second best 220–21 ■ Taxation and economic incentives 270–71 are planning a vacation and a new produce nothing, Turgot argued Aristocrats at Versailles were fuel tax puts the airfare above the that the landowners should be targeted by Turgot’s tax reforms of level you are prepared to pay, the taxed on the rent they charged. 1776. He suggested they should no tax has made you unhappy. The longer be exempt from tax, so they new fuel tax has reduced your Later economists refined the arranged his dismissal from office. welfare, but not necessarily the principles of fairness and efficiency airline company’s profits. that go into an optimal tax system. goods (for sale to final users); Fairness includes the idea that those income taxes should be linked to Who should pay taxes? most able to pay should pay the ability rather than income; and Turgot argued that taxes interfere most; that similar people should face taxes on company profits and with the free market and should be similar taxes; and that those who income from capital should be simplified. Powerful groups should benefit from government spending, minimal. “Market failure” analysis, not be exempt from taxation, and such as users of a new bridge, on the other hand, suggests that the details of its implementation should contribute to it. Efficiency taxes on undesirables such as matter. His recommendation was means both effectiveness in pollution increase people’s welfare. for a single tax on a country’s net collection and maximizing society’s product—the value of its total goods welfare while raising the required In general, tax policies have and services minus depreciation. revenue. Economists argue that moved in the directions shown efficiency means disturbing the by such theories while paying His thinking was influenced by market as little as possible, attention to revenue and political an early school of economists particularly to avoid blunting acceptability. ■ known as the physiocrats, who incentives for work and investment. believed that only agriculture (land) produces a surplus. Other Perfect tax design industries do not produce a surplus The last few decades have seen and so cannot afford to pay tax— huge strides in the sophistication they will always try to pass it on by of tax design, integrating both increasing prices and charges until fairness and efficiency. “Perfect finally it reaches the landowners. markets” theory, for example, As farmers pay much of their suggests commodity taxes should surplus in rent to landowners, who be uniform and apply only to “final” Anne-Robert-Jacques Born in Paris, France, in 1727, labor to build roads by Turgot Turgot was destined for the instituting a road-building tax priesthood until an inheritance instead. Louis XVI did not in 1751 allowed him to pursue a approve and dismissed Turgot career in administration. By the from office. His reforms—which late 1760s, he had become friendly some felt might have averted with the physiocrats, and later the French Revolution of 1789— met Adam Smith. From 1761 to were overturned. He died aged 1774, he was the Intendant of 54 in 1781. Limoges, a regional administrator. On the accession of Louis XVI in Key works 1774, Turgot became Minister of Finance and set about making 1763 Taxation in General reforms that encouraged free 1766 Reflections on the trade. In 1776, he abolished the Production and Distribution guilds and ended a government of Wealth policy that used unpaid, forced 1776 The Six Edicts

66 DIVIDE UP PIN PRODUCTION, AND YOU GET MORE PINS THE DIVISION OF LABOR IN CONTEXT When workers concentrate on one task… FOCUS Markets and firms … repetition increases … no time is skill and speed. wasted through switching KEY THINKER Adam Smith (1723–90) between tasks. BEFORE This increases production 380 BCE In The Republic, and reduces cost. the Greek philosopher Plato explains how a city emerges, Divide up pin production, then grows by exploiting the and you get more pins. gains made by dividing labor. W henever people work in sequence required to make 1705 Dutch philosopher a group, they invariably something, and when several Bernard Mandeville coins the start by deciding who is people each do just one task each. term “division of labor” in his going to do what. It was the great Writing in 1776, Smith noted that The Fable of the Bees. Adam Smith (p.61) who turned if one man set about making a pin, this division of labor into a going through the many steps AFTER central economic idea. At the very involved, he might make “perhaps 1867 Karl Marx argues that start of his influential book The not one pin in a day.” But by division of labor alienates Wealth of Nations, Smith explains dividing the process among several workers and is a necessary the differences between production men, with each specializing in a evil that will eventually be when one person carries out the full single step, many pins could be superseded. 1922 Austrian economist Ludwig von Mises argues that division of labor is not alienating but brings huge benefits, including greater leisure time.

See also: Comparative advantage 80–85 ■ Economies of scale 132 ■ THE AGE OF REASON 67 The emergence of modern economies 178–79 All-American jobs? What was groundbreaking about Smith’s idea was that he put When people working in division of labor at the heart of industry worry about the the economic system, insisting that strength of their home it is the engine that drives growth. economy and rates of The more specialized the workers employment, they sometimes and businesses, the greater the urge consumers to buy home- market growth and the higher produced goods. However, it the returns on investments. can be hard to know what is home-produced since division In a busy stockroom, labor may be A necessary evil of labor has now become divided between porters, inventory Karl Marx (p.105) saw the power global in scope. For example, clerks, a manager, accountants, of this idea but believed that the Apple is a US company, so distribution specialists, IT workers, division of labor was a temporary, consumers might suppose that and truck drivers. necessary evil. Specialization by buying an iPhone they are alienates, condemning workers contributing to US jobs. In fact, made in a day. Smith concluded to the dispiriting condition of a of all the processes involved in that the division of labor causes machine performing repetitive making an iPhone, only the “in every art, a proportionable tasks. He distinguished between product and software design increase of the productive powers the technical division of labor, and marketing occur primarily of labor.” such as each specialized task in in the US. house building, and social division, The engine of growth which is enforced by hierarchies Each iPhone is assembled Smith was not the first to of power and status. by workers in China, using appreciate the value of the division parts—such as the case, of labor. About 2,200 years earlier Labor division is the norm screen, and processor—made Plato had argued that a state needs within most companies today. by workers in South Korea, specialists, such as farmers and Many large corporations now Japan, Germany, and six builders, to supply its needs. The outsource tasks formerly carried other countries. In addition, Islamic philosopher Al-Ghazali out by their own staff to cheaper each of these parts has been (1058–1111) noted that if we take overseas workers, giving the assembled by a range of into account every step involved division of labor a new, specialists around the world. in making bread, from clearing the international dimension. ■ The iPhone is a truly global weeds in the fields to harvesting product, made by perhaps the wheat, we would find that the Every expansion of the tens of thousands of people. loaf takes its final form with the personal division of labor help of over a thousand workers. Assembly-line workers in brings advantages China build computer processors Many early thinkers linked to all who take part in it. with components made in up to division of labor to the growth of nine different countries. cities and markets. Some thought Ludwig von Mises that the division of labor caused the growth, while others proposed that the growing cities allowed the division of labor.

68 POPULATION GROWTH KEEPS US POOR DEMOGRAPHICS AND ECONOMICS IN CONTEXT D uring the 18th century output is added. The result is enlightened thinkers an ever-widening imbalance FOCUS began to consider the between the number of people Growth and development possibility of improving society’s lot and the supply of food. through wise social and economic KEY THINKER reforms. The British economist However, there is a Thomas Malthus (1766–1834) Thomas Malthus was a pessimistic counteracting force. Malthus voice in this optimistic era, saw that malnutrition and disease BEFORE claiming that the growth of caused by a more limited food 17th century Mercantilist populations dooms societies to supply would lead to increased thought argues that a large poverty. Malthus argued that the mortality and stop the imbalance populace benefits the economy. human sex drive causes faster and from getting out of control. Less faster expansion of the populace. food to go around would also mean 1785 French philosopher Food production would not keep up fewer children could be supported, Marquis de Condorcet because of the law of diminishing and the birth rate would fall. This argues for social reform returns: as more people work on a would lessen the pressure on land, to raise living standards. fixed amount of land, less and less restoring living standards. 1793 English philosopher Survivors of an earthquake in The Malthusian trap William Godwin advocates Pakistan receive food handouts. As well as preventing total the redistribution of national Malthus opposed any such relief— starvation, changes in birth and resources to help the poor. to assist the destitute would only death rates stop the population encourage them to have more children. from benefiting from higher living AFTER standards for very long. Suppose 1870s Karl Marx attacks that the economy has a windfall Malthus’s ideas, characterizing through the discovery of land. Extra him as a reactionary defender land gives a one-time boost to food of the status quo. production and provides more food per person. People become 1968 US ecologist Garrett healthier and the death rate falls. Hardin warns of the dangers of Higher living standards allow for overpopulation in his essay more children. Together, these The Tragedy of the Commons. forces add to population growth. Food production cannot keep up, and the economy reverts to the

