Gravitation, Full Cost Pricing and Prices of Production

Franklin Serrano (Guest blogger)

Most Sraffians understand that gravitation of market prices to normal prices is much quicker than the slower, but inevitable, adaptation of capacity to demand. But other eminent Sraffians have made some confusion by wrongly identifying classical prices of production with full cost pricing.

Classical prices of production are the centre of gravitation for market prices and are determined by the costs of the dominant techniques (at the level of normal utilization of fixed capital) and the state of distribution. It is a general theory of the structural determinants and limits for the trend of market prices in all types of markets. In spite of the similar name it has little or nothing to do with “normal cost” or full cost pricing which is a generalization of the descriptions given by some firms as to how they actually calculate their own prices based on a markup over their own costs (not those of the dominant technique).

First of all, there is obvious fact that the theory of prices of production was developed in a historical period in which such these pricing rules simply did not exist (see Hicks’ Market Theory of Money, 1989). And prices of production can still explain, in my view, the structural or trend element even in markets with highly flexible prices subject to wild short run fluctuations and rampant speculation, as in the so-called “commodity” markets (in Garegnani’s comment on Asimakopulos he explicitly mentions the importance of explaining the trend of the relative price of copper even though “at any one time copper prices are 50% or more above or below trend”)

Second, even in the so called fix price markets, were firms set the prices of their products directly, the full or "normal cost" that particular firms use to calculate their own price is the actual cost of these particular firms and the markup these particular firms think they can add to prices without trouble. These calculations generate actual market prices or (if stylized enough to have some generality short run theoretical prices) that are not unique even for a single market as the full cost prices can be different for different firms. These prices differ from prices of production because they refer to the actual costs of some firms and not the costs of the dominant technique available. For that particular product that determines a single price of production for that market.

The way prices of production may regulate the full cost prices of firms is by getting them in trouble whenever their actual costs plus their desired markups are too high relative to the costs (including normal profits) of the dominant technique, thereby attracting new entrants or cause some rival firms inside that market not to follow price rises that are due to increase in costs particular to that firm or “excessive” desired markups of these firms.

Professors Fred Lee and Marc Lavoie are both absolutely right and some Sraffians wrong in saying that full cost pricing is NOT the same thing as the classical theory of prices of production. Where I think they are definitely wrong is in thinking that classical prices of production are thus irrelevant for market forms in which firms follow such rules. For, through the power of actual or potential competition, the classical prices of production are the centers of gravitation that regulate even the trend of the prices of firms that practice full cost pricing. The closest analogy between classical prices of production and the industrial organization literature is thus the concept that Sylos-Labini called “limit” prices.

So market prices in both fix and flex price markets gravitate, towards or around classical prices of production. Any theory of full cost pricing can at best be a particular theory of short run price behavior of some firms in particular types of markets. There are old papers by James Clifton that started this confusion many years ago in Contributions to Political Economy and the Cambridge Journal of Economics. It is about time we stop confusing ourselves and our post Keynesian friends on this issue.

References:

Lavoie, M. (2003), “Kaleckian Effective Demand and Sraffian Normal Prices: Towards a reconciliation,” Review of Political Economy, 15(1) available here.

Lee, F. and T-H. Jo (2011) “Social Surplus Approach and Heterodox Economics,” Journal of Economic Issues, 45(4) available here.

Garegnani, P. (1988), “Actual and Normal Magnitudes: A Comment on Asimakopulos,” Political Economy, republished in Essays on Piero Sraffa: Critical Perspectives on the Revival of Classical Theory, Routledge, 1990.

Sraffian economics vs. Post Keynesian methodology

A very nice debate on the nature of heterodox economics took place yesterday in a heterodox conference in Buenos Aires. Sergio Cesaratto and Marc Lavoie (depicted above during the interval) presented alternative views which, in spite of some important differences, agreed that Sraffian economics is part of the broadly defined heterodox Keynesian camp (or Post Keynesian if one prefers the term). The question of the relation of Sraffians, and more broadly all of those that believe in the importance of the old classical political economy school (from Petty to Marx, including Quesnay, Smith and Ricardo), with non neoclassical Keynesians, that is, those that believe that unemployment does not result from some rigidity or imperfection (be that of the price, wage or interest rate), has been difficult to say the least.

Marc presented first. A version of the paper is here. Taking aside obvious confusions, and sloppy scholarship of the type that suggests that Sraffians accept Say’s Law, because in the determination of normal prices quantities are taken as given (the fact that those quantities are determined by demand in accumulation theory is, apparently, not understood by these critics), the main line of critique of Sraffians comes from what Marc refers to as Post Keynesian methodologists. For him, “the influence of methodologists ... felt through the study group around Tony Lawson at Cambridge ... that [argues that] proper economics should be based on critical or transcendental realism and ‘open’ systems” and that has led to an “‘open systems’ criterion to judge whether a model can be given a post-Keynesian stamp of approval” (Lavoie, pp. 6-7).

