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market rate of interest is the connecting link between money and prices; at any bank rate below the long-term equilibrium interest rate, the demand for loans and discounts is insatiable. The same product may be sold a number of times, each sale giving rise to a new real bill. In this way, the money supply may expand far beyond the needs of business, even though each loan is made on short-term commercial paper. Moreover, bankers may have difficulty to distinguish real bills form speculative bills and anyway tend to regard customers’ loans as the least liquid of their assets. The expansion of loans increases money incomes and raises demand and then justifies additional borrowing. Stability either in the quantity of money or in the volume of credit cannot be achieved by the restriction of discounts to real bills. Mill starts by endorsing the real bills doctrine, as his evaluation of the Charter Act of 1844 was negative, but he seems to establish a compromise between the two schools, Banking School is valid for quiescent states and Currency School for speculative states.

The essential Mill, according to Blaug, is to be found in his proposals for economic reform and in his pervasive moral tone at once sentimental and austere with the flourishes of abstract theory kept in check by a desire to preach social amelioration. He attributed the social ills of his time to the untrammelled exercise of private property rights. He said that laissez-faire should be the general practice, but he was willing to advocate piecemeal collective action in the interest of some greater good.

5. The Economics of Karl Marx

The first volume of Capital tries to bring out the essential nature of profit as surplus value produced by labour. All products exchange in proportion to the total labour embodied in their production. Therefore, if one states that all prices correspond to labour values, how is it that surplus value emerges at all, that is, a surplus over and above wages paid out? The answer that Marx gives runs in terms of the historical dispossession of a large group of society that is impelled to live by the sale of personal services as a result of the concentration of property in the hands of a few. As Marx would say, the exchange value of labour power is bought and paid for but what is actually acquired is the use value of labour. Only a part of the workers’ working day is spent in replacing the equivalent of his own value,

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namely the wage goods that go to maintain him; during the remainder of the day, the workers work for the capitalists.

Surplus value is nothing but unpaid labour. Surplus value can be increased either by lengthening the working day (absolute surplus value) or by raising the productivity of labour, thus lessening the time required to produce wage goods (relative surplus value). The rate of surplus value (the rate of exploitation) is a function of the direct labour employed. Constant capital in the form of machinery and raw materials only transmits its own value to the product; it does note create additional value. It differs from variable capital because it is bought and sold by capitalists, whereas variable capital is sold by workers and bought by capitalists, and it seemed obvious to Marx that the origin of surplus value cannot lie in an exchange between capitalists.

In a boom, the demand for labour resulting from accumulation will run ahead of the available supply; the reserve army of labour is depleted and the relative scarcity of labour causes wages to rise; hence, profits fall and accumulation slows down. A reduction in the rate of capital accumulation leads to a fall in aggregate demand and hence to a downturn. In the slump, capital values are written off and the reserve army is replenished, thus driving wages down. This restores the profitability of production and sets the stage for a resumption of accumulation. The cyclical reserve army theory is joined to the secular tendency of the rate of profit to fall and the possibility of disproportionate rates of growth of capital goods and consumer goods industries.

The misdistribution of income under capitalism owing to the failure of real wages to rise as fast as output per man is, for Marx, the last cause of all crises. Marx thinks that capitalism tends continually to expand production without any reference to the effective demand that alone can give it meaning. The expansion of production does not automatically generate a proportionate increase in effective demand because the excessive rate of capital formation lowers the rate of profit, even while the innovation embodied in the increments of capital hold down wage rates by being largely laboursaving.

Marx’s problem is to state how surplus value is reserved in an economy in which prices are determined by impersonal forces and the relation between employer and worker is based on contract rather than status. Under perfect

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competition, one might think that capitalists, whose individual contributions to total output are too small to influence market price, would expand output in the effort to reap more surplus value until wages are bid up so as to reduce the surplus to zero. But there are some logical problems in Marx’s theoretical construction. In a system in which relative prices correspond to relative labour values, the net product of equal quantities of labour would be sold for equal quantities of money; given uniform money wage rates between industries (because of the rate- equalising-conditions of perfectly competitive markets on which Marx seems to be reasoning), the rate of surplus value would be everywhere the same. But the organic composition of capital (capital per man) is not the same in different industries while profits per man can be everywhere the same. Then, the rate of profit per unit of capital will vary inversely with capital per man which implies that the higher the degree of mechanisation (differences between the capital per man ratios of industries), the lower the rate of profit, which flies in the face of the fact that capitalists are motivated to substitute capital for labour by the prospect of earning higher profits (throughout, for example, innovations).