THE AGE OF REASON 69 See also: Agriculture in the economy 39 ■ Diminishing returns 62 ■ The emergence of modern economies 178–79 ■ Economic growth theories 224–25 The human sex Growth in the drive causes the food supply is unable population to grow. to keep up. The population As there is not enough Thomas Malthus decreases, and the food for all, some people Thomas Robert Malthus was food supply is die from hunger. born in Surrey, England, in adequate again. 1766, and was given a liberal education by his father, a Population growth “Poor relief” (welfare country squire. His godfathers keeps us poor. benefits) would bring were the philosophers David health to the poor, but Hume and Jean-Jacques encourage them to have Rousseau. He was born with a cleft palate and suffered more children. from a speech defect. original, lower level of living allowed more food to be produced At Cambridge University standards. This is called the from the same amount of land and Malthus was tutored by a Malthusian trap: higher living labor. New machines and factories religious dissenter, William standards are always choked off allowed more goods to be produced Frend, before being ordained by population growth. So whatever per worker. Technological progress into the Church of England in happens, the economy always meant that growing populations 1788. Like his teacher he reverts to the level of food output enjoyed ever-higher living never shied away from that is just enough to support a standards. By 2000, Britain controversy. In 1798, he stable population. had more than three times the published his Essay on the population of Malthus’s time, Principle of Population, Malthus’s vision was one of with incomes 10 times higher. the work that would bring economic stagnation, with the him notoriety. In 1805, the population eking out a living and Over time, technology has new East India College its growth being checked by overcome the constraints of land appointed him Professor of hunger and disease. However, his and demographics. Malthus did Political Economy, a subject model—an economy of farmers not foresee this. Today, his ideas not yet taught at universities, toiling with simple tools on a fixed are echoed in fears that population which perhaps makes him the amount of land—was already out of levels are pushing against the first academic economist. step with the times by the turn of capacity of the Earth in ways that Malthus died of heart disease the 18th century. New techniques new technology cannot offset. ■ in 1834, aged 68. Key works 1798 An Essay on the Principle of Population 1815 The Nature of Rent 1820 Principles of Political Economy

70 IN CONTEXT MEETINGS OF FOCUS MERCHANTS END Markets and firms IN CONSPIRACIES TO RAISE PRICES KEY THINKER Adam Smith (1723–90) CARTELS AND COLLUSION BEFORE 1290s Wenceslas II, Duke of Bohemia, introduces laws to prevent metal ore traders from colluding to raise prices. 1590s Traders from the Netherlands collaborate in a cartel with a monopoly of the spice trade in the East Indies. AFTER 1838 French economist Augustin Cournot describes competition in oligopolies. 1864 US economist George Stigler publishes A Theory of Oligopoly, examining the problems of maintaining successful cartels. 1890 The first antitrust law is passed in the US. C ompetition is key to the efficient working of free markets. The presence of several producers in a market drives production and keeps prices down as each competes to attract customers. If there is only a single supplier—a monopoly—it can choose to restrict its output and charge higher prices. Between these two extremes sits the oligopoly, where a few suppliers—sometimes only two or three—dominate the market for a particular product. Competition between producers in an oligopoly would clearly be in the interests of the consumer, but there is an alternative for the producers that

THE AGE OF REASON 71 See also: Effects of limited competition 90–91 ■ Monopolies 92–97 ■ The competitive market 126–29 ■ Markets and social outcomes 210–13 ■ Game theory 234–41 Where a market has only … they may decide to a few suppliers… collude, forming a cartel. The market is Cartel members can British Airways was fined $546 transformed into a set prices high and million for collusion in 2011, after virtual monopoly and production low, and enjoy Virgin Atlantic admitted that the competition disappears. two companies had met six times increased profits. to discuss proposed price rises. Meetings of merchants despite being a notable feature of end in conspiracies the German and US economies to raise prices. in the 1920s and 1930s. may be more beneficial to their meet together, even for merriment In the 20th century the US and profit levels: cooperation. If they and diversion, but the conversation the European Union (EU) used choose this route and can agree ends in a conspiracy against the legislation to discourage collusion. not to undercut one another, they public, or in some contrivance to However, cartels among producers can act collectively like a monopoly raise prices.” remain a feature of market and dictate the terms of the market economies. Collaborations might be to their own benefit. Collaborations between a simple agreement between two producers have existed for as firms, such as when Unilever and Forming cartels long as there have been markets, Procter & Gamble colluded to fix This sort of cooperation between and businesses in many areas the price of laundry detergent in firms is known by economists of commerce have formed Europe in 2011, or they can take as “collusion.” The price fixing associations to their mutual benefit. the form of an international trade that results makes markets less In the US in the 19th century association, such as the efficient. Scottish economist Adam these restrictive or monopolistic International Air Transport Smith (p.61) recognized the practices were known as “trusts,” Association (IATA). The IATA’s importance of self-interest in free but the word “cartel” is now used original function was to set prices markets but was suspicious enough to describe such collaborations, for fares, which led to accusations of the motives of suppliers to warn: which operate on a national or of collusion, but it still exists as a “People of the same trade seldom international level. The word has representative organization for the gained a negative connotation airline industry. Cartels can even be formed through cooperation between governments of countries producing a particular commodity, as happened in the case of the Organization of Petroleum Exporting Countries (OPEC), ❯❯

72 CARTELS AND COLLUSION which was founded in 1960 to a version of the prisoner’s dilemma wealthy members see the chance coordinate oil prices among (p.238), in which two prisoners can of gaining some extra profit member countries. each choose either to remain silent and exceed their output quota, or confess. If both remain silent or introducing an element of Challenges for cartels both confess, they will receive light competitiveness and weakening However, there are problems in sentences; but if only one confesses, the power of the cartel as a whole. setting up and sustaining a cartel, he will receive immunity while his It only takes one cheat to undermine which focus around prices and trust partner in crime will get a heavy the operation of a cartel, and the between members. Participants in sentence. The best strategy for more members in the cartel, the a cartel cannot simply fix prices. each of them is to remain silent (this greater the danger of the rules They also have to agree on output incurs the shortest jail term), but the being broken. quotas to maintain those prices and, temptation is to opt for immunity of course, the share of the profits. and confess in the hope that the Enforcing agreements The fewer the members of a cartel, other does not. The strategies that Very often, one of a cartel’s the easier these negotiations are. apply here are equally applicable to members—the most powerful in Cartels are more robust when cartels, where the rewards for all the terms of production—emerges as there are a small number of firms players are greater if they collaborate an “enforcer.” When the efficacy of accounting for most of the supply. than if they compete but are OPEC becomes threatened, for greatest for any one player who instance, by a country such as The second problem is ensuring breaks the agreement, while the Angola overproducing to increase that members of a cartel abide by others suffer as a consequence. its profits, Saudi Arabia, the largest the rules. Producers are attracted to member of the cartel, can take collusion by the prospect of higher In practice, this is what tends to action to stop this. As the largest prices, but this self-interest is also happen within a cartel, particularly producer with the lowest production the weakness of the arrangement. when the quotas are unequally costs it can afford to increase Individual members of a cartel divided. The 12 members of OPEC, production and lower prices to a may be tempted to “cheat” by for example, meet regularly to agree level that will punish or may even overproducing and undercutting on output and prices, but these are bankrupt the smaller countries, their collaborators. In effect, this is seldom adhered to. The smaller, less while only lowering its own profits in the short term. However, in many Cartels can arrange price-fixing cases, the temptation to cheat and by operating as a virtual monopoly. If the reluctance of the enforcer to no one can offer the consumer a lower reduce its profits eventually lead price, the one price offered can be much to the break-up of cartels. higher than production costs, generating high profits for the cartel. We must not tolerate oppressive government or industrial oligarchy in the form of monopolies and cartels. Henry A Wallace US politician (1888–1965)

