One may consult with quite a few (hundred)  theoretical and empirical sources pertaining to analytical study of economic data and policy. A number of selected publications on different specific subjects of this field were saved to my files according to my study needs. They were used as elementary background literature for  my investigations of East-European economic strategy alternatives. Specifically, macro-economical research on inflation, growth, unemployment and international economics had to go much further than these elementary representations did. Elaborations based partly on these and many other sources are included in the article “Capital, equilibrium, welfare” available in Hungarian on this homepage ( Only a minor part of those sources consisted of textbook chapters. But the latter were the main reading material for  teaching this discipline. From the early 70-ies I used extensively the neoclassical synthesis textbooks and the consecutive editions of „Economics” by P. A. Samuelson and W.D. Nordhaus for my university lectures. A not less correct, but even more didactic explication of the discipline for outsiders was found in Rüdiger Dornbusch’ works. The first divison of the lectures (begun from the 80-ies) presented below heavily relies on selected parts of his book: Open Economy Macroeconomics, Basic Books, New York, 1980. The reedited text of the latter was his contribution to a book written together with Stanley Fisher: Macroeconomics, McGraw-Hill, New York, 1990 (with S. Fischer) 5th ed. A  publication on his major topic deserved my attention because of my involvement in international economics: R.Dornbusch: International Economic Policy: Theory and Evidence, Johns Hopkins University Press, (edited with J. A. Frenkel.)
The second divison of the lectures (from the 90-ties and on) relies on selected parts of the Essential Principles of Economics (hypertext). The latter draws heavily on the above authors. It is an  attempt to express views that are established in the economic research literature, being the main purpose of the said hypertext.



Lectures following Rüdiger Dornbusch’ works



The basic questions in economics-What should be produced? How? and For whom?-have to be decided by society in some way. One way of making these decisions is through the use of markets and the price system. Buyers and sellers in markets, each responding to prices, effectively decide among themselves what gets produced, how, and for whom.
In this chapter we will define markets and see how the responses of buyers and sellers to prices determine what goods are produced, how, and for whom. The framework of analysis is a very general one that can be applied to the markets for cars, labor, and nu#clear reactors as well as the markets for banana splits, haircuts, and baseball players. In each case the interplay between demand (the behavior of buyers) and supply (the behavior of sellers) determines the price and the amount of output produced and sold.
The U.S. economy and most other economies rely heavily on markets to allocate resources. To take only two examples: the quantity of cars produced and their prices
are determined in the market for cars, and the wages of labor are determined in the market for labor. Because of the heavy reliance on markets and prices, the information contained in this chapter is a basic element of economics and a vital tool for the analysis of economic issues. It has to be mastered by anyone who wants to understand the economies in which we live.
At the center of the analysis of the allocation of resources through the price system is the notion of a market. We can readily think of a market as a place where people get together to buy and sell, haggling over the prices of goods such as food, clothing, or jewels. But the term “market” has a broader meaning. A market is a set of arrangements by which buyers and sellers of a good are in contact to trade that good.
Here are some examples. The market for used cars operates with dealers and private sellers on the selling side. Buyers come into contact with sellers by reading newspaper advertisements, by visiting dealers, by looking at notices on bulletin boards, and by hearing from friends about people who want to sell. Some markets, such as the New York Stock Exchange, operate through intermediaries or traders.

Lectures following Rüdiger Dornbusch’ works (2)

Buyers and sellers call in their orders from all over the country and can have the orders carried out within minutes or even seconds. The markets for internationally traded commodities such as wheat or copper work largely over the telephone, with potential buyers and sellers talking to each other from anyplace in the world. Still other examples are auctions, where buyers compete against each other, and supermarkets, where the sellers flll the shelves and post the prices at which the buyers do the shopping.
These situations all describe different setups by which buyers and sellers get together and by which the price and amount to be traded are determined. An auction, where people bid for a good, is clearly dif ferent from a supermarket checkout counter, where prices are read off the boxes, jars, and cans. But once we look beyond the features of a particular market, we will see that all markets have a common, basic economic core. All help determine the answers to the what, how, and for whom questions. They determine why a box of cornflakes costs $2 rather than 20 cents or $20, who will supply cornflakes, and who will buy them. They determine why it is possible for top baseball players to receive over a million dollars a year and top football players much less.
To understand how prices are determined and resources allocated, we have to build up a model of the market. Such a model will enable us to identify the factors that matter in a market-for determining both price and the quantities bought and sold-and the precise way in which they affect price and quantity. Demand and supply are the basic ideas. By “demand” we mean the behavior of buyers. By “supply” we mean the behavior of sellers. This behavior is summarized by the amounts of goods buyers want to buy at each price and sellers sell at each price. We will now set out the determinants of demand and supply.
Demand is the amount of a good buyer want to purchase at different prices. Thus demand is not a particular quantity, say, three six-packs of beer, but rather a description of the amount of beer the buyer would want to buy at different prices for six-pack. In Table 3-1 we take the hypothetical example of fish. The first column shows a range of prices, from $0 (when fish is free) to $7 per pound of fish. The second column shows the quantities demanded by buyers at the different prices. For each price there is a corresponding quantity of fish demanded. When fish is free, the quantity demanded is 50 million pounds. At $4 a pound, the quantity demanded is only one million pounds. The first and second columns together describe demand.
Supply is the amount of a good sellers want to sell at different prices. Supply, too, is not a particular quantity. Rather it is a complete description of the amount sellers would want to sell at different prices. In the third column of Table 3.2 we show the quantities suppliers in the fish market want to sell at the different prices of fish. For each price there is a corresponding quantity of fish supplied. When fish is free the quantity supplied is zero. When the price of fish is $5 per pound, the quantity supplied is 40 million pounds. The first and third columns together describe supply.
There is an important distinction between demand and quantity demanded. Demand describes consumer behavior at different prices. But at any given price, like $2, there is a particular quantity demnanded. Thus the term “quantity demanded” makes sense only in relation to a particular price. The term “demand” describes consumer behavior- the entire relationship between quantity demanded and price-rather than a particular quantity of goods at a particular price.