Marc correctly dismisses this supposition that from a methodological point of view the Sraffian approach is limited to closed models. As he clearly notes the Sraffian price equations require that one distributive variable (real wages or rate of profits) are determined exogenously outside of the system by historical and institutional circumstances, which by definition makes it an open system, that is, one in which there is an exchange with its environment. Marc, in fact, suggests that the strong case for a Sraffian-Keynesian interaction is based on the fact that the determination of the rate of profit by the exogenous short term rate of interest set by the central bank provides an obvious link to Post Keynesian endogenous money literature (Pivetti and Panico’s work in that area, among others, shows that Sraffians do have a lot to say about money too, by the way).

Marc notes that the main reason, however, why Post Keynesians reject the Sraffian approach is there is “little enthusiasm for any notion of long-period ‘prices of production’ as centers of gravity towards which short-period or market prices are supposed to tend” (p. 14). However, as Marc suggests there is little difference between prices of production and full cost pricing. Full cost pricing, in my view, should be connected to the Oxford Economists Research Group (particularly P.W.S. Andrews, a tradition that through Andrews’s disciple Wynne Godley influenced Cambridge Keynesians). In other words, I see full cost pricing as compatible with the normal prices in Sraffa, both being determined by a mark up, which represents the social conflicts that allow one class to subtract surplus from another, over costs, which are determined by the technical conditions of production.

My main disagreement with Marc’s exposition, then, is related to his argument that “if one wishes to connect Sraffian economics with the other strands of post-Keynesian economics, one needs to examine production prices in a different light, not as long-run or long-period centers of gravity to which market prices tend” (p. 15). This is also complicated by the incorrect notion that gravitation requires the use of marginalist principles in order to obtain that market prices converge to normal long term prices, which is not the case [I’ll leave the details of that for another post though]. It seems to me that Marc believes somehow that full cost prices are somehow not fully adjusted prices, and that firms do not use their normal costs rather than their short run costs when computing prices.

Sergio counter presentation (not available, but you can check some of his extensive publications here), was narrower in scope, and dealt with the difference between certain Post Keynesian growth models (in particular the so-called Neo Kaleckian school) and Sraffians (he also distinguished among certain Sraffian groups). I should note that Cesaratto agreed with Marc in his rejection of the critique of the so-called Post Keynesian methodologists, and suggested that their lack of understanding of the capital debates and its consequences, reduces the significance of their views. He correctly points out that the capital debates produced the only occasion that forced neoclassical economics to openly recognize its flaws, and, I would add, led to a significant change in the way they do economics, forcing the change in the notion of equilibrium and the development of disaggregated intertemporal short term models (i.e. without a uniform rate of profit, something first noted by Piero Garegnani).

Sergio notes that when dealing with models of accumulation there are three features that most heterodox groups would want to incorporate in their models, namely: (A) the Classical (or in general exogenously given) income distribution, (B) the Keynesian Hypothesis of an investment rate independent from an exogenously given rate of savings, and (C) normal accumulation paths, with the traditional corollary of a long run normal degree of capacity utilisation. Between these three features one obtains what Sergio refers to as the Magical Accumulation triangle.

Neo Kaleckian (NK) models (some of Marc’s models, particularly in his Foundations of Post Keynesian Economic Analysis are of this type, but not the ones in his book with Wynne Godley) tend to assume A and B, but not C. The absence of the notion of normal (or fully adjusted) positions, as we saw above with regards to prices, is the main difference between the NKs and what Sergio calls the supermultiplier Sraffians (which have A, B and C). The supermultiplier models (which are in a sense Kaldorian, on Kaldor and Sraffa see this paper) implies that long term capacity output (not optimal in the sense of full employment) is determined by the exogenous components of demand, and investment is derived demand (as noted by Sergio the key contribution here is Franklin Serrano’s PhD thesis).

Here it is important to note why long term normal positions are important. It has little to do with a belief that economic systems are stable and tend to optimal levels, since the normal positions are tendencies, and are, generally, below full capacity, and crisis are the norm. Normal positions are important because they show that the regular functioning of capitalist economies does not produce efficient allocation of resources. Without suggesting that those that deny the relevance of long term positions are imperfectionists in the same sense that neoclassical authors that believe that an accumulation path below full employment is due to price, wage or interest rate rigidities, the argument still relies on an inability of capacity to adjust fully to the exogenous growth of the autonomous components of demand. The question then is why would a business not invest enough to keep its capacity growing in line with the growth of its demand? Here, I believe, lies the fundamental difference between classical-Keynesians (or supermultiplier Sraffians) and Neo Kaleckians.