The difficulty in forming and Economists have their THE AGE OF REASON 73 maintaining cartels means that glories, but I do not these “conspiracies” are less believe that antitrust Antitrust laws common than Adam Smith law is one of them. might have expected. In the George Stigler Cartels, like monopolies, are 1960s US economist George Stigler generally seen as harmful to showed that the natural suspicion of into price-fixing of Atlantic flights, the efficiency of free markets competitors acts against collusion confessed its collusion with British and a threat to overall in a cartel, and that cartels are less Airways, who were heavily fined. economic well-being. Most likely to occur as more firms enter governments have attempted a market. As a result, even in Government approval to prevent this kind of collusion industries where there are only a few Some libertarian economists, such by legislation in the form of large producers, such as for video as Stigler, are skeptical of the need antitrust or competition laws. games consoles and mobile phones, for such laws, given the instability The first such intervention the preference is generally for of cartels. Governments are often was in the US in 1890, when competition rather than cooperation. ambiguous about cartels, seeing the Sherman Act outlawed some forms of cooperation as every contract or conspiracy Nevertheless, the few cartels potentially desirable. For example, that restrained interstate or that do exist pose enough of a while IATA’s price-setting policy foreign trade. This was threat to the market for governments was considered collusion, OPEC followed by further antitrust to feel the need to intervene. Public has sometimes been seen in a more laws including the Clayton Act pressure from consumers opposed benign light as a trade bloc whose in 1914, which prohibited local to price-fixing drove the move to policies lead to stability. The same price cutting to “freeze out” “antitrust” legislation (see right) argument has been put forward in competition. Economists have during the 20th century, outlawing defense of public cartels in certain tended to be skeptical about cartels in most countries. Because industries, such as oil or steel, in antitrust legislation, which is, of the difficulty of proving collusion, countries during times of depression. in any case, often difficult to many of these laws offer immunity When regulated by governments, enforce. They point out that to the first member of a cartel to cooperation between producers can cooperation does not always confess—just as in the prisoner’s stabilize production and prices, lead to collusive practices, dilemma—offering yet another protect the consumer and smaller such as price-fixing and incentive to break up the cartel. producers, and make the industry bid-rigging, and many believe This tactic was notably successful as a whole more competitive that much “trust-busting” recently, when Virgin Atlantic internationally. Public cartels such legislation has been motivated Airlines, worried by an investigation as these were common in both by political pressure rather Europe and the US during the than economic analysis. Mobile phone operators in the 1920s and 1930s, but mostly Netherlands were investigated for disappeared after World War II. This 1906 cover of a political paper suspected cartel practices in 2011, National cartels are still a feature lampoons US politician Nelson including price-fixing mobile data of the Japanese economy. ■ Aldrich for building a “web” of tariffs bundles for prepaid phones. to protect US goods from foreign competition and raise local prices.

74 SUPPLY CREATES ITS OWN DEMAND GLUTS IN MARKETS IN CONTEXT People produce commodities and sell them to earn money. FOCUS The macroeconomy Nobody wants to hold on … people swap money for the to money because it falls other products they want. KEY THINKER Jean-Baptiste Say in value, so… (1767–1832) Supply creates its BEFORE own demand. 1820 British economist Thomas Malthus argues that I n 1776, when Adam Smith Say claimed that as soon as a underemployment and wrote The Wealth of Nations product is made, it creates a market overproduction can occur. (pp.54–61), he noted that for other products “to the full extent merchants around him commonly of its own value.” This means, for AFTER felt there were two reasons why example, that the money a tailor 1936 John Maynard Keynes business failed: a scarcity of money receives when he makes and sells states that supply does not or overproduction. He debunked the a shirt is then used to buy bread create its own demand—it is first of these myths by explaining from the baker and beer from the possible for a lack of demand the role of money in an economy, brewer. Say believed that people to cause production to slow, but it was left to a later French had no desire to hoard money, creating unemployment. economist, Jean-Baptiste Say, to and therefore the total value of dismiss the second. His 1803 work, commodities supplied would equal 1950 Austrian economist A Treatise on Political Economy, the total value of goods demanded. Ludwig von Mises argues is devoted to explaining the The common expression of what is that Keynes’ denial is at the impossibility of overproduction. known as Say’s law has become basis of Keynesian fallacies about economics. 2010 Australian economist Steven Kates defends Say’s law and calls Keynesian economics a “conceptual disease.”

THE AGE OF REASON 75 See also: Free market economics 54–61 ■ Economic equilibrium 118–23 ■ Depressions and unemployment 154–61 “supply creates its own demand.” buying goods. They might, for Jean-Baptiste Say In fact, Say never used this phrase; instance, want to save some it was probably coined in 1921 by of their income. If these savings The son of a French Protestant the US economist Fred Taylor in were not borrowed by others (such textile merchant, Jean-Baptiste his Principles of Economics. as through a bank) and invested in Say was born in Lyons, France, the economy (as capital for running in 1767. At the age of 18 he The idea was important to Say a business, perhaps), the money moved to England, where he because if supply creates an equal would no longer be circulating. spent two years apprenticed to value of demand, there can never As people hold on to their money, a merchant before returning to be overproduction, or “gluts,” in demand for goods eventually Paris to work at an insurance the economy as a whole. Of course, becomes lower than the value company. He welcomed the firms could mistake the level of of the goods produced. This French Revolution of 1789, demand for a commodity and state of “negative demand” is both for its ending of the overproduce, but as the Austrian- known as “demand deficiency,” religious persecution of the born US economist Ludwig von and Keynes said it would lead protestant Hugenots, and for Mises (p.147) later said, “the to pervasive unemployment. its removal of an essentially bungling entrepreneur” would feudal economy, opening up soon be driven from that market Given the dire state of the more prospects for commerce. by losses, and the unemployed world economy during the Great resources would be reallocated Depression of the early 1930s, In 1794, Say became editor to more profitable areas of the Keynes’s argument seemed a of a political magazine in which economy. In fact, it is impossible powerful one, especially when he promoted the ideas of Adam to overproduce overall, because contrasted with a world based Smith. In 1799, he was invited human wants are far greater than on Say’s law, which said that to join the French government, our ability to produce commodities. unemployment would only occur in but Napoleon rejected some of some industries for a short time. ■ his views, and Say’s work was Say’s law has become a forum censored until 1814. During for conflict between the classical this time he made a fortune by and the Keynesian economists. The setting up a cotton factory. In former, such as Say, believe that his later years he lectured on production, or the supply side of economics in Paris. He died the economy, is the most important after a series of strokes in factor in growing an economy. 1832, aged 66. Keynesians argue that growth comes only with increased demand. Key works Why keep money? Say believed that supply and demand 1803 A Treatise on Political In his 1936 masterpiece The operate through a type of barter. We Economy General Theory of Employment, swap the money we earn for goods we 1815 England and the English John Maynard Keynes (p.161) want. In this image meat is bartered 1828 Complete Course of attacked Say’s law, focusing on the for vegetables in an Incan marketplace. Practical Political Economy role of money within the economy. Say had suggested that all money earned is spent on purchasing other commodities. In other words the economy works as if it were based on a system of barter. Keynes, however, suggested that people might sometimes hold money for reasons other than for

76 BORROW NOW, TAX LATER BORROWING AND DEBT IN CONTEXT Should government spending be financed by borrowing FOCUS Economic policy or taxation? KEY THINKER If the government If the government David Ricardo (1772–1823) borrows now… increases tax now… BEFORE … people will know that … people will have to 1799 Britain introduces they will pay more tax later pay more tax. income tax during war with revolutionary France. Public to repay the debt. debt approaches 250 percent of national income. It makes no difference whether the government chooses to tax now AFTER 1945 Following World War II, or “borrow now, tax later.” government spending, taxation, and borrowing rise in S hould government spending Political Economy and Taxation, developed economies to meet be financed by borrowing or Ricardo argued that the method new welfare commitments. taxation? This question was of financing should make no first addressed in detail by British difference. Taxpayers ought to 1974 US economist Robert economist David Ricardo during realize that government borrowing Barro revives the idea of Britain’s expensive Napoleonic today will lead to more taxation in Ricardian equivalence, which wars against France (1803–15). the future. In either case they will says that people spend in In his 1817 book Principles of be taxed, so they should set aside the same way regardless of whether their government taxes or borrows. 2011 The European debt crisis intensifies, sparking debate about the limits of taxation and public borrowing.