Lectures following Rüdiger Dornbusch’ works (3)

TABLE 3-1 (see: )



DEMAND, SUPPLY, PRICE – model data)

It is important to make the distinction between demand and quantity demanded and between supply and quantity supplied even though it is not common in everyday language. In everyday language we would say that the demand for football tickets exceeded the supply, so some people couldn’ get in. Not so, the economist would say. Rather, the quantity demanded at the price that was set for the tickets exceeded the quantity supplied. At a higher price the quantity demanded might have been much smaller, and the stadium half empty. There is no change in demand between the two situations even though the quantity demanded changes as the price rises.
The reason for emphasizing the distinction between demand and quantity demanded (and between supply and quantity supplied) is that in economics much of the focus is on finding prices that will balance the quantity demanded with the quantity supplied. To find this balance, it is necessary to allow the price to change. Noting the distinction between supply and demand and the quantities supplied and demanded at particular prices drives home the lesson that prices guide the allocation of resources.
Consider now the demand side. Suppose fish were free. Most households would choose a diet with plenty of fish and relatively little meat or poultry. The quantity demanded of fish would be high. But it would not be unlimited. Nobody would want to eat only fish or have huge amounts of fish lying around the house, possibly spoiling. Table 3-1 accordingly shows that with a zero price, the quantity demanded is 50 million pounds.
Suppose next that the price was $1 per pound. The table shows that the quantity demanded would be lower: only 40 million pounds. Other foods find a larger place in the diet as fish becomes more expensive and households want to purchase less fish, consuming it perhaps only 4 days per week. The table shows that at progressively higher prices of fish, there is an increasing substitution toward other foods. The quantity of fish demanded falls off rapidly; it is down to 10 million pounds at a $4 price and all the way down to zero at $5, where even the most fish-enthusiastic household eliminates fish entirely from the menu. Table 3-1 exhibits the pattern of demand: The lower the price, the higher the quantity demanded of a part cular comnodity.
On the supply side, as the third column of Table 3-1 shows, the opposite holds true. The quantity supplied increases as the price increases. On the supply side we have to ask what persuades people to devote labor and machinery (such as boats and ships) to catching and marketing fish rather than doing something else with their time and equipment. The higher the price at which fish can be sold, the more resources will be used in fishing and the more fish will be of fered for sale. As the price of fish rises, fishermen use their boats more intensively, and new fishermen come into the market. Also, it becomes profitable for sellers of fish to expand their supply by importing fish from other parts of the country and even from other countries.
Accordingly, Table 3-1 shows the quantity supplied rising as the price increases. At a price of zero there will be no fish offered for sale; indeed, the price has to rise above $1 per pound before any fish appears on the market. At $2 per pound there is already some quantity supplied, and the quantity supplied increases further as the price rises. The third column shows supply behavior: The higher the price, the higher the quantity supplied of a particular commodity.
The Market and the Equilibrium Price
In talking about a market, we need to specify not only what is traded in the market but also what area the market covers and the length of time being considered. To be concrete, we will talk about the market for fish in Chicago and about the weekly supply and demand. We will want to know what determines the price of fish and the quantity sold per week.
Consider now supply in relation to demand, and look at Table 3-1. At low prices the quantity demanded exceeds the quantity supplied, and at high prices the quantity supplied exceeds the quantity demanded. At an intermediate price the quantity demanded and the quantity supplied are equal; in other words, there is a price that equates demand and supply. That price is the equilibrium price.
The equilibrium price is the price at which the quantity demanded and the quantity supplied are equal.
Table 3-1 shows that the equilibrium price is $3 per pound. It is only at that price that the quantity buyers want to buy is equal to the amount sellers want to sell. At any price below $3, the quantity demanded is greater than the quantity supplied, and so there is an unsatisfied demand, or a shortage, or excess demand. If the price somehow fell below $3, sellers would want to sell less than the amount demanders would want to buy. Fish would be sold out before everyone who wanted some could buy it. If the price were above $3, however, sellers would want to sell more than the amount buyers would want to buy, and at the end of the day the sellers would be left with un#sold fish. In this situation there is ezcess supply, or a surplus. Only at a price of $3 do the quantities supplied and demanded match; as it is put alternatively, only at the $3 price does the market clear.
Corresponding to the equilibrium price of $3 is an equilibrium quantity, in this case 20 million pounds. That is the amount bought and sold when the market is in equilibrium-when the quantity supplied equals the quantity demanded.
Will the price in fact be $3, and if so, how does the price get there? The price will, indeed, tend toward the equilibrium price because if it is not at the equilibrium level, there is reason for it to change. Suppose that sellers set the price at $5 and correspondingly brought 40 million pounds of fish to market. At a $5 price they would face a zero quantity demanded and therefore find themselves with more fish than they know what to do with. Their reaction would be to lower the price. If the price were below $3-say, at $2-sellers would want to sell only 10 million pounds. Buyers would want 30 million pounds. The sellers would be overwhelmed in the rush for the small quantity of fish. They would react by raising the price and trying to obtain more fish to meet the demand. Only at the price of $3, with the quantities demanded and supplied equal (at 20 million pounds), are there no forces tending to change the price. For that reason we expect the actual price to be close to the equilibrium price.
Of course, on any particular day it is quite possible that the quantity demanded and the quantity supplied are not exactly equal and that the price is not equal to the equilibrium price.
Perhaps there is a sudden increase in the demand for fish and suppliers do not adjust prices quickly enough. In this case they sell out. Or perhaps the weather keeps customers away, and some fish goes unsold. But in each case there is an incentive for the price to change and to move toward the equilibrium price. Thus on the average we expect the price to be at about the equilibrium level.
We have talked about the fish market as if the sellers of fish set the price. But the actual arrangements about who sets the price in any market differ. In some markets there is an auctioneer-an individual who calls out prices until the quantity available for sale is sold. Auctioneers may be found in wholesale markets for fish, in many agricultural markets, or at auctions of household objects or used cars. In other markets prices are set by a process of haggling. The particular methods differ enormously, but in most cases we can think that the price is set so as to equate the quantity supplied and the quantity demanded.1