By the way, as I noted before in the blog, the use of the term Kaleckians for the NKs is a bit of a misnomer, since the models derive really from Joan Robinson (and as noted by Sergio, Harrod and Steindl too). In part, I think, for her role in the rejection of normal positions and her views on history versus equilibrium, Sergio suggested that Robinson played a negative role in these debates.

There are several other things to discuss about this topic (the role of Joan Robinson among the important ones), brought about by the interesting, controversial, but very friendly debate between Marc Lavoie and Sergio Cesaratto which I’ll leave for other posts.

The capital debates: A brief introduction

Teaching on the capital debates this and last week. So here are some thoughts, based on my class notes and the required readings (see below). The capital debates remain a puzzling chapter in the history of economic ideas. Nearly everyone accepts that the British (as opposed to the Massachusetts) Cambridge won the debate, something Paul Samuelson acknowledged early on.[1] Yet, no one seems to grasp the full implications and relevance of the debate itself. Typically it is assumed that the capital debates relate simply to problems of aggregation, and that the use of aggregate production functions and aggregative measures of capital are still justifiable, for simplicity’s sake. However, contrary to this viewpoint the capital debates did not rest upon the possibility of building aggregate measures.

The capital debates are associated with the very notion of capital. Classical political economy authors, from William Petty to Karl Marx, including Quesnay, Smith and Ricardo, treated the process of production as a circular one. In this context, capital is a produced means of production,[2] rather than a factor of production used in the process of obtaining final goods. The most important result of the capital debates is that, once capital is defined as produced means of production, there is no direct relation between the relative abundance or scarcity of the means of production and its remuneration. Distribution, in other words, is not governed by supply and demand.

Since the Marginalist Revolution, and the rise of the so-called neoclassical school, the notion that relative prices are determined by supply and demand, and that these reflect the relative abundance or scarcity of all goods and services – including factors of production – became consensual. As a result, the supply and demand for capital became the determination for the remuneration of capital. The more abundant is capital, the lower its remuneration, and vice versa if it is scarce. Conflict has no role to play in the determination of distribution, and social classes vanished entirely from analysis.

Additionally, substitution leads to the full utilization of resources and their optimal allocation. If capital is scarce and expensive, and labor abundant and cheap, economic agents substitute labor for capital and fully utilize labor. Thus, despite the abundance of labor, its relative cheapness, through the principle of substitution, leads to full employment. Indeed, unhampered markets do lead to the veritable best of all possible worlds.

It is the logic of the principle of substitution, based on relative scarcities that the capital debates shattered. Contrary to the neoclassical parable, the capital debates showed that it is not generally possible to obtain a univocal relation between remuneration and relative scarcity. For example, assume that we have two commodities produced with capital and labor, and that one can be said to be univocally more capital abundant than the other. In this case, as capital becomes more abundant the profit-to-real-wage ratio will fall, more capital will be used, and more of the capital-intensive good will be produced. However, it is possible that one good would be more capital intensive at high levels of the profit-to-real-wage ratio, and that the other becomes the capital intensive good at lower levels of the same ratio. That is, we would have factor intensity reversal. In the instance of factor intensity reversals, the conventional relation between factor scarcity and relative prices breaks down.

In this situation, it would be possible that as the profit-to-real-wage ratio falls, more labor will be used, and more of the labor-intensive good will be produced. In other words, there would be reverse capital deepening and a lower rate of profit associated with a reduction in the use of capital. Substitution moves in the wrong direction, so to speak, and more of the scarce factor is demanded. A simple algebraic exercise may help understand the point.

Let’s assume that there are two methods of production, associated to the manufacture of capital (iron) and consumption (corn) goods respectively. The prices are determined by:

(1) pc=wlc+rpkkc
(2) pk=wlk+rpkkk

where the subscripts refer to consumption and capital, l and k are the technical coefficients of production, and w and r are the real wage and rate of profit. Using pc as a numeraire and solving for pk we obtain:

(3) pk=(1-wlc)/rkc

From (3) into (2) we get:

(4) [(1-wlc)/rkc]=wlk+rkk[(1-wlc)/rkc]

Simplifying, and solving for w we find:

(5) w=(1-rkk)/[lc+(lkkc-lckk)r]

If the expression in the small parenthesis in the denominator is equalized to zero we obtain a wage-profit frontier that is linear. This assumption is what Samuelson (1962, p. 225, n. 7) refers to as the equi-proportional assumption. Figure 1 shows the choice of technique under this assumption.