THE AGE OF REASON 77 See also: Economic man 52–53 ■ The tax burden 64–65 ■ The Keynesian multiplier 164–65 ■ Monetarist policy 196–201 ■ Saving to spend 204–05 ■ Rational expectations 244–47 savings that are equivalent to the One assumption is that people are economists to argue against amount they would have been rational decision makers and have Keynesian policies—government taxed today in order to meet that perfect foresight; they know that spending to increase demand and eventuality. Ricardo suggested that spending now means taxes later. drive growth. They claim that if people understand a government’s However, this is unlikely to be the people know that a government is budget constraints and continue to case. Borrowing and lending must spending money to lift an economy spend in the same way regardless of also take place at identical interest out of depression, their rational its decision to tax or borrow because rates without transaction costs. expectations will ensure they they know these will ultimately cost anticipate greater taxes in the them the same. This idea became A further problem is that human future so they will not blindly known as Ricardian equivalence. life is finite. If people are self- respond to the increased amount interested, they are unlikely to care of money in the system now. Imagine a family with a about taxes that will be imposed However, the practical evidence— gambling father who resorts to after they die. Barro suggested, for or against—is inconclusive. ■ taking money from his sons. The however, that parents care about father tells his sons that he will let their children and often leave them keep their money this month bequests, partly so that their because he has borrowed from his children can pay any tax liabilities friend Alex. The happy-go-lucky that arise after the parents’ deaths. younger son, Tom, spends his extra In this way individuals factor into cash. The wise older son, James, their decision making the impact realizes that next month, Alex’s loan of taxes that they expect to be will have to be repaid with interest, imposed even after they die. at which point his father will probably ask him for money. James Government spending The Greek state was forced to borrow hides away today’s extra cash, Ricardian equivalence, which large sums in 2011 to avoid bankruptcy. knowing he will have to give it to is sometimes known as debt The civil unrest that followed made it his father in a month. James has neutrality, is a hot topic today clear that there are limits to how much recognized that his overall wealth because of the high spending, a government can borrow and tax. hasn’t changed so he has no borrowing, and taxation of modern reason to alter his spending today. governments. Ricardo’s insight has been used by new classical Ricardo was theorizing, and did not suggest that Ricardian New classical macroeconomics equivalence would ever be apparent in the real world. He believed that US economists Robert Barro, through the mutual adjustment ordinary citizens suffer from the Robert Lucas, and Thomas of supply (number of people same fiscal illusion as Tom in our Sargent formed the school of seeking work) and demand example, and will spend the money new classical macroeconomics (number of people needed). on hand. However, some modern in the early 1970s. Its key Under this view everyone who economists argue that citizens tenets are the assumption wants to work can, if they accept suffer no such illusions. of rational expectations the “going wage.” Therefore, (pp.244–47) and market all unemployment is voluntary. The modern debate clearing—the idea that prices Rational expectations claims The idea reemerged in an article by will spontaneously adjust to that people look to the future as US economist Robert Barro (1944– ) a new position of equilibrium. well as the past when making in 1974, and modern analysis has New classical theorists claim decisions so they cannot be focused on examining the conditions that this applies in the labor fooled by a government when under which people spend market: wage levels are set it chooses to borrow or tax. regardless of taxation or borrowing.

78 THE ECONOMY IS A YO-YO BOOM AND BUST IN CONTEXT B usiness cycles are the shift the occurrence of periodic between strong economic economic crises, but it was the FOCUS growth, described as a work of a later economist, the The macroeconomy boom or expansion period, and Frenchman Charles Dunoyer periods of economic decline or (1786–1862), who revealed their KEY THINKER stagnation. They are often referred cyclical form. Sismondi challenged Jean-Charles Sismondi to as cycles of boom and bust. The the “market knows best” orthodoxy (1773–1842) Swiss historian Jean-Charles of Adam Smith (p.61), Jean-Baptiste Sismondi was the first to identify Say (p.75), and David Ricardo (p.84). BEFORE 1776 Adam Smith argues that In boom times This leads to natural market forces create companies have excess supply. an economic equilibrium. high profits. They increase production 1803 Jean-Baptiste Say claims to satisfy demand that the market will balance supply and demand naturally. for goods. 1817 Welsh social reformer Eventually The Companies Robert Owen identifies lower prices lead economy is cut prices to overproduction and compete for underconsumption as causes to an increase a yo-yo. customers… of economic downturns. in demand and … leading to AFTER profits go lower profits, 1820s French economist back up. lay-offs, and Charles Dunoyer identifies the economic cyclical nature of the economy. depression. 1936 John Maynard Keynes urges governments to spend in order to avoid economic fluctuations.

THE AGE OF REASON 79 See also: Free market economics 54–61 ■ The Keynesian multiplier 164–65 ■ Financial crises 296–301 ■ Housing and the economic cycle 330–31 Skyscrapers are often built during overlooked short-term economic recover once prices become cheap times of excessive optimism, a sure booms and busts or had attributed enough to stimulate demand and sign that the economy is overheating. them to external events, such as credit becomes more available, By the time they are finished, the war. Sismondi showed that short- starting the cycle all over again. economy has often crashed. term economic movements are due to the natural results of market An early crisis that confirmed They believed that if the market forces—overproduction and these economic cycles was the Panic is left to its own devices, an underconsumption—caused by of 1825. This stock-market crash was economic equilibrium is quickly growing inequality during booms. one of the first documented crises and easily achieved, leading to full caused solely by internal economic employment. Sismondi thought a Fueling the boom events. It was precipitated by sort of equilibrium would eventually As economies grow and businesses speculative investments in Poyais be reached, but only after a do well, workers are able to demand —a fictional country invented by a “frightful amount of suffering.” wage increases and buy more of the con man to attract investments— goods they produce. This fuels the and the repercussions were felt in Before Sismondi published his economy’s boom. As more and markets across the world. New Principles of Political Economy more goods are sold, companies in 1819, economists had either expand, hiring more workers to Sismondi argued against the produce more goods. The new laissez-faire approach of Adam workers then have money to buy Smith and claimed that government goods, and the boom continues. intervention is necessary to regulate the progress of wealth and Competition means that all avoid these periodic crises. companies will increase production until supply outstrips demand, The discovery of these cycles Sismondi argued. This forces enabled economists to analyze the companies to cut prices in order to economy in a new way and to attract customers, triggering falling devise strategies for trying to avoid profits, falling wages, and lay-offs crashes and recessions. Keynes among the workforce—in other built on Sismondi’s and Dunoyer’s words an economic crash followed work to develop his own theories, by a recession. Companies begin to which were to make up one of the world’s dominant economic approaches in the 20th century. ■ Bull and bear markets more optimistic about Universal competition, economic prospects and or the effort to always As whole economies grow and buy shares in companies, so produce more, and always contract, markets within them fuelling rising asset values. at a lower price… has been rise and fall. Markets that As the economy falters, the a dangerous system. show sustained price rises process goes into reverse. Jean-Charles Sismondi are sometimes known as bull Investors become “bearish” markets; those in which prices and start to sell assets as the are falling as bear markets. market falls. US stocks were These labels are usually in a bull market in the 1990s applied to assets such as with the dot-com boom. A shares, bonds, or houses. Bull major bear market took place markets—for example, a rising during the Great Depression stock market—often occur of the 1930s. during periods of economic growth. Investors become