To summarize the essential points of this and the previous section:
1 Demand is the quantity of a good buyers want to buy at each price. The lower the price, the greater the quantity demanded.
2 Supply is the quantity of a good sellers want to sell at each price. The higher the price, the larger the quantity supplied.
3 The market clears, or is in equilibrium, when the price is at the level at which the quantity demanded and the quantity supplied are equal.
‘ Veteran economists often say that price eduates supply and demand rather than that it equates quantity supplied and quantity demanded. This should be thought of as a way of saving words. But it is not strictly accurate and should not be said until you have been practicing economics for at least 8 years.
4 If the price is not at the equilibrium level, it will tend in a free market to move toward it. On the average, therefore, the price will be at the equilibrium level.

Table 3-1 shows demand and supply conditions in the fish market and allows us to find the equilibrium price and quantity. For further applications we introduce another way of looking at supply and demand, namely, supply and demand curves. (Curves will be shown on special pages.)
We start by drawing the demand curve in Figure 3-1. Prices corresponding to the first column of Table 3-1 are measured on the vertical axis. Quantities, in millions of pounds per week, are measured on the horizontal axis. From Table 3-1, the quantity demanded at a price of $1 is 40 (million pounds). We show this with point A, at which the price is $1 and the quantity is 40. Consider next a price of $4 and the corresponding quantity demanded of 10. This is shown with point B. Clearly we can continue plotting all the prices and the corresponding levels of demand. This is done in Figure 3-l, where we have connected the points to show the demand cuţve.
The demand curve or demand schedule shows the quantity demanded at each price.
Supply conditions are similarly shown by the supply curve or supply schedule.
The supply curve shows the quantity that would be supplied at each price. The points corresponding to the third column of Table 3-1 are shown in Figure 3-2 (for example, price = $4, and quantity supplied = 30 million pounds). Again, the points have been connected.
The demand and supply curves can be combined in the same diagram:



Lectures following Rüdiger Dornbusch’ works (4)


The diagram shows how the prices and quantities demanded specified in Table 3-1 can be translated into a demand curve. The vertical axis measures price and the horizontal axis quantity demanded. We can pick a price in the table, say, $1, and observe the corresponding quantity demanded, 40 million pounds. Point A represents the price-quantity combination. Similarly, point B represents a price of $4 and the corresponding quantity demanded of 10 million pounds. Plotting all the data in the table and connecting the resulting points yields the demand curve, shown as the negatively sloping schedule.
We are going to reexamine the discussion of excess supply, excess demand, and equilibrium. This is done in Figure 3-3. Now we have labeled the demand schedule as DD and the supply curve as SS. When the quantity demanded exceeds the quantity supplied at a given price, the horizontal distance between the demand and supply curves is the excess demand. At a price of $2, for example, the quantity supplied is only 10, and the quantity demanded is 30. There is an excess demand of 20, shown by the distance AB in Figure 3-3. When the quantity supplied exceeds the quantity demanded at a given price, there is an excess supply.
FIGURE 3-2 THE SUPPLY CURVE. The data in Table 3-1 include for each price the corresponding quantity supplied by sellers. The price-quantity curve can be plotted to yield the supply schedule, SS. The supply schedule is upward-sloping, showing that price increases, so does the quantity supplied.
At a price of $4, the quantity supplied and quantity demanded are 30 and 10, respec tively. There is an excess supply of shown by the distance CF.
When there is an excess supply, we say that there is a surplus. Suppliers wan sell more than buyers want to buy. The suppliers will be out looking for customers, but the customers can’t take all thet at the going price, and they do not want to buy as much as sellers would like to sell. When there is an excess demand, we say there is a shortage. Buyers look for sellers hoping to find someone who has the needed goods. But the total quantity demanded exceeds the quantity supplied, and buyers cannot buy as much as they would like.
Price Determination
Now we will discuss price determination.

At point E the market price is such that the quantity demanded by buyers is equal to the quantity supplied by sellers. The market is in equilibrium. At a higher price there is an excess supply or a surplus of the quantity sellers want to sell over the quantity demanded. At a lower price there is a shortage or an excess demand, as the quantity demanded exceeds the quantity supplied.
Sellers find themselves running out of fish before all the customers who want to buy at that price can obtain the quantities they want. The price therefore rises. At any price above $3 there is an excess supply. Sellers find that they cannot sell as much as they want at that price and are left with unsold fish. They therefore reduce the price. Only at point E in Figure 3-3 is there neither excess demand nor excess supply. At point E the quantity demanded at the $3 price is equal to the quantity supplied, the market clears, and there is no reason for the price to change. Thus $3 is the equilibrium price, and 20 (million pounds per week) is the equilibrium quantity.
To get a firmer idea of the determinants of the equilibrium price and quantity, we ask what is behind the data in Table 3-1 and in the diagrams. In concentrating on the relationship between the quantity demanded and the price, we are implicitly assuming that other things are constant. What are those other things? Similarly, in saying that the quantity supplied increases with the price, we are assuming that other things are given, or ceteris paribus. What are the relevant factors that are taken as given?
Three factors are important on the demand side: the prices of related goods, consumer income, and consumer tastes. We now look at each of these factors.