Figure 1

The firm chooses the highest rate of profit for a given real wage, which implies that as the rate of profit falls the firm must choose the more capital intensive (b in this case). In this case, the neoclassical parable works; there is an inverse relation between factor intensity and its remuneration.

Once, the assumption of equi-proportional capital to labor ratios in the machine and consumption sectors (which would mean in Marxist terminology the same organic composition of capital in both sectors) is dropped the wage-profit frontier is not linear anymore. If we assume that the capital goods sector is more capital intensive than the consumption sector then the wage-profit frontier will be concave (as shown in Figure 2).

Figure 2

In this case, we have two switches; at high levels of the rate of profit the firm choose technique a, which is more labor-intensive, and as the rate of profits falls it switches to b the capital-intensive one as prescribed by neoclassical economics. However, at even lower levels of the rate of profit, the firm switches back to the more labor intensive technique. Reswitching and reverse capital deepening, hence, result from the dismissal of the equi-proportionality assumption, which is what one would expect in a world with several goods.

The implications for neoclassical theory cannot be overstated. First and foremost, there is no relation between relative scarcity and the remuneration of factors of production, and, as a result, distribution is not simply the product of market forces. Further, there is no guarantee that all resources will be fully utilized.[3]

It must be noted that, even though the capital debates are fundamentally about the logical coherence of the neoclassical approach, the results of the capital debates have important empirical implications. Neoclassical theory makes strong predictions vis-à-vis substitution effects and the relation between relative scarcity and remuneration. Yet the capital debates suggest that some of those predictions might not be consistent, and, as a result, the absence of those relations might be expected in the real world.

The most obvious prediction is the inverse relation between investment (capital intensity) and the rate of interest (its remuneration). As it is well known, there is little evidence that investment is sensitive to variations in the real rate of interest. In a rare survey of the empirical literature on the determinants of investment Robert Chirinko (1993, p. 1906) argues, “[T]he response of investment to price variables tends to be small and unimportant relative to quantity variables.” In other words, interest rates have little effect on gross capital formation, and the substitution effects that imply that agents use the cheaper factor of production are not operative. Further, the empirical evidence suggests that investment reacts to quantity variables, meaning the level of activity. This suggests that the income effects tend to be larger tahn substitution effects and that a firm facing less demand will not buy capital goods, even if the interest rate is low. These results underscore the empirical relevance of the capital debates.[4]

Similarly, the capital debates highlighted the futility of using the aggregate production function to measure the growth and productivity performance of real economies. The theoretical problems with the aggregate production function, associated to the notion of capital as a scarce resource, are compounded by the impossibility of disentangling it from the identity of income with the structure of the functional distribution of income (Felipe and Fisher, 2003). In other words, if one runs a regression of income on capital and labor, as is often done by those using a production function, it necessarily follows that income grows because capital and labor grow. Furthermore, changes in income distribution also affect income growth, as total income (net of taxes) is by definition the wage multiplied by labor utilized in production plus capital multiplied by its remuneration.

In this way, the capital debates demolished the theoretical foundations of neoclassical economics, and provided significant empirical evidence that those neoclassical models and their resultant policy prescriptions should be viewed with a healthy measure of skepticism.

Faced with the impossibility of using both the notion of aggregate capital and the principle of substitution, neoclassical economics opted to apply the principle of substitution to each kind of capital good taken as a distinct factor of production, by using the Arrow-Debreu model of intertemporal general equilibrium (Garegnani, 1976; Milgate, 1979). Even though the idea of intertemporal equilibrium, in which capital is treated as a vector of heterogeneous capital goods, was first developed by Eric Lindahl and then popularized by John R. Hicks in the 1930s, and used by Arrow and Debreu in the 1950s, it was only after the capital debates that it came to be dominant within the mainstream.

The problem with the use of heterogeneous capital goods is that it implies a change in the traditional method of economics. Normal equilibrium positions are associated to a uniform rate of profit; however, when dealing with heterogeneous capital goods that are not substitutable between each other, it becomes necessary to discard the notion of long run equilibrium. In Arrow-Debreu models all prices are short run prices, associated to differential rentals for each capital good, and any change in the data of the system – preferences, technology, and information for given initial endowments – affects the direction to which the economy adjusts (Petri, 2003).

In other words, the forces of competition that lead capitalists to those sectors with higher remuneration and establish a uniform rate of profit do not operate in the Walrasian world.[5] Hence, the Walrasian models are incapable of ascertaining tendencies in real economies, a defect that is not mitigated with the introduction of imperfections (Stiglitz, 1993, p. 109), which Stiglitz calls the post-Walrasian and post-Marxist paradigm. Far from increasing the realism of the model, the casting about of such lifelines only complicates the results of an exceptionally unrealistic one.