TRADE IS BENEFICIAL FOR ALL COMPARATIVE ADVANTAGE



82 COMPARATIVE ADVANTAGE IN CONTEXT Making a product entails Even if Country A costs. One of these costs can do everything better FOCUS than Country B, it will profit Global economy is time. most by focusing on the things it does best. It is KEY THINKER Both countries benefit too costly to sacrifice time David Ricardo (1772–1823) from a comparative on something it does BEFORE advantage, which makes the less well. 433 BCE The Athenians impose most efficient use of their trade sanctions on the time and resources. This allows Country B, Megarians in one of the first which is good (but not recorded trade wars. Overall, more goods are the world’s best) at making produced, giving consumers the products Country A 1549 John Hales, an English does not make, a chance politician, expresses the a wider range of products to make them without widely held view that free at lower prices. undue competition. trade is bad for the country. Trade is AFTER beneficial for all. 1965 US economist Mancur Olson shows that governments respond more to the appeal of a concentrated group than one that is more dispersed. 1967 Swedish economists Bertil Ohlin and Eli Heckscher develop Ricardo’s trade theory to examine how a comparative advantage might change over time. T he ideas of the renowned Elizabethan times. Ricardo thought to growing crops. However, as the 18th-century British that in the long run such protectionist war temporarily came to an end in economist David Ricardo policies were more likely to restrict 1802, the price threatened to fall were clearly shaped by the world he the ability of the country to increase back so the landowners—who also inhabited and by his personal life. its wealth. controlled Parliament—passed He lived in London, England, at a Corn Laws to restrict the importation time when mercantilism (pp.34–35) Early trade protection of foreign wheat and place a “floor,” was the dominant economic view. Ricardo was particularly concerned a bottom price, on grain. When the This held that international trade by the introduction of a British tax wars ended in 1813, the Corn Laws should be heavily restricted. As a known as the Corn Laws. During were used to raise the floor price result governments introduced the Napoleonic Wars (1803–15) it again. The laws protected farmers policies that aimed to increase was not possible to import wheat but also pushed the price of bread exports and decrease imports in from Europe so the price of wheat beyond what poorer people could an attempt to enrich the nation in Britain had risen. As a result pay at a time when newly returned through an inflow of gold. In many landowners increased the soldiers and sailors were unable England the policy dated back to proportion of their lands dedicated to find work.

THE AGE OF REASON 83 See also: Protectionism and trade 34–35 ■ Market integration 226–31 ■ Dependency theory 242–43 ■ Exchange rates and currencies 250–55 ■ Asian Tiger economies 282–87 ■ Trade and geography 312 50% 20% countries would benefit from specializing and trading when one If Worker A is Worker B is not party had an absolute advantage in 20 percent better better than Worker both goods. Would it be worth at making hats A at anything, but trading if one country could produce but 50 percent he is better at both more wine and more wool per better at making making hats than worker than the other country? shoes, he should shoes. If he makes focus on shoes. hats, he will have Another way of looking at this is That is the most a competitive to consider whether a person who is profitable way advantage and can better at making both hats and to use his time. trade with Worker shoes than someone else should split A for shoes. his time between the two jobs or Ricardo vigorously opposed the choose one job and then trade with Corn Laws, despite being a wealthy of resources than a competitor is the less-skilled worker, who makes landowner himself. He claimed that said to have an “absolute advantage.” the other product (see diagram, left). the laws would make Britain poorer, Smith said that both Britain and Suppose that the superior worker and developed a theory that has Portugal would profit most by is 20 percent better at making hats, become the mainstay for all those specializing in what they did best but 50 percent better at making wishing to justify free trade and trading the surplus. Ricardo’s shoes—it will be in the interest of between countries. contribution was to extend Smith’s both of them if he works exclusively argument to examine whether at making shoes (the product he really excels in), and the inferior man works in making hats (the product he is least bad at making). The logic behind this argument has to do with the relative costs of making a product in terms of the amount of production time taken or lost. Because the superior worker is so good at making shoes, the cost of his making hats is high—he would ❯❯ Comparative advantage Adam Smith (p.61) had pointed out that the climate differences between Portugal and Britain meant they would benefit from trade. A worker in Portugal could produce more wine than a worker in Britain, who in turn could produce more wool than a worker in Portugal. Any person or state able to produce more per unit In 1819, a crowd of 80,000 gathered in Manchester, England, to protest against the Corn Laws, which kept the price of wheat high by limiting imports. The protest was brutally suppressed.

84 COMPARATIVE ADVANTAGE The increased importation of tires from China (left) led the US to impose trade restrictions in 2009. This, in turn, led to a full-blown trade battle and a deterioration in diplomatic relations. have to forfeit a lot of valuable shoe advantage, more goods are produced that it comes from countries’ relative production. Although in absolute in total, and trade delivers more and abundance of capital and labor. terms the inferior worker is worse cheaper goods to both nations. Capital-rich countries will have a at making shoes and hats than the comparative advantage in capital- superior worker, his relative cost Comparative advantage resolves intensive products such as machines. when making hats is lower than for a paradox highlighted by Adam Labor-rich countries will have a the superior worker. This is because Smith—that countries that are comparative advantage in labor- he forfeits less shoe production per inferior at producing goods (they intensive products such as farming hat than the superior worker would. are said to have an “absolute goods. The result is that countries The inferior worker is therefore said disadvantage” in them) can tend to export goods that use their to have a “comparative advantage” nonetheless export them profitably. abundant factor of production; in hats, while the superior worker has capital-abundant nations such as a comparative advantage in shoes. 20th-century advantage the US are most likely, therefore, When countries specialize in goods What determines comparative to export manufactured goods. for which they have a comparative advantage? Swedish economists Eli Heckscher and Ohlin’s analysis led Heckscher and Bertil Ohlin argued to another prediction. Not only would trade tend to reduce the differences in prices of goods in different countries, it would also reduce wage differences: the specialization in labor-intensive sectors by labor-abundant economies would tend to push up wage rates, while an effect in the other direction would be seen in the capital-abundant country. So despite the overall increase in the David Ricardo Considered one of the world’s economists of his day, including greatest economic theorists, David Thomas Malthus (p.69) and John Ricardo was born in 1772. His Stuart Mill (p.95). He retired parents moved to England from from the stock exchange in 1819, Holland, and at the age of 14 and became a member of Ricardo began working for his Parliament. He died suddenly of father, a stockbroker. Aged 21, an ear infection in 1823, leaving Ricardo eloped with a Quaker, an estate worth more than $120 Priscilla Wilkinson. Religious million in real terms today. differences between the families resulted in both sides abandoning Key works the couple, so Ricardo started his own stockbroking firm. He made a 1810 The High Price of Bullion fortune betting on a French defeat 1814 Essay on the Influence of at Waterloo (1815) by buying a Low Price of Corn English government bonds. 1817 On the Principles of Ricardo mixed with notable Political Economy and Taxation