Prices of Related Goods
Changes in the prices of related goods will affect the demand for a good. Let us think about the demand for automobiles and ask what are the other relevant prices that affect the demand for automobiles. One price that matters is the price of public transportation, which is an alternative form of transportation. Another price that is relevant is the price of gasoline, for it affects the cost of using an automobile and therefore the desirability of owning an automobile. How could a change in either of these prices affect the dcmand for automobiles? A rise in the price of public transportation would shift people from using buses and subways to owning and using automobiles. The demand for automobiles increases when the price of public transportation rises. That is, at each given price buyers stand ready to buy more than they did at the same price before. Next consider a rise in the price of gasoline. The increased cost of using an automobile (given other things, including the price of public transportation) would shift people from owning and using cars to using public transportation, bikes, or their own two feet.
In everyday language we think of public transportation as a substitute for automobiles. When people switch away from public transportation, they use instead (or substitute) cars. We can say that using public transportation is a substitute for automobile use because an increase in the price of public transportation leads people to use cars more. Economists use a more exact definition of substitutes, which is introduced in Chapter 5 of the companion volume.2
But the everyday languge certainly gives the right idea of what a substitute is. We can also use everyday language to say that gasoline and cars are complements, for when the price of gasoline rises, people reduce the use of cars. Again, the economist’s definition is slightly different, but the everyday language gives the right idea.
How do these ideas about substitutes and complements relate to the demand for fish? Clearly, other foods (meat, poultry, etc.) are substitutes, and a rise in their prices will shift people toward fish consumption, raising fish demand. It is harder to think of fish complements-commodities whose rising prices would reduce the demand for fish. In some countries where fishand-chips (fried fish and french fries) is a typical dish, one might expect potatoes to
2 In that text we say that using public transportation is a substitute for using cars because an increase in the price of public transportation leads people to use cars more. But does an increase in the price of cars lead people to use public transportation more? Sometimes these questions have different answers. For instance think of sugar and coffee. An increase in the price of sugar leads people to drink less coffee (suggesting that sugar and coffee are complements). But an increase in the price of coffee could increase the consumption of sugar (suggesting that coffee and sugar are substitutes). How could this happen? Suppose that people use more sugar in tea than in coffee. Then when the price of cof fee goes up, they switch to tea and use more sugar. We wouldn’t want to have a definition that says coffee and sugar are substitutes in one sense and complements in another. They should be either substitutes or conlplements. The economist’s definition avoids this difficulty (see companion volume).
be a complement for fish. The difficulty thinking of a complement for fish suggests that goods are typically substitutes and that complementarity, while present many instances, is a more special feature (hats and feathers, coffee and nondairy cream, hammers and nails, screws and screwdrivers).
The second important factor underlying the demand curve, in addition to the prices of other goods, is income. When income goes up, the demand for most goods will increase. But there are exceptions.
A normal good is a good for which deman increases when income rises, inferior good is a good for which demand falls when income rises. Inferior goods are typically goods for which there are alternatives of higher quality or greater convenience. For instance, bus riding is an inferior good. As income rises people reduce their use of buses and switch to taxis or their own cars. Margarine is another inferior good.3 As incomes rise, households buy more butter and less margarine.
The third determinant of demand we take as given is tastes. Consumer tastes are shaped in part by convenience, social milieu and habits. The demand for haircuts is determined in part by social conventions about how long hair should be worn. Demand for textiles to produce skirts depends on fashions and the length of skirts. The health and fitness consciousnes today has expanded the demands for gimn equipment, health centers, natural foods, and tennis facilities while redu-
3 Studies of the demand for margarine show that margarine is inferior. It might be that the concern over amount of cholesterol in the diet has transformed margarine from an inferior good to a normal good. There are not yet enough years of data to show this versatility.
cing the demands for creamy cakes and other rich foods.
Conventions, habits, and tastes are quite stable. They usually change gradually over time (except perhaps for clothing fashions). But when they change, demand behavior also changes.
Along with tastes and habits, new products also affect demand. The invention of new products, such as hand-held calculators, automobiles, personal computers, or light beer, affects demand behavior in markets for related goods-just as changes in the prices of goods do. Indeed, one way of thinking of the introduction of a new good is to say that its price has just fallen from infinity (making it effectively impossible to buy) to an affordable range.

The demand curve is drawn for given tastes, the prices of related goods, and consumer income. What happens to the demand curve when there is a change in one of these factors2 Specifically, looking again at the fish market, suppose there is an increase in the price of beef. Consumners will then shift their purchases of food away from beef and toward fish. At each price of fish, there will be an increase in the quantity of fish demanded. Table 3-2 shows how the demand for fish increases as a result of the beef price
increase. Figure 3-4 shows the same thing with a shift in the demand curve from DD to DD’. At every price iţor fish there is an increase in the quantity demanded, as shown by the rightward shift of the entire demand schedule.
A change in demand conditions changes the equilibrium price and quantity. In Figure 3-5 the demand schedule shifts from DD to DD’. At point E, the initial equilibrium, the price was $3 and the quantity was 20 million pounds. The increase in the price of beef has shifted the demand curve to the right. At the initial equilibrium price of $3, the quantity demanded is now 40 million pounds, shown at point F. There is an excess demand of 20 million pounds at the price of $3. The excess demand leads to an increase in the equilibrium price from point E to E ‘. The price rises to $4, and the equilibrium quantity offish produced and sold is 30 million pounds.
What explains the shift from E to E ‘ P When the price of beef rises, consumers decide to buy more fish. The sellers of fish find themselves unable to meet the new higher quantity demanded, and so they raise the price of fish and at the same time try to obtain more fish to sell. Because the price is higher, it makes sense to work longer hours to bring more fish to market, to import fish from other areas, and for more people to go into the fishing business.