The contradiction is that with a uniform rate of profit per unit of capital and with different values of organic composition of capital, we cannot have a uniform ratio of profits per man. Since the organic composition of capital differs between industries, so must the ratios of profits per man. This implies, however, that the net product of equal quantities of labour cannot sell for equal quantities of money, that is, relative prices cannot correspond to relative labour values. The labour theory of value does not claim that the price of a commodity is equal to the labour embodied in its production or that competition enforces such a distribution of productive resources between various industries that relative prices in the long run tend to be proportional to labour inputs. In Marx, long-run prices are determined in the same way as in orthodox theory (by long-run costs of production, including profit at the ruling rate). But a theory of value must explain how market forces produce such an equilibrium normal price. On this count, we get no assistance from Capital.

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Chapter II. The marginal revolution and neo-classical economics4

In classical economics, the economic analysis tries to reveal the effects of changes in the quantity and quality of the labour force on the rate of growth of aggregate output. As the rate of growth of output is held to be a function of the rate of profit on capital, secular trends in factor prices and in distributive shares are supposed to be the key elements in the economic process. Therefore, the accent is on capital accumulation and economic growth in the context of a private enterprise economy. Free competition is thought to be desirable because it tends to expand the area of the market by bringing about an improved division of labour.

After 1870, the term “marginal revolution” is usually taken to refer to the nearly simultaneous but independent discovery by Jevons, Menger and Walras of the principle of diminishing marginal utility as the fundamental reasoning of a new static microeconomics approach. The essence of the economic problem becomes the search of the conditions under which given productive services are allocated with optimal (in the sense of maximising consumers’ satisfactions) results among competing uses.

The economics become the study of the relationship between given ends and given scarce means that have alternative uses for the achievement of these ends. The classical theory of economic development is replaced by the concept of general equilibrium.

1. Emergence of marginal utility

1. 1. The neoclassical method and the maximisation principle

The quarter century from the early 1870s was a period of deep structural change. Growth proceeded in different countries, accompanied by an increase in the concentration of capital, with a spread of collusive practices, mergers, and the formation of cartels. This process was encouraged by great changes in productive techniques and the organizational form of the limited company became the privileged instrument for the mobilisation and control of the huge amounts of capital.

4 See Blaug (1997) and Screpanti and Zamagni (1995).

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Inside the firms, the relations among individuals assumed a hierarchical and bureaucratised form (appearance of the management science). In society as a whole, class conflict sharpened and began to assume the form of a direct battle between powerful political and union groups. Serious financial crises occurred in various countries in 1873, 1882, 1890, and 1893. In many European countries, a long agricultural depression was aggravated these crises. At the same time, three important books were published: The Theory of Political Economy (1871) by William Stanley Jevons, the Grundsätze der Volkwirtschaftslehre (Fundamental Principles of Political Economy) (1871) by Carl Menger, and the Eléments d’économie politique pure (volume 1 in 1874 and volume 2 in 1877) by Léon Walras. These books marked the beginning of the marginalist revolution. But there was an almost complete silence for a decade. In the 1880s and 1890s, the revolution exploded. Marshall, Edgeworth, Wicksteed, Böhm-Bawerk, Wicksell all published fundamental works in this new spirit.

In the following 30 years, the neoclassical system had imposed itself. In the analysis of the conditions ensuring the optimal allocation of given resources among alternative uses, the neoclassical economists identified a universally valid principle. The neoclassical method is based on the principle of the variation of proportions: the substitution principle. In the theory of consumption, the substitutability of one basket of goods for another is assumed; in the theory of production, the substitutability of one combination of factors of production for another. The objective is to search the conditions under which the optimal alternative is chosen. This method presupposes that the alternatives at stake are open and that the decisions taken are reversible.