THE AGE OF REASON 85 The diminution of money damaged US export industries. Other economists have questioned in one country, and its The jobs of some US tire workers whether trade always helps increase in another, do may have been saved, but in the developing countries. The US not operate on the price wider economy many more jobs economist Joseph Stiglitz (p.338) of one commodity only, were lost. argues that developing countries but on the prices of all. often suffer from market failures and David Ricardo Protectionism today institutional weaknesses that might The US economist Mancur Olson make a too rapid liberalization of short run, ultimately there may has helped to explain why politicians trade costly for them. be losers as well as winners, and continue to impose policies that are consequently opposition to the likely to damage the overall economy, There are also contradictions opening up of trade. even though the costs are widely between theory and practice. When known. He points out that those the government of India removed The cries for protectionism against the tariffs—a small number tariffs on imports of cheap palm oil are as loud today as they were in of large domestic producers and from Indonesia, for instance, it had Ricardo’s time. In 2009, China their workers—suffer a visible the positive effect of raising the accused the US of “rampant impact from cheap imports. living standards of hundreds of protectionism” for imposing heavy However, the potentially larger millions of Indians, in line with taxes on imported Chinese car number of consumers who have to Ricardo’s theory, but it destroyed tires. The decision to increase pay higher prices because of tariffs the livelihoods of 1,000,000 farmers tariffs came after pressure from US and those workers in affiliated who grew peanuts for oil, which was workers, who had seen tire imports industries who might lose their jobs now passed over for palm oil. In a grow from 14 to 46 million from through connected impacts are perfect Ricardian world the peanut 2004–08, reducing US tire output, dispersed around the economy. farmers would simply transfer into causing factory closures, and the production of other goods, but creating unemployment. However, Contemporary trade in practice they can’t because their the US had previously accused Today, most economists support investment in capital is immobile— China of unfairly subsidizing its the basic Ricardian position on a machine that processes peanuts own tire industry, so tensions trade and, in particular, believe that has no other use. mounted. China’s response was it helped today’s industrialized to threaten retaliatory increases in countries. US economists David Ricardo’s critics argue that in import taxes on US cars and poultry. Dollar and Aart Kraay have argued the long run these kinds of impacts Tariffs produce effects that ripple that over the last few decades trade might hamper the industrialization through economies. Any protection has helped developing countries to and diversification of poorer gained for US tire producers from grow and reduce poverty. They countries. Moreover, although rich the tariffs on tires, for example, was claim that the countries that cut industrialized countries became counteracted by other negative their tariffs have grown faster and successful traders, they did not impacts. Higher tire prices increased have seen less poverty. practice free trade when they the costs of US cars, making them were first developing. How less competitive and reducing the countries build up comparative numbers bought by US consumers. advantage over the long run may The retaliation by China also be more complex than Ricardo’s model suggests. Some argue that Europe and then later the Asian Tigers (pp.282–87) built it up through trade protection in which skills were developed before trade opened up. ■ Goods made in Asia are transported to Western countries in vast container ships. It is estimated that 75 percent of goods in a typical US shopping cart are exported to the US from Asia.

INDUSTR AND ECO REVOLUT 1820–1929

IAL NOMIC IONS

88 INTRODUCTION Antoine Cournot John Stuart Mill Karl Marx publishes Carl Menger establishes introduces the roles of advocates both trade the first volume of the Austrian School, function and probability Capital; subsequent to economics and is the and social justice, which defends free first to express demand laying the foundation volumes are published market economics and supply as a graph. for liberal economics. posthumously against the ideas by Friedrich Engels. of socialism. 1838 1848 1867 1871 1841 1848 1871 1874 The phenomenon of Karl Marx and William Jevons Léon Walras economic bubbles is Friedrich Engels describes the marginal sets out the basis described in Charles utility theory of value, Mackay’s Extraordinary publish the of the general Popular Delusions and the Communist which sees value as equilibrium theory, Manifesto. coming from a product’s Madness of Crowds. claiming that free value to its buyer. markets are stable. B y the early 19th century in the number of firms producing Smith had assumed that men the effects of the Industrial goods, many of which were offering behaved rationally in an economy, Revolution were spreading shares of their business for sale in but this also came into question as from Britain to Europe and across the stock markets. These provided investors rushed to buy shares in North America, transforming the competitive market that was companies whose worth had been agricultural nations into industrial the focus of the “classical” view of exaggerated. This caused bubbles, economies. The change had been economics, in which the operations contradicting the idea of a stable rapid and dramatic, bringing about of the market are central. However, economy based on reasoned a fundamental shift in the structure as market economies developed behavior. Despite this, some of economies. The focus had and grew, new problems began economists, such as Léon Walras shifted from the merchants who to emerge. For example, as Adam (p.120) and Vilfredo Pareto (p.131), traded in goods to the producers, Smith (p.61) had warned in 1776, argued that the market economy the owners of capital. As well as there was a danger that large would always tend toward a new way of thinking about producers would dominate the equilibrium, which would in turn the economy, capitalism also market and operate either as determine the levels of production brought with it new social monopolies or as cartels, fixing and prices. Their contemporary and political issues. prices at a high level and keeping Alfred Marshall (p.110) explained production low. Although regulation supply and demand and how these Distorting the market could prevent such practices, in and prices interact in a system Most noticeable of the social instances where only a few of perfect competition. changes was the emergence of a producers operated, they could new “ruling class” of industrialist easily develop strategies to distort The question of price was one producers, and a steady growth the competitiveness of the market. that concerned many economists at the time because it affected both

INDUSTRIAL AND ECONOMIC REVOLUTIONS 89 Robert Giffen Social campaigners Vilfredo Pareto formulates Arthur Pigou Joseph Schumpeter introduces the Beatrice and Pareto efficiency, argues that describes the vital concept of Giffen Sidney Webb a state in which no companies should goods, for which publish their be taxed for role of the entrepreneur consumption individual can become the pollution as an innovator rises with price. landmark History better off without making they make. who moves of Trade Unionism. industry forward. another worse off. 1870S 1894 1906 1920 1927 1890 1899 1914 1922 Alfred Marshall In The Theory of the Friedrich von Ludwig von Mises publishes his Principles Leisure Class, Thorstein Wieser describes criticizes communist of Economics, bringing opportunity cost, planned economies in Veblen describes the which measures the new mathematical conspicuous value of choices that Socialism: An approaches consumption have been rejected. Economic and to economics. of the rich. Sociological Analysis. producers and consumers in the for capitalist employers. Looking prosperity—although tempered new capitalist society. Taking their at value in this light, Karl Marx to some extent with measures to lead from the moral philosophers argued that the inequalities of a compensate for its injustices. of the previous generation, they market economy amounted to an Following a mathematical approach began to see the value of goods exploitation of the working class to economics that focused on in terms of their utility (the by the owners of capital. In the supply and demand, and as a satisfaction they would give), Communist Manifesto and his reaction against the ideas of rather than the labor that added analysis of capitalism Capital, socialism, an Austrian School value to raw materials. The idea Marx argued for a proletarian of economic thought emerged, of marginal utility—the gain revolution to replace capitalism stressing the creative power of brought about by the consumption with what he saw as the next the capitalist system. of a particular product—was stage in economic development: explained in mathematical terms a socialist state in which the The free market economy was by William Jevons (p.115). means of production are owned soon to receive some hard knocks by the workers, and an eventual after the Wall Street Crash of Marx’s theory of value abolition of private property. 1929. However, the theories The theory that the value of a of neoclassical economists, and product is determined by the labor Although Marx’s ideas were the Austrian School in particular, involved in producing it still had subsequently adopted in many later resurfaced as the model some adherents, particularly as parts of the world, market for economies in the Western it concerned not the producers economies continued to operate world in the late 20th century or consumers so much as the elsewhere. Generally, economists and even came to replace workforce producing the goods continued to defend capitalism most of the world’s communist as the best means of ensuring planned economies. ■

90 HOW MUCH SHOULD I PRODUCE, GIVEN THE COMPETITION? EFFECTS OF LIMITED COMPETITION IN CONTEXT B y the second half of the high. French economist Antoine 17th century economists Cournot wanted to find out what FOCUS had begun to observe the happened when there were only a Markets and firms effects in markets of monopolies few firms selling similar products. and of fierce competition. They KEY THINKERS found that monopolies tended to Dueling duopolies Antoine Augustin Cournot restrict output to keep prices and Cournot created his model based (1801–77) profits high. Where there was on a duopoly of two firms selling Joseph Bertrand (1822–1900) plenty of competition, prices were identical spring water to consumers. driven down to the level of costs, The two firms are not allowed to BEFORE profits were low, and output was form a cartel by working together, 1668 German scientist Johann Becher discusses the impact If there are just two … each firm knows that the of competition and monopoly competing firms (a duopoly) other firm’s output will in his Political Discourse. producing identical goods… affect their own profits. 1778 Adam Smith describes Each firm reacts by how perfect competition selecting its best output maximizes social welfare. given the level of output the other firm chooses (plotted AFTER 1883 French mathematician on a reaction curve). Joseph Bertrand changes the strategic choices in Cournot’s The market will be in a This is how much the model from quantity to price. Cournot equilibrium firm should produce, where the two reaction given the competition. 1951 US economist John Nash publishes the general curves meet. definition of equilibrium for game theory, using Cournot’s duopoly as his first example.