FIGURE 3-4 AN INCREASE IN THE PRICE OF BEEF SHIFTS THE DEMAND CURVE FOR FISH. A rise in the price of beef increases the quantity of fish dernanded at each price. Thus the entire demand schedule for fish shifts to the right. At the $3 price, for example, the de#mand was 20 million pounds originally and is now 40 million. The new demand curve, corre#sponding to the higher price of beef, is DD ‘.
FIGURE 3-5 AN INCREASE IN THE PRICE OF BEEF SHIFTS THE DEMAND SCHEDULE FOR FISH AND RAISES THE EQUILIBRIUM PRICE OF FISH. The increase in the price of beef shifts the demand for fish from DD to DD ‘. At each price the quantity of fish demanded in#creases. At the initial equilibrium price of $3 there is now an excess demand of 20, equal to the distance EF. The equilibrium price there#fore rises, and the equilibrium quantity of fish supplied increases. The new equilibrium is at point E’, with the price equal to $4 and the quantity equal to 30 million pounds per week.
Lectures following Rüdiger Dornbusch’ works (5)
At a higher equilibrium point there is a higher price and a greater quantity of fish sold. We can use Table 3-2 just as easily as Figure 3-5 to find the new equilibrium price of fish. We note that at the old equilibrium price of $3 there is now an excess demand, but at a price of $4, the quantity demanded (30 million pounds) is equal to the quantity supplied at that price. Hence from the table the new equilibrium price is $4, and the new equilibrium quantity of fish consumed is 30 million pounds, as we can also see from Figure 3-5.
The final result of a rise in the price of beef is an increase in the price of fish. Consumers do succeed to some extent in replacing the more expensive beef with fish-the total quantity of fish bought does go up but in doing so, they make fish more expensive. Under these circumstances, consumers feel that the world is against them. All foods will go up in price when the beef price rises, and there is a feeling that there is nowhere to turn for cheap food. That is actually what happens-and by using supply and demand analysis we can understand the reasons.
In the problems section we ask you to show how changes in income and an increase in the price of a complement affect the demand for a good and then how the change in demand in turn affects the equilibrium price and quantity.

In this section we will first explain the upward slope of the supply curve and the factors that are held constant in drawing it. Then we will show how changes in those factors shift the supply curve.
The supply curve shows the quantity of fish supplied rising as the price rises. The curve slopes upward because more resources have to be drawn into fishing in order to increase the quantity supplied. Fishermen have to work longer hours and will have to be rewarded for doing so by receiving overtime pay or higher wages. The firms in the industry will be able to pay these higher wages only if the price received for fish is higher. Or maybe more workers have to be attracted into the industry, and the wages paid in the industry have to rise. Again, firms will be able to pay higher wages only if prices are higher. Or perhaps the machinery used in the industry has to be worked harder, breaks down more often, and needs more maintenance. All these factors explain why the supply curve has an upward slope.
Shifts of the Supply Curve
In drawing a demand curve, we hold constant the prices of related goods, income, and tastes. On the supply side, too, there are three relevant factors affecting supply behavior. They are the technology of the firm; the costs of using the factors of production (machinery, labor, fuel, etc.), or input costs for short; and government regulation and taxation. A change in any of these leads to a shift of the supply curve-that is, a change in the quantity supplied at each price.
The supply schedule is drawn for a given technology. Therefore, changes in technology shift the supply schedule. Specifically, if technology improves, firms will be willing to supply a larger quantity of output at each price level. For example, the introduction of new sonar equipment makes it easier to track fish and therefore increases the catch a given boat can make per week. At each price of fish, firms will be willing to sell more fish, since a given crew and boat will be more productive in bringing in fish. Another improvement in technology that we can think of is the introduction of motherships to supply the individual boats in a fleet with maintenance and process the catch. This change makes it unnecessary for boats to return to the harbor every time a catch has been made or every time there is mechanical trouble.The improvement implies reduced costs or an increased quantity of supply.

The supply schedule in the cost of fuel raises production costs in fishing industry and therefore leads to a decline of fish supply. At each higher price the quantity of fish firms are willing to supply declines.The supply schedule shifts to SS’. At the initial equilibrium price there is now an excess demand. The equilibrium price rises.
Technology as one of the determinants of the quantity of supply must be understood very broadly.In agriculture, for example, it includes techniques and seeds.The invention of new seeds that are less vulnerable to disease orthe weather would clearly be an innovation that increases the quantity supplied at each price. So is the improvement of weather forecasting techniques that make it possible to achieve better timing of harvests or planting.
In industry, too, there is room for changes in technology to affect supply.The invention of robots and their use in the automobile industry to replace more expensive and less reliable human workers leads to cost reductions and quality improvements. These in turn make it possible for firms to increase the quantity supplied at each price.
Input Costs
Input costs are the second determinant of the supply schedule.The supply schedule is drawn for given prices of the inputs (machinery,land,labor) . The inputs affect production costs and therefore the quantity of output firms are willing to supply
at each price. Specifically,an increase in input prices will reduce the quantity of output of the fishing industry at each price. The higher wages will cause the prices shift the supply schedule to the right. The supply curve for fish reshifts when other input costs increase resulting from an increase in the price of fuel.Because fuel costs more, firms will only bring a given quantity to the market.