It is assumed that if economic agents have to be subjects able to make rational decisions with a view to maximising an individual goal, such as utility or profit, they must be individuals, or, at the most, minimum social aggregates characterised by the individuality of the decision-making unit, such as households and companies. Thus the collective agents, the social classes and political bodies of the classical theoretical system disappear from the scene and replaced by what is later called ‘methodological individualism’ which consists in reasoning in terms of sole individual goals when one deals with the optimal allocation problem of economic resources. Therefore, the main economic problem becomes the

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allocation of a fixed income among a number of consumer goods or the allocation of a fixed outlay among a number of productive factors or a given amount of time between work and leisure, the principle always remains the same. In each case, the allocation problem has a maximum solution if and only if the process of transferring a unit of the dividend to a single use among all the possible uses is subject to diminishing results.

In the theory of the household, an optimum situation is obtained when the consumer has distributed his given income in such a way that the marginal utility of each unit of income spent in purchase is equal; the law of diminishing marginal utility insures that such an optimum exists. In the theory of the firm, an optimum result is obtained when the marginal physical product of each outlay’s worth of factor purchases is equalised. The standard demonstration is given assuming that perfect competition does, under certain conditions, produce equimarginal allocations of expenditures and resources.

Another distinctive element of the neoclassical system is in the substitution for the objective theory of value of a subjective one. The principle of subjective value means that all values are individual and subjective. Values are considered always as the ends of particular individuals. Values are subjective because they are assumed to arise only from a process of choice: an object has value if it is desired by a subject (an individual). This principle implies that a value is such because somebody has chosen it as an end (in the opposite conception –objective value’s onevalues exist independently of individual choices). An important consequence of this approach is that the theory of the distribution of income becomes a special case of the theory of utility-value: Factors are rewarded because they are scarce relative to consumers’ wants for the products that the factors could produce. The process of production and distribution has significance only insofar as it modifies the possibility of consumers’ choice. The demand for factors is a derived demand; given the supply of factors and their technical rates of transformation, the prices of productive services and the prices of consumer goods alike are determined by consumers’ wants. Hence, there is no room for a special analysis of the value of each factor of production as it was the case in the classical theory.

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1. 2. The theory of exchange: Jevons, Walras and Menger

* Jevons and the exchange

Jevons approached value theory by looking at two individuals engaging in exchange. Exchange cannot take place unless the relative marginal significance of the commodity received exceeds that of the commodity given up for each party in the exchange. This marginal significance is not a constant magnitude but changes with different persons and under different circumstances. According to Jevons, what the classical writers called value in use or total utility is an abstraction. All we know is the relative significance of an increment of one commodity to a decrement of another. Using the law of diminishing marginal utility, Jevons proceeded to the equation of exchange: the ratios of increments of commodities consumed must, in equilibrium, be equal to the corresponding ratios of the intensities of last wants satisfied, or, as Jevons put it, to the final degrees of utility; and the ratios at which the two goods exchange must be inversely proportional to the final degrees of utility (in modern terms, we call it: the proportionality of marginal utilities of goods to their relative prices).

Jevons’s equation of exchange assumes that the individuals engaged in exchange are in possession of a given initial stock of commodities. Jevons stated that: cost of production determines supply; supply determines final degree of utility; and final degree of utility determines value. But Jevons supplied no theory of production and he didn’t show how market demand curves are built up from individual demand curves.

* Walras and the general economic equilibrium

The central problem of Walras’s theory is to show how the voluntary exchanges among individuals who are well informed (each one is perfectly aware of the terms of his own choices), self-interested (each one thinks about himself), and rational (each one tries to maximise his own goals) will lead to a systematic organisation of the production and the distribution of income which is efficient and mutually beneficial.

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In order to account for the fact that the individual actions are co-ordinated on the market, it is necessary to demonstrate that prices exist that render advantageous to each individual precisely those activities and choices which satisfy his needs in an efficient way.

The prices are the parameters (given in the markets and not established by individuals, who are therefore price-takers) on the basis of which individual choices are made. Of course, the prices are not independent of the choices themselves because they are assumed to be determined throughout the individuals’ demand and supply propositions on the markets, but individuals, taken one to one, have no influence on these prices. The prices of goods contribute to determining the demand prices of a factor used to produce goods. From the comparison between the supply price and the demand price, the market price of that factor is obtained. This, in turn, influences the supply price of the product and therefore its market price. So, there is a well-articulated set of relationships between prices and quantities exchanged in regard both to inputs and to outputs. This set of relationships is in a state of general equilibrium when the prices and the quantities are such that the maximum satisfaction each agent pursues by his own choices is compatible with the maximum satisfaction pursued by all the other agents. More precisely, an economy is in a Walrasian competitive equilibrium when there is a set of prices such that:

-in each market the demand equals the supply;

-each agent is able to buy and sell exactly what he planned to do (under his budgetary constraint);

-all the firms and consumers are able to exchange precisely those quantities of goods which maximise, respectively, profits and utilities.