INDUSTRIAL AND ECONOMIC REVOLUTIONS 91 See also: Cartels and collusion 70–73 ■ Monopolies 92–97 ■ The competitive market 126–29 ■ Game theory 234–41 no other firms can enter the industry Cournot’s model uses (because there are no other natural springs), and each firm has to If Firm A thinks Firm B will two reaction curves to decide, simultaneously, how many 30 produce 30, Firm A will illustrate the output bottles of water to supply. produce zero (to avoid losses) decisions of two firms, The total output of the industry is the sum of the two firms’ output where each firm is aware decisions. Each firm must choose the output that maximizes its profit 25 of the other’s existence based on what it thinks the other but does not know how firm’s output will be. If Firm A thinks that Firm B will produce Firm A much the other intends nothing, Firm A will select the low 20 to produce. output of a monopolist to maximize profits. On the other hand if Firm A FIRM B’S OUTPUT 15 thinks that Firm B will produce a Cournot equilibrium high output, Firm A may choose to (the perfect production point) produce nothing—because prices would fall too far to make production 10 If Firm A thinks Firm B will worthwhile. Cournot represented produce zero, Firm A will produce 15 the decisions of both firms on a (to make a monopoly level of profit) “reaction curve.” The equilibrium of the market is where the two 5 reaction curves intersect. At this point each firm is selling the most Firm B profitable amount given what the other firm is doing. This notion of 0 equilibrium became known as the 0 5 10 15 20 25 30 Nash equilibrium, and it is a central plank of game theory, the FIRM A’S OUTPUT branch of modern economics that analyzes strategic interaction model was developed by French competition. This is because any between firms and individuals. economist Joseph Bertrand, who firm that sets a high price will be showed that if firms choose by their undercut by another, who will then Cournot used mathematics to desired price levels rather than steal all its buyers. In this way the find this equilibrium and prove that output, the equilibrium for price will be driven to the most the duopolists would choose an duopolists equals that of perfect competitive level. ■ output that was higher than would occur in monopoly, but lower than Antoine Cournot works that pioneered the use with perfect competition. In other of mathematics in economics, words a few firms would be better An insatiable reader, Antoine before going blind. His work was for society than a monopolist, but Augustin Cournot was born in not well received in his lifetime worse than perfect competition. France in 1801. Although because of its reliance on novel relatively poor, he studied mathematical notation. Today he From this starting point, Cournot mathematics at one of the best is regarded as a profound thinker extended the model to show how, schools in the country and who advanced prophetic ideas. if the number of firms increases, completed a PhD in engineering. the industry output reassuringly After spending some time as a Key works moves closer to the level expected private tutor and as a secretary for perfect competition. Cournot’s for one of Napoleon’s generals, 1838 Researches into the he became a university lecturer Mathematical Principles of the and then professor. Cournot was Theory of Wealth plagued by eye problems but 1863 Principles of the Theory managed to publish several of Wealth

PHONE CALLS COST MORE WITHOUT COMPETITION MONOPOLIES



94 MONOPOLIES A monopoly is a situation be rich if they wanted. For where one firm has control economists the story warns of IN CONTEXT of a particular market, the potential power of monopoly. such as the cell phone market. The FOCUS firm may be the only supplier Market power Markets and firms of a product or service, or it may In 1848, the English political have a dominating market share. scientist John Stuart Mill published KEY THINKER In many countries a firm is said to his Principles of Political Economy. John Stuart Mill (1806–73) have a monopoly if it controls more It drew together much of the than 25 percent of a market. thinking about whether a lack of BEFORE competition caused prices to rise. c.330 BCE Aristotle’s Politics The suggestion that monopolies The general view was that some describes the impact of can cause the price of goods to be industries were likely to tend a monopoly. higher than they would be if many toward a lack of competition. companies were supplying them has This trend was created either 1778 Adam Smith warns of existed for millennia. It dates back through artificial means, such the dangers of monopolies in at least as far as Aristotle (384– as the introduction of a tax by The Wealth of Nations. 322 BCE), who warned about the governments on imported goods, problem in a story about the Greek or through natural means, as a 1838 French economist philosopher Thales of Miletus. The consequence of firms growing ever Antoine Cournot analyzes the public taunted Thales for practicing larger. Large firms had begun to impact on price of a reduction philosophy, which they said was a dominate the market because late in the number of firms. useless profession that made no 19th-century industry required money. To prove them wrong, Thales ever-increasing amounts of capital. AFTER bought up all the local olive presses The firms that could grow by 1890 Alfred Marshall develops in the winter when they were cheap, capturing enough of the market to a model of monopoly. and then—using his monopoly finance the necessary investment, power—sold them at very high had the ability to use their market 1982 US economist William prices in the summer when the power to drive their smaller Baumol publishes Contestable presses were needed. In doing so he competitors out of business and Markets and the Theory of made himself rich. For Thales the to charge higher prices. Industry Structure, redefining moral was that philosophers could the nature of competition. Competition between … and drives But monopolies, like producers increases down prices. some telephone companies, output… have no competition. Phone calls cost They can produce less more without and charge higher prices. competition.

INDUSTRIAL AND ECONOMIC REVOLUTIONS 95 See also: Cartels and collusion 70–73 ■ The competitive market 126–29 ■ Economies of scale 132 ■ Creative destruction 148–49 During the Industrial Revolution coal, the labor market too. He pointed John Stuart Mill railways, and water supply all showed to the case of goldsmiths, who a tendency toward concentrated earned much higher wages than Born in London in 1806, ownership. In mining the ownership workers of a similar skill because John Stuart Mill grew up in of the land was concentrated in just they were perceived to be a wealthy family that was to a few hands. In the case of railways trustworthy—a characteristic that become a great intellectual and water supply there was no is rare and not easily provable. This dynasty. His father was an alternative to a limited number of created a significant barrier to entry overdemanding parent, who firms offering services because the so that those working with gold educated Mill at home on a scale of the infrastructure required could demand a monopoly price for difficult and accelerated was so great that if there were any their services. Mill realized that the program that included Greek more than a few firms, no one would goldsmiths’ situation was not an from the age of three. The aim be able to cover their costs. Like isolated case. He noted that large was for Mill to carry on and Adam Smith (p.61) before him, Mill sections of the working classes develop his father’s work on believed that these features of were barred from entering skilled philosophy. The pressure of markets did not inevitably lead to professions because they entailed his upbringing was at least monopoly. The most likely outcome many years of education and partly responsible for the was collusion between firms, training. The cost of supporting mental health problems Mill allowing them to fix high prices. someone through this process was suffered in his early 20s. Such arrangements would lead to out of reach for most families, so high costs for consumers in the those who could afford it were able One of the great minds of same way as monopolies. to enjoy wages far above what ❯❯ the day, he was willing to speak out in defense of Monopoly workers The railways were an example of a difficult and unpopular causes Mill realized that it is not only monopoly industry at the time Mill was such as the French Revolution within the goods market that a lack writing. New lines were expensive and and women’s rights. He was of competition is able to push prices impractical on routes that were already also an eloquent opponent of up. Monopoly effects can emerge in serviced by existing companies. slavery. A 20-year affair with Harriet Taylor, whom he credited with inspiring much of his written work, caused scandal in his own private life. He died in 1873, aged 66. Key works 1848 Principles of Political Economy 1861 Utilitarianism 1869 The Subjection of Women