The third determinant is government regulation. The supply curve shifts under the impact of government regulation.
Government may require to use expensive , nonpolluting equipment rather than less expensive, polluting machinery. As a result, the supply curve will shift to the left.
The scope for regulation to affect supply behavior is very wide. Safety regulations, for example, restrict the technology firms can use or require a minimum number of workers to perform a given task. Government regulations restricting less expensive and possibly more dangerous ways of producing will tend to raise the firms’ costs. Therefore, they will reduce the quantity of output firms are willing to supply at each price. In other words, to supply a given quantity of output, firms subject to restrictions and regulations will require a higher price. Thus regulation will tend to shift the supply schedule to the left.
The government also affects supply behavior through taxes and subsidies. If the government, for example, subsidizes producers by paying them a given amount per unit of output produced, this will have the effect of increasing the quantity supplied in the market at each price. Since the government is paying firms to produce, the firms are willing to sell more at each price, and the supply schedule shifts to the right. On the other hand, if the government imposes a tax on producers of certain goods-for example, cigarettes-then the producers will sell less at each price, since they now have to turn over to the government part of their receipts. Government regulation and taxation have a very important role in the operation of many markets in the U.S. economy. This is the case in agriculture and also in industry.
Other Determinants
On both the demand side and the supply side we have identified three factors that are held constant along a given schedule: the prices of related goods, income, and tastes on the demand side and input prices, technology, and government on the supply side.
These are the main factors included in the “other things being equal” category. But in any particular market there may be other relevant factors that are being held constant when the demand and supply curves are drawn. For instance, the weather affects the demand curve for umbrellas. In a rainy winter, the demand curve for umbrellas shifts to the right. The weather also affects supply curves. Other things being equal, bad weather shifts the supply curve of agricultural goods to the left, reducing the quantity supplied at each price.
In studying any particular market we isolate the factors that, in that market, may cause the supply and demand curves to shift. The factors we have mentioned are crucial in almost all markets.

The Effects of Shifts of the Supply Curve
We will now use demand and supply curves to study the effects of shifts of the supply curve on equilibrium price and quantity. The shifts result from changes in input prices or changes in technology. Suppose an increase in the cost of fuel used for fishing boats increases the costs of fishing and shifts the supply curve from SS to SS ‘ in Figure 3-6. The equilibrium in the fish market moves from E to E ‘. The price rises from Pa to P1, and the equilibrium quantity falls from Q o to Q,.4 Thus an increase in the price
4 Note that Figure 3-6 is different from the earlier diagrams in this chapter in that we have not put the units on the vertical and horizontal axes. The reason is that we want only to ask whether a shift in supply caused by a cost increase increases or decreases the equilibrium quantity and price. We do not need to know the exact numbers that apply at E and E ‘. It is enough to call the prices Po and P, and to know that the price rises-we can see that P, is greater than Po. Similarly, we call the quantities Qo and Q” and we are not interested in the exact size of Qo and Q, . All we really need to know is that Q, is less than Qo, implying that an upward shift in the supply curve reduces the equilibrium quantity. It is not necessary for answering most of the interesting questions to put numerical values on the axes. Usually we want only to know whether some price or quantity goes up or down when there is a change.

Lectures following Rüdiger Dornbusch’ works (6)
We illustrate the use of supply and demand analysis with an application that concerns tastes, the Pope, and the price of fish.5 Up to 1966 Catholics were not allowed to eat meat on Fridays, and they tended to eat fish. In 1966 the Pope allowed Catholics to eat meat on Fridays. What happened to the price of fish? This section draws on an interesting article by Frederick W. Bell, “The Pope and the Price of Fish,”American Economic Review; December 1968. You may want to refer to this article for some details.
FIGURE 3-7 EFFECTS OF A REDUCTION IN THE DEMAND FOR FISH. A change in habits reduces the demand for fish. At each price of fish the quantity demanded declines. The demand schedule shifts from DD to DD’. The excess supply of fish at the initial equilibrium price, Po, leads to a fall in price and a reduction in the quantity of fish supplied. The new equilibrium is at point E’, where the price has fallen to P, and Q, fish is consumed.
Figure 3-7 shows the now standard supply and demand curves. As a result of catholics being allowed to eat meat on Fridays the demand for fish falls. The demand shifts down to DD’, the equilibrium to E’, and the equilibrium price and quantity of fish fall. And that is in fact what happened.