Information imperfections, and other related imperfections like price rigidities or lack of rationality, once introduced leave the Arrow-Debreu model unable to produce Pareto efficient solutions, or even market equilibrium, since some markets may not exist. Additionally, the introduction of imperfections renders the aggregative model prone to suboptimal outcomes. Suboptimal results in the presence of imperfections suggest that in their absence markets would still produce optimal outcomes.[6]

Some authors tend to confuse the imperfectionist arguments, and the implicit support that they provide for policy intervention, as a break with orthodoxy. While it is clear that they provide space for flexibility in policy advice, they remain firmly based on orthodox grounds.[7] The capital debates, in contrast, showed that unhindered markets, free of imperfections of any type, do not lead to market efficiency in general.

Faced with the logical problems that neoclassical aggregative models are riddled with on the one hand, and the irrelevance of general equilibrium models on the other, neoclassical economists did what any rational agent would do: disregard the critiques and in so doing, their deleterious results, and proceed as if nothing had happened. However, an innovative, if not peculiar, development generated a curious division of labor within neoclassical economics. Aggregative models were deployed for the purposes of teaching and policymaking, while the Arrow-Debreu model became the retreat of neoclassical authors when questioned about the logical consistency of their models. In this response, a harsh tradeoff between logical consistency and relevance was cultivated in the very core of mainstream economics.

The degree of fragmentation – as Roncaglia (2005, p. 468) so aptly expresses it – and confusion in the mainstream today is the result of such inconsistency at the core of economics, and not uniquely, as is frequently asserted, because of the demise of the Keynesian consensus. The collapse of the certainties provided by the old aggregative neoclassical model has brought about an often cynical defense of market-oriented policies for their own sake. The return of Vulgar Economics, which “sticks to appearances … [and] believes that ‘ignorance is a sufficient reason’” (Marx, 1867, p. 307) is complete.

Notes:
[1] See Samuelson (1966). A typical position is that of Robert Lucas (1988, p. 36) who notes the victory of the British argument, and yet remains oblivious to the problems of using the aggregate production function in the same paper.

[2] For Marx (1867, p. 189) capital also involved a social relation between the owners of the means of production and those forced to sell their labor power. For him, capital “can spring to life, only when the owner of the means of production and subsistence meets in the market with the free laborer selling his labor-power.”

[3] Both results are important, for example, for the Keynesian possibility of unemployment equilibrium. Keynes’ (1936, p. 243) emphasis on the unimportance of the natural rate of interest not only implies that the supply and demand for capital (loanable funds) do not determine the equilibrium rate of interest, but also that the conventional rate of interest may be set at such a level that brings about persistent unemployment.

[4] In the same way, the empirical evidence seems to contradict the notion that higher wages would lead to substitution of cheaper factors of production for labor. The exemplary case is the well-know study of the fast food industry in New Jersey, which found a positive correlation between the minimum wage and employment (Card and Krueger, 1995).

[5] That GE models do not support the notion that the abundance of a factor of production will be associated with lower remuneration has been pointed out by a survey of those models (Bliss, 1975).

[6] The same is valid for Bowles and Gintis’ (1993, p. 84) notion that market exchanges are usually contested and endogenous enforcement costs are not zero, and, as a result, there are conflicts of interest among exchanging parties. Therefore, if enforcement costs were nonexistent the Arrow-Debreu results would prevail. It must be noted that all the literature on post-Walrasian economics presumes continuity between the classical political economy authors and the post-marginalist revolution economics, which would mean that there are no significant distinctions between Smith, Marx, Walras and Arrow.

[7] Colander et al. (2004), for example, seems to suggest that several of the post-Walrasian developments can be seen as breaking up with orthodoxy. For a critique see Vernengo (2010).

Additional Readings:

Bliss, Christopher (1975), Capital Theory and the Distribution of Income, Amsterdam and New York: Elsevier North-Holland.

Bowles, Samuel and Herbert Gintis (1993), ‘The revenge of homo economicus: Contested exchange and the revival of political economy’ The Journal of Economic Perspectives, 7(1), 83-102.

Card, David and Krueger, Alan (1995), Myth and Measurement: The New Economics of the Minimum Wage, Princeton: Princeton University Press.

Chirinko, Robert (1993), ‘Business fixed investment spending: Modeling strategies, empirical results, and policy implications’, Journal of Economic Literature, 31(4), 1875-1911.

Colander, David, Rick Holt, and J. Barkley Rosser Jr. (2004), “The changing face of mainstream economics,” Review of Political Economy, 16, pp. 485-99.

Felipe, Jesus and Franklin Fisher (2003), ‘Aggregation in production functions: what applied economists should know’, Metroeconomica, 54(2-3), 208-262.