96 MONOPOLIES Monopoly The lower the price of a good, the greater willingness to pay will equal the the demand for it. In a theoretical state of perfect price, and no more apples can competition between firms, a good will sell at the be sold. The welfare loss of price it costs to produce. This is the highest demand monopoly comes from the fact that and lowest price possible. In a monopoly, the price is fewer apples are sold compared set at a higher level and demand is reduced. to the amount that would have been sold in perfectly competitive Supply in markets. Essentially, this means monopoly that there are apples that could be supplied to the market, that would Supply in perfect generate consumer surplus, but competition they never appear on the market. PRICE Demand will always Perfect be higher Advantages of monopoly competition at lower Monopolies also create more prices complex price and welfare effects. 0 Marshall suggested that a 0 QUANTITY Perfect competition monopolist might actually cut its Monopoly prices to attract customers to His consumer surplus from the its phone network, for example, might be expected. Similarly, purchase of the apple is 30 cents. since people will likely keep using some historians have viewed the In a market with many firms, they the service once it is connected, guilds of the medieval era as an compete on price and together even though rival technologies such example of privileged craftsmen supply an amount of apples that as cell phones offer alternatives that attempting to shut out competition generates a certain amount of are at least as good. from other workers. overall consumer surplus. For an apple sold to the last consumer his Some economists have pointed From the late 1890s British out that monopolies can have economist Alfred Marshall (p.110) Monopolists, by keeping benign effects. In many markets rigorously analyzed the effects of the market constantly a monopoly would have lower costs monopolies on prices and on than the total costs of a set of consumers’ welfare. Marshall was understocked… sell their smaller firms because a monopolist interested in determining whether commodities much above would spend less on advertising the higher price and lower output and make full use of economies that result from monopolies cause the natural price. of scale. For these reasons a a loss in total welfare for society. Adam Smith monopolist may enjoy higher In his Principles of Economics, profits even when its price is lower Marshall formulated the concept than would be the case if many of consumer surplus. This is the firms—with higher costs—were difference between the maximum competing. In this case the lower amount that a consumer would be prices might help consumers and willing to pay for a good and the help to drive economic growth. amount he actually pays. Suppose the consumer buys an apple for In a similar fashion large firms 20 cents when he would have can attempt to gain monopoly been willing to pay 50 cents. profits, driving out rivals by aggressively cutting prices in the short run. Economists call this predatory pricing. In the long run it can hurt consumers as the market becomes monopolized. However, in the 1950s and 60s US economist William Baumol claimed that it

INDUSTRIAL AND ECONOMIC REVOLUTIONS 97 Operators work the switchboards of This idea led to an acceptance Whatever renders a the AT&T company in New York in the of national monopolies in the larger capital necessary 1940s. Because of the company’s size public utilities in many countries. in any trade or business, and dominance, it was considered to Even so, governments began to limits the competition be a natural monopoly. intervene in these markets to counteract the possible monopoly in that business. does not matter if there is a monopoly effects. The problem is that in the John Stuart Mill as long as there are no barriers to case of a natural monopoly, entering and exiting the market— the fixed costs are so high that through advertising and marketing, the mere threat of competition compelling the firm to charge a and through large firms innovating means that the monopoly will set competitive price might make the and creating new products. the price at a competitive level. firm unprofitable. Solutions to this This is because a higher price problem include the wholesale Slightly apart from this school might attract new entrants to the nationalization of industries or of economists, Austrian economist market, who would take market the establishment of regulatory Joseph Schumpeter (p.149) also share from the monopoly. For this organizations that place limits stressed the dynamic potential reason prices may be no higher on price increases, helping of monopoly as firms compete to under a monopoly than in a market consumers but also ensuring the create new products and dominate with many competing firms. economic viability of the industry. entire markets because of the potential profits. What economists Natural monopolies Mainstream economists argue agree on is that true competition One argument that began to take that monopolized markets fall short is good for consumers. It is less shape during Marshall’s lifetime is of the perfectly competitive ideal. certain whether or not monopoly is that some monopolies are “natural” This view has led to government incompatible with this. In the early because of the enormous cost anti-trust policies, which seek 20th century German economist advantages of having a single firm. to move markets toward Robert Liefman claimed that Many public utilities are natural competitiveness. This has meant “only a peculiar combination of monopolies, including telephone the introduction of measures aimed competition and monopoly brings networks, gas, and water. The at preventing monopolies from about the greatest possible fixed cost of setting up a network abusing their market power, satisfaction of wants.” ■ of gas distribution pipes is huge, including the breakup of monopolies compared to the cost of pumping and the banning of mergers of firms an extra amount of gas. that would create monopolies. The modern Austrian School, including US economist Thomas DiLorenzo (1954– ), are critical of this approach. Both argue that real market competition is not the passive behavior of perfectly competitive firms operating in a state of equilibrium. It is about cut-throat rivalry between an often small number of large businesses. Competition takes place through price and non-price competition, In 1998, the US pharmaceutical industry asserted its monopoly on an AIDS drug by taking legal action against the South African government, which had been buying cheaper, generic versions of the drug.

98 CROWDS BREED COLLECTIVE INSANITY ECONOMIC BUBBLES IN CONTEXT I n 1841, the Scottish journalist any intrinsic value they might Charles Mackay published have. When assets rise in such an FOCUS Extraordinary Popular Delusions uncontrolled way, the situation is The macroeconomy and the Madness of Crowds, a called an economic bubble. Like classic psychological study of actual bubbles, in an economic KEY THINKER markets and the irrational behavior bubble prices rise upward but Charles Mackay (1814–89) of people acting in “herds.” The become more and more fragile— book looks at some of the most and they inevitably burst. BEFORE famous examples of frenzied 1637 Dutch nurseryman P. speculation in history, including Tulipomania Cos publishes The Tulip Book, Tulipomania (1630s), John Law’s The Dutch tulip mania of the 1630s which provides raw data for Mississippi Scheme (1719–20), and is one of the earliest and most the future prices of tulips. the South Sea Bubble (1720). notorious instances of an economic bubble. At the beginning of the 17th AFTER Mackay’s hypothesis was that century tulips from Constantinople 1947 US economist Herbert crowds acting in a collective frenzy became popular with the wealthy Simon writes Administrative of speculation can cause the prices of Holland and Germany, and soon Behavior, introducing the idea of commodities to rise far beyond everyone wanted them. Tulips were of “bounded rationality”—poor seen to bestow the qualities of decisions are due to limits in Hendrik Pot’s painting of tulip mania wealth and sophistication on their ability, information, and time. (1640), shows the goddess of flowers owners, and the Dutch middle class riding with drunken, money-weighing became obsessed with collecting 1990 Peter Garber critiques men. Other people follow the cart, rare varieties. By 1636, the demand Mackay’s work in his essay, desperate to keep up with the group. for rare species of tulips was so Famous First Bubbles. intense that they were traded on Amsterdam’s stock exchange. 2000 US economist Robert Shiller publishes Irrational Many individuals grew suddenly Exuberance, analyzing rich. A golden bait hung temptingly the causes and policy out before the people, and interventions that might everyone—from noblemen to prevent the occurrence of maidservants—rushed to the tulip future economic bubbles. markets, all imagining that the passion for tulips would last forever. But when the rich stopped planting