Sometimes it is not possible to adjust price to equate the quantity demanded and the quantity supplied. This is the whenever there are price controls in a particular market.
Price controls are government rules or laws that forbid the adjustment of prices to clear markets.
Price controls may take the form of offer prices (minimum prices) or ceiling (maximum prices). We will see controls, for example, or other price measures affect the operation of markets. In p lar, we will see how they create a disequilibrium between quantities supplied and demanded, leaving shortages or excess supplies. Whenever price controls are in and therefore prices cannot be freely adjusted, we say that markets are not free.
Price ceilings are laws or rules introduced by the government in a particular field that make it illegal for sellers to charge more than a specified maximum price. Price ceilings are typically introduced by governments when a shortage in a market tends to raise prices. The higher prices reduce the living standard of those who buy the good. Price controls are frequently established for such goods as food and housing, for increases in the prices of these goods would have especially serious impact on the poor. These people cannot do without these goods, but they cannot pay higher prices for them. Price controls thus seem to be an attractive solution, but how do they work? In Figure 3-8 we look again at the fish market of Figure 3-2 and Table 3-1 and assume that the government has imposed a ceiling price of $2. Sellers are prohibited from selling fish at a price higher than $2.
At the ceiling price, the quantity demanded exceeds the quantity supplied. There is an excess demand for fish equal to the distance AB, or 20 million pounds. In the absence of controls, the price would rise, thereby reducing the quantity demanded and increasing the quantity supplied. In the presence of controls, however, demand is encouraged by the relatively low price, while supply is discouraged. Accordingly, there is an excess demand. The quantity of fish actually sold at the $2 price, shown by point A, is 10 million pounds. Thus the effect of the price control is to create a shortage. The price is held below the level that would clear the market.
Although a higher price would clearly hurt those consumers who can not obtain fish, it is also true that it would increase the quantity of fish supplied. Some of the consumers who now go without fish would be able to buy fish. Further, the existence of excess demand means that some form of rationing has to be used to allocate the available fish. The rationing rules themselves may be arbitrary. For instance, the sellers may make fish available to their old customers and keep new customers out, or perhaps everyone will get the same amount of fish but a reduced amount.
The effect of price controls in creating shortages is common all around the world. Many cities in the United States impose rent controls. These limit the rents landlords can charge. If the rent controls are very tough, not allowing the landlord to raise rents when the costs of maintaining the building go up, the building can be-
FIGURE 3-8 EFFECTS OF PRICE CONTROLS. The government imposes a ceiling price of $2. No seller is allowed to charge more than $2 per pound. At that price the quantity supplied is given by point A (10 million pounds), but the quantity demanded is 30 million pounds, as shown by point B. The distance AB represents the 20-million-pound excess demand for fish. The available fish must somehow be rationed.
come unprofitable. The costs of running it might be larger than the rents that are allowed. In such cases owners often abandon the buildings and let them deteriorate. The South Bronx, in New York City, is the scene of widespread abandonment of buildings. Tough rent controls lead to the disappearance of rental space and start hurting everybody. Milder rent controls-rent controls that allow rents to rise enough so that landlords can look after their property but not to a level that prevents a shortage of housing favor people who already have a low-rent apartment and hurt those who are seeking a place to live. Rent controls also reduce the incentives for building new houses.
Gasoline price controls were in effect in the United States at the time oil prices jumped in 1973. With the price of gasoline controlled and a reduction in the quantity of oil supplied by foreign producers, lines formed at gas stations. The gas stations were not open long hours, since there wasn’t much to sell anyway. Eventually gasoline prices were allowed to increase, and the shortage disappeared.
Another example illustrating the problem of disequilibrium prices – prices that create shortages or surpluses- is given in Figure 3-9. Here we look at the consequences of a floor price. The idea is that the price will be kept above a minimum, or floor, price of $5 so that producers will be guaranteed a certain level of profits on their sales. A floor price is typically introduced by the government or sometimes by an agreement between producers in order to raise the profitability of an industry.
Consider now how a floor price of $5 works. At the $5 price, the quantity demanded is Qo and the quantity supplied is Qs. There is an excess supply equal to Qs
FIGURE 3-9 A MARKET WITH A FLOOR PRICE. The government imposes a floor price of $5. At that price, the quantity supplied is given by point B on the supply curve and is equal to Qs. The quantity demanded at point A on the demand curve is equal to QD. The floor price leads to an excess supply and the need for the government to support the price by buying up the surpus, AB. minus QD, or the distance AB in Fi, Suppliers want to sell more than buyers want to buy. If the price were free the suppliers would cut the price.
Some other mechanisms may be found for allocating supplies and buyers.
One mechanism that is often used by the government is to buy up the excess supply. Thus the government establishes floor price and buys any amount that buyers will not buy. U.S. dairy product ports work this way. The U.S. government guarantees specific prices for those products and buys up excess supply of them. Every now and then the question arises of what to do with the stocks government has bought. At Christmas l U.S. government decided to dispose of million pounds of cheese that it had It disposed of the cheese by giving it to poor people.
The U.S. government is certainly the only government that has built up large stocks of agricultural products, particularly dairy products. The European Common Market countries have for years been buying dairy products at floor prices and then trying to figure out how to get rid of them all.
A key feature of our model of the market and of price determination is the assumption that buyers and sellers respond to prices. The demand and supply schedules that we have drawn show that a decline in price leads to an increase in the quantity demanded and a decrease in the quantity supplied. But is there evidence that buyers and sellers respond to prices2 Here are some striking examples.
Table 3-3 shows the behavior of the market for refined sugar in the period 1972-1979. From 1972-1973 to 1974 -1975 an increase in the world price of sugar doubled the price to U.S. consumers. Accordingly, the quantity demanded of sugar declined from 1972 to 1975.
In everyday talk we refer to an increase in demand; we do not make a distinction between shifts of the demand curve and movements along the demand curve. The accompanying figure shows that from point A on the demand curve DD there are two quite different “increases in demand” that are possible. One is an increase in the quantity demanded, moving along the demand curve from A to B. This increase in the quantity demanded results from consumer adjustment to a reduction in price.
But there is also the possibility of a shift in demand. The entire demand curve shifts to DD`. At the going price, Pa, the consumer initially purchases Qo, but a shift in demand now increases the quantity demanded to Q’ units. Such an adjustment represents the response to an increase in the price of substitute goods (increase in the demand for tea because of higher coffee prices), the response to an increase in income, or a change in tastes and habits.
The distinction between the two kinds of demand change must be kept in mind. The movement along the demand curve represents a consumer adjustment to changes in the market price. A shift in demand, by contrast, represents an adjustment to outside factors (other prices, income, tastes) and leads in turn to an adjustment in the equilibrium price.
The same distinction between movement along a schedule and a shift arises on the supply side. Sellers adjust to an increase in price by a movement along the supply schedule. But changes in factor prices, changes in technology, or other determinants of supply lead to shifts of the supply schedule.
A demand schedule is drawn for given prices of related goods, income, and tastes. Thus a decline in price, with other things being constant, will increase the quantity demanded. The same language applies to the supply side. An increase in price, with other things being constant, will increase the quantity supplied.