Garegnani, Pierangelo (1976), ‘On a change in the notion of equilibrium in recent work on value: a comment on Samuelson’, in M. Brown, K. Sato and P. Zarembka (eds), Essays in Modern Capital Theory, Amsterdam: North-Holland.

Heim, John J. (2009), ‘Which Interest Rate Seems Most Related to Business Investment?’, American Society of Business and Behavioral Sciences E-Journal, 5(1), February.

Keynes, John M. (1936), The General Theory of Employment, Interest and Money, New York: Harcourt Brace.

Lucas, Robert (1988), 'On the Mechanics of Economic Development,' Journal of Monetary Economics 22 (1), pp. 3–42.

Marx, Karl (1867), Capital, NY: International Publishers.Capital, NY: International Publishers.

Milgate, Murray (1979), 'On the origin of the notion of ‘intertemporal equilibrium’,' Economica, 46(181), 1-10.Economica, 46(181), 1-10.

Petri, Fabio (2003), ‘A ‘Sraffian’ critique of general equilibrium theory, and the classical Keynesian alternative’, in F. Petri and F. Hahn (eds), General Equilbrium: Problems and Prospects, London and New York: Routledge, pp. 387-421.

Samuelson, Paul (1962), “Parable and Realism in Capital Theory: The Surrogate Production Function,” Review of Economic Studies, 29(3), pp. 193-206.

Samuelson, Paul (1966), ‘A summing up,’ Quarterly Journal of Economics, 80(4), 568-583.Quarterly Journal of Economics, 80(4), 568-583.

Vernengo, M. (2010), 'Conversation or Monologue? On Advising Heterodox Economists,' Journal of Post Keynesian Economics, 32(3), pp. 389-96.

Scope and flexibility of alternative economic paradigms

Teaching the basics of the surplus approach this week. One important feature of what Garegnani refers to as the core of the surplus approach, shown in the figure below, is the flexibility that it provides for the development of alternative theories.

In the core output, technology and real wages are taken as data of the system. With output and technology one can determine the labor requirements for production. Further, with real wages one can get the necessary consumption needed to reproduce the labor force. Finally, extracting necessary consumption from output one obtains the surplus, and the surplus is what allows for expanded reproduction or accumulation, the main preoccupation of classical political economy authors.

An important thing to emphasize is that the relations within the core do not imply that the theories regarding the data must be similar. For example, while Ricardo accepted Say's Law, Marx clearly rejected it. Hence, the core is compatible with alternative theories of output, and similarly about the determination of real wages and technological change. The core is flexible and capable of encompassing different theories.

Further, nothing precludes the existence of feedback mechanisms and relations between the data of the system in classical analysis. The level of surplus might certainly have a relation to output, and that is central for the theories of accumulation, but those relations lack the generality that is attributed to the core relations. In those, less rigid relations, the role of institutional and historical elements loom large.

In the marginalist approach, in contrast, output and distributive variables (the real wage and profits, which are part of the surplus and, thus, residual for surplus authors) are determined simultaneously by supply and demand. There is no space for alternative views on the determination of output or the real wage. Full employment (a version of Say's Law) is a necessary result with flexible prices (hence, rigidities are necessary to get unemployment).

Suggested Reading:

Garegnani, P. (1984), “Value and Distribution in the Classical Economists and Marx,” Oxford Economic Papers, 36, pp. 291-325. Link here (subscription required).

PS: A complementary post, diagram and suggested reading at Robert Vienneau's Thoughts on Economics.

Sraffian environmentalism

It is well known that the surplus approach authors dealt with exhaustible resources when discussing land and rent. The so-called Ricardian theory of rent, discovered by West and Malthus, has important implications for income distribution as it is well known. Landlords benefited from protection, which forced the use of scarce land, and led to higher rents (and for a given output and a fixed wage at subsistence) lower profits. Thus, the existence of an exhaustible resource led to a transfer from the dynamic capitalists to the backward landlords.

The rent paid for the extensive use of land of different quality is significantly different than the intensive case of marginalist (neoclassical) theory. Marx was critical of certain aspects of the Ricardian theory of rent. In particular, he argued that 'absolute rent' would arise even if there were no differences in the levels of land productivity, if owners had a monopoly power over the natural resource. In this sense, the nature of rent is highly dependent on the historical contingencies and institutional arrangements that make one social group or class able to obtain greater bargaining power.

One important conclusion from this approach is that ownership and taxation of natural resources is crucial to determine which groups win or loose with the continuous use of exhaustible resources. Nationalization of natural resources not only might provide a situation in which the benefits and costs of extraction are shared more equitably, but also furnish the funds for the investment needed to promote alternative technologies. Below some readings that might be useful.