In order to obtain this result, it is only necessary to know as initial data, in the Walrasian model, the number of consumers, the number of firms, the initial endowments of resources, the consumers’ preferences, and the techniques available. All the rest is left to the maximising behaviour of the agents and to the competitive mechanism.

The model of price formation underlying Walras’s theory is one of competitive bargaining. According to this model, markets are conceptualised as

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auctions in which there are, on the one hand, stockbrokers, and, on the other, the auctioneer. At the beginning of the bargaining the auctioneer shouts a price vector (the set of all prices of all goods, one price for each good) and leaves the agents to formulate their buying and selling proposals. If, in correspondence to the shouted prices, the auctioneer notices that, for each good, the supply and demand are equal, he will declare bargaining closed, and that price vector will be the equilibrium vector. If this does not happen, the auctioneer will adjust the prices according to the rule: increasing the prices of goods in excess demand (if the demand of the good exceeds its supplied quantity at the price shouted) and decreasing the prices of goods in excess supply (if the supply of the good exceeds its demanded quantity). This trial and error process –called the Walrasian tâtonnement- will continue until all excesses of supply and demand have been eliminated, i. e. until the markets clear throughout the prices’ changes. At this point the auction ends; the final quotations are registered as the equilibrium prices. Exchanges are carried out on these terms. This is the single-agreed-price bargaining. The prices shouted by the auctioneer during the adjustment process and which do not equal to the equilibrium prices equalizing all supplies and demands are called virtual prices. The Walrasian description of the operation of the economy uses the device of a ticket economy which is really different from a market economy.

Walras constructed a system of simultaneous equations to describe the interaction between consumers and sellers. The production equations are defined in such a way that the price of each product is equal to its cost of production, so that in equilibrium the producers make neither profits nor losses (in equilibrium, all factors of production (included the factor capital) receives their equilibrium level of payment, wages for the labour and profits for the owners, equalizing their respective marginal product).

The general interdependency of all markets makes that if there is equilibrium in all the markets except one, this means that consumers have spent a sum of money equal to the value of the goods offered. But, given that the total value of the goods produced equals by definition the total income earned by consumers (the national product equals the national income), there will also be equality between supply and demand in the last market. That is the Walras’s Law:

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in a general equilibrium system, if all markets, except one, are in equilibrium and the budgets of all agents break even, then the remaining market must also be in equilibrium.

* Menger’s utilitarianism

Menger considered the value to be an expression of the judgement of the consumer in regard to the goods suitable to satisfy his needs. But Menger stated that it is necessary to extend the principle of marginal utility to the phenomena of production and distribution and it is not enough to explain how it is possible, for a given quantity of consumer goods, that a set of exchanges is established which, in perfect competition, maximise the utility of the subjects and at the same time determines the equilibrium configuration of the relative prices.

Supply is regulated by the costs that must be sustained to produce the various goods; but it seems that costs cannot be reduced to utility. The only way to preserve the symmetry between supply and demand would be to link costs to a certain homogeneous entity which is comparable to utility. Menger’s specific contribution is on this problem.

With his theories of imputation and opportunity cost, Menger resolved costs into utility. Goods are classified according to their distance from final consumption. The higher-order goods (the factors of production) derive their utility from the goods of the first order (consumer goods) they contribute to produce. This indirect utility can be imputed to each productive factor by taking into account the marginal contribution it makes to the production process. Consequently, the actual cost of producing a given good becomes an opportunity cost represented by the sacrifice of utility of those other goods that could have been obtained from the resources actually used to produce the considered good. Then, the production costs are evaluated in relative terms: in terms of sacrified alternatives. So, the principle of marginal utility is extended by Menger to cover the cost phenomenon and the conditions of supply. Supply and demand appear to be two aspects of the same problem which is explained in terms of utility. Moreover, as the cost of a firm is an income for the owners of the productive factors, the cost phenomena and the formation and distribution of income are explained by the same manner. Wages,

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