Suggested readings:

Bidard and Erreygers (2001), The Corn-Guano model, Metroeconomica 52(3), 243-53.

Burkett (2006), Marxism and Ecological Economics, Leiden, Brill.

Parrinello (2001), The price of exhaustible resources, Metroeconomica 52(3), pp. 301-15 (subscription required).

Ravagnani (ND), Classical Theory and Exhaustible Natural Resources, processed.

Rethinking Trade and Commercial Policy at the University of Utah

Peter Ho, from the University of Denver, gave a nice and stimulating talk based on his recently published book. He tries to rethink classical political economics views on trade, reviewing the contributions of Smith, Ricardo and Stuart Mill, and the trade policy advise that derives from it. Without having read the book, the presentation suggests a sort of institutionalist approach to the critique of the mainstream.

One thing that did strike me out as peculiar to the presentation, but which may not be reflected in the book, was the critique of the mainstream view of trade on the basis of Ricardo/Mill rather than the Heckscher-Ohlin (HO) model. Note that comparative advantage in the HO story is associated to full utilization of resources and relative prices determined by scarcity (for a critique see here). That's clearly not the case in Ricardo.

Also, the Ricardian (properly understood as part of the surplus approach) story is less about the benefits of trade in general, and more about which social class benefits and which one loses from protection (see my discussion here).

One last point about the talk, that I would have liked to discuss with Peter (I had to leave for a defense) was on Mill. He was a peculiar author in-between classical political economy and marginalism, and his contributions are more problematic to properly understand than authors like Ricardo and Marshall. In fact, Mill is a key author to understand the break between the surplus approach and marginalism. As noted by Krishna Bharadwaj, what was Ricardian in Mill's theories does not appear in Marshall's work, and what is proto-Marshallian in Mill's ideas was not part of Ricardo's views of political economy. In that sense, while I'm comfortable with a Smith/Ricardo approach to trade, I'm less keen about adding Stuart Mill to the mix.

PS: I should have noted that his discussion of trade policy builds on Hamilton, List, Prebisch, Myrdal, Singer and others, like the work of Ha Joon-Chang. A paper of mine on a similar subject is the entry on Export Promotion for the International Encyclopedia of the Social Sciences, edited by Sandy Darity (here).

Historians and the surplus approach

An interesting feature of the literature in history, particularly when related to ancient history, is that ideas that are clearly in the tradition of classical political economy, that is the developments from William Petty to Marx including mainly, but not uniquely Quesnay, Smith and Ricardo, are often used in contrast with the dominant supply and demand approach of the literature in economics. The typical discussion of development presumes that it was the surplus obtained with the domestication of plants and animals, and the transition from hunter/gatherer to agricultural societies, that allowed specialization (the division of labor) and the development of social classes.

The figure below comes from William McNeill's classic The Rise of the West, and the essential concept of surplus is at the center of the stage.

In that sense, historians, contrary to economists (even economic historians) do not tend to fall into the trap of describing markets as autonomous institutions that are disconnected from society. Also, historians tend to think in terms of classes, and restrict individual behavior to the kinds of actions that are related to the underlying social class. That is true in several popular books like Jared Diamond's Guns, Germs and Steel.

Garegnani and the revival of the surplus approach

(1930-2011)

Last weekend Pierangelo Garegnani passed away in Rome. He was the main disciple of Piero Sraffa, and one of the most important heterodox critics of the mainstream marginalist (neoclassical) approach. A full account of his contributions to economics is well beyond what I can offer in this space, but here are a few highlights.

As early as 1961, while spending an academic year at MIT, he suggested during a presentation by Paul Samuelson that his results depended on the assumption that all sectors use the same capital-labor ratio. The final results of his critique were presented in Garegnani's paper "Heterogeneous Capital, the Production Function and the Theory of Distribution." His paper shows conclusively that the marginalist theory of value and distribution based on an aggregate production function is untenable. This of course builds on Sraffa's work in the Production of Commodities (PC). By 1966, in the famous Quarterly Journal of Economics (QJE) Symposium, Samuelson had admitted that the neoclassical parable was not defensible.

In his 1976 paper "On a Change in the Notion of Equilibrium in Recent Work on Value and Distribution" Garegnani argued that to avoid the problems associated with the aggregative marginalist model, the mainstream had switched to Arrow-Debreu (AD) General Equilibrium models, which did not use aggregative capital, but also did not assume a tendency to a uniform rate of profit, which implies that it can only be seen as a short run equilibrium. Further, Garegnani later argued that, beyond the problem of being stuck with a short run theory, the AD model was still open to the capital critique, since a notion of aggregate capital was still needed for the equilibration of savings and investment (see his 2003 paper "Savings, Investment and Capital in a System of General Intertemporal Equilibrium").

Garegnani was also the central author arguing that the recovery of the classical theory of value and distribution (and hence Marx) was not incompatible with the Principle of Effective Demand (PED), as developed by Keynes and Kalecki. His two papers in the Cambridge Journal of Economics show that a rejection of the marginalist notion that labor and capital markets tend to full employment depends on the rejection of the mainstream theory of value and distribution, and that Keynes' PED is fully consistent with the old and forgotten classical or surplus approach. He also actively contributed to the extension of the PED to the long run until the end of his life (e.g. his paper with Trezzini).

There are several other contributions, in particular his work on the interpretation of Ricardo and his debates with orthodox Marxists, which again follow in the steps of his teacher. His work is essential for those interested in the understanding of the functioning of capitalist economies, and the incapacity of the mainstream to provide a useful tool to analyze reality.

The meaning of heterodox economics, and why it matters

Heterodox economics is often defined as potpourri of of schools, too many to mention. Further, most of these heterodox schools are defined against marginalism (or neoclassical economics, which is also a fragmented school of economic thought).  In this sense, the heterodox camp is defined in a negative (against orthodox) and fragmented (depending on what aspect of orthodoxy is contested) way.  I think that is a counter productive approach, and that heterodoxy should be seen as a set of principles.  A positive (in its own terms) and unified (in the sense of the minimum set of propositions that are universally accepted) definition of heterodoxy is necessary.

Two things are central from my point of view.  First, heterodox economists are concerned with the amplified reproduction of society, and this implies that the production and distribution of the social surplus is central for their theories.  This is part of a tradition that harks back to classical political economy.  The determinantion of the surplus implies that distribution is determined exogenously by social and institutional conditions (be that the real wage as affected by the bargaining position of the labor class, or the rate of profit as determined by the monetary rate of interest influenced by the central bank).  Further, the determination of surplus, for an externally determined distribution, and a given technology, provides an explanation of relative prices (value).

It is important to note that there are several particular theoretical ways of approaching each of these questions associated to the reproduction of the economy.  For example, some Marxists emphasize that relative prices are proportional to the amounts of labor directly and indirectly needed to produce the commodities.  Sraffa provides a different approach, that is compatible with Marx's views of the working of the economy.  Post Keynesian groups that emphasize the determination of prices according to full cost pricing are also compatible with this general preocupation about the determination of the social surplus.  In other words, several schools of thought are heterodox in the acceptance of the necessity of understanding how the surplus is generated and distributed, even if they have different theories (that are not always compatible among them).

The second essential proposition that defines heterodoxy is related to the theory of output and employment determination.  Heterodox economists believe that output is demand determined.  That is, autonomous spending determines the level of activity.  There are a few implications to this simple proposition.  First, the level of autonomous spending will only generate full employment of productive resources by chance, and unemployment is a permanent feature of the economic system.  Second, as the level of income equilibrates savings to investment, the rate of interest must be a monetary (not real phenomenon). Additionally, heterodox economists argue that effective demand is valid in the long run.

In sum, if one believes that prices reflect, for a given technology, the way classes struggle for higher income shares within the process of reproducing the material conditions for survival (including processes in which there is accumulation), and one believes that output and the process of accumulation are driven by the exogenous forces of demand, one may be called heterodox.

Some other issues are often seen as central for defining heterodox economics.  Endogenous money is a typical example.  And it is true that most, if not all, heterodox economists follow some version of endogenous money theory.  However, it is clear that even if money is not endogenous, the rate of interest is still a monetary variable in heterodox economics (e.g. in Keynes' General Theory).  Also, several mainstream economists have endogenous money, from Wicksell to those using the Taylor rule now. The same could be said about true or non-probabilistic uncertainty.  It is important, but neither the determination of prices of production or effective demand are directly affected by uncertainty.  And several Austrians (hardly heterodox according to the criteria above) are very fond of the idea of uncertainty.  The last additional issue that sometimes is used to define heterodoxy is complexity (or non-ergodicity), but is the least relevant.  The main difference between heterodox and orthodox are related to causality issues, and they can be reproduced in simple or complex theoretical frameworks.

The obvious question that anyone may pose is why does it matter to define heterodox economics precisely.  For example, Colander, Holt and Rosser (CHR) suggest that heterodox economists should not consider themselves heterodox but just economists, and try to influence the mainstream working with the best among the orthodox.  The problem is that logic and evidence can support either prices of production or supply and demand, and, by the same token, either Say's Law or Effective Demand must be wrong.  In economic policy compromise might be possible, but in theory principles cannot be compromised.  I replied to their paper here.

PS: My paper is published in the Journal of Post Keynesian Economics, with CHR's reply (subscription required).