Lectures following Rüdiger Dornbusch’ works (7)
An example: the shift of the demand curve for tea
When the price of coffee dropped back toward the initial level, accordingly, the quantity demanded increased. The increase in the equilibrium price of coffee should have affected the demands for other goods and thus spread to other markets. We would have expected the demand for tea, which is a substitute for coffee, to shift. The quantity of tea demanded at the given price of tea should have risen. Thus there should have been an increase in the price of tea and an increase in the quantity of tea consumed. In fact, this is what happened. The quantity of tea consumed in the United States in 1977 was slightly higher than the quantity consumed in 1976. The price of tea in 1977 was nearly double the price in 1976.
Thus the increased price of coffee shifted the demand curve for tea, leading to a higher price for tea and a higher quantity demanded.
The other example we will consider involves technological innovation and cost reductions on the supply side that work to shift the supply schedule. We will take the case of digital watches. Table 3-5 shows the relevant data.
The price of digital watches declined from $76 to only $33 between 1975 and 1979. The reduction in price led to an increase in the quantity demanded from 4.2 million watches to 19.7 million. Once again, demand is seen to be responsive to price.
The free market is one method to solve the three basic economic problems What is produced? How? For whom?
This chapter has shown how supply and demand, determine price and output and explain how supply and demand through markets solve economic problems.
In Figure 3-I 1 we show a demand schedule and a supply schedule at point E, the equilibrium price and the equilibrium quantity. The free market “decides” how many of a particular good to produce by price at which the quantity equals the quantity supplied.
FIGURE 3-11 THE FREE MARKET AN BASIC ECONOMIC QUESTIONS. The free market price is P0, and the equilibrium quantity supplied is Qa. Consumers who are able to pay at least Po per unit will receive the output; consumers who are willing to pay 0 receive none.
The quantity amount depends both on the position of the supply schedule and on the position of the demand schedule. If at each price consumers demanded a larger quantity, DD would be located farther to the right, and the equilibrium quantity would be higher. If at each price the quantity supplied were lower, the supply schedule would be farther to the left, and the equilibrium quantity would be lower. Thus the free-market answer to the question of how much of a good to produce is determined by both supply and demand conditions. Other things being equal, more of a good will be produced in market equilibrium the higher the quantity demanded is at each price (the farther to the right the demand schedule) and the higher the quantity supplied at each price (the farther to the right the supply schedule).
The free market tells us for whom the goods are produced. They are produced for all those willing to pay the price Po per unit of the good. The free market also tells us how goods are produced, but to understand the answer to that question we have to learn more about the production side of the economy.
It is worth emphasizing that although the free market solves the basic economic problems, its answers may be controversial. The free market does not provide enough food for everybody to go without hunger, and it does not provide enough medical care for everybody to be healthy. It provides enough food for those willing and able to pay, and it also provides enough medical care for them. The answers given by a free market, therefore, may differ very radically from what society may want to see as an allocation of resources. It is for this reason that government intervention in the free market through regulation, taxation, and the redistribution of income is so pervasive throughout the world.
1 Demand is the quantity ofa good buyers want to buy at each price. The lower the price, the greater the quantity demanded. The demand curve shows graphically the relationship between price and the quantity demanded. It slopes downward.
2 Supply is the quantity of a good sellers want to sell at each price. The higher the price, the larger the quantity supplied. The supply curve shows the relationship between price and the quantity of the good sellers want to sell. It slopes upward.
3 The market clears or is in equilibrium when the price is at the level at which the quantity demanded and the quantity supplied are equal. This is the point at which the demand and supply curves intersect. At prices below the equilibrium price there is an excess demand (or a shortage), and this tends to raise prices. At prices above the equilibrium price there is an excess supply (or a surplus), and this tends to cause prices to fall. Thus in a free market, prices tend to move toward the equilibrium level.
4 The factors that are assumed to be constant along a given demand curve are the prices of related goods, consumer income, and consumer tastes and habits.
5 An increase in the price of a substitute will increase the quantity of a good demanded at each price, and an increase in the complement will reduce the quantity demanded. An increased income increases the demand for the good if the good is normal, an increase in income reduces the demand for a good, if the good is inferior.
6 The main factors determining the position of the supply: technology, input costs, and government regulation and taxes: increase in input costs will reduce the quantity supplied. Any factor increasing demand causes the demand curve to move to the right and increases both the price and the quantity being sold. Any factor reducing supply causes the supply curve to move to the left, increasing price and reducing the quantity bought.
Demand Supply
Quantity demanded
Quantity supplied Equilibrium price
Excess demand (shortage) Excess supply (surplus) Equilibrium quantity, Substitute,
Normal goods, Inferior goods,
Shift of demand curve. Shift of supply curve,
Free market Price controls
Floor price
Ceiling price
Movement along demand curve


Lectures following Rüdiger Dornbusch’ works (8)

It seems clear that the government, by its actions, has the potential to affect major macroeconomic variables such as unemployment and inflation. For instance, if the government increases its demand for goods, it adds to the total demand for goods and services and probably increases output and unemployment. But at the same time it pxobably increases the price level. Or if the government increases taxes, leaving people with less to spend, that probably reduces demand, output, and the price level.
Economic pollcy consists of government actions to affect the economy. The variables the government adjusts in carrying out economic policy; such as tax rates and government spending, are called policy variables; or policy instruments.
Partly because it is closely related to policy – to questions of what the government can do-macroeooţomics is an area where there are disagreements among economists. Frequently, this disagreements result from differences in value judgments. As always, we should be on guard for these in reading any economist’s advice about macroeconomic policy. But sometimes there are disagreements on positive economics, for instance, on what happens to total production and inflation when the government cuts taxes. Here‚ we have to make up our minds on the basis of theory and data.
In presenting macroeconomic theory and evidence, we do not go out of our itinery to focus on controversies. Where there are differences of opinion on issues that matter; we mention and explain them. But most of the macroeconomics section develops the widely agreed-on solid core of the subject.

The economy is made up of many independent units: millions of households and millions of firms (and federal, state, and local governments, which we leave out of he picture for a while). Households decide how much to buy and how much to work. Correspondingly, firms decide how much to produce and sell and how many people to hire. Together, these decisions by all households add up to the economy’s total spending, and the decisions by all firms add up to the economy’s total level of production. We now develop this interdependence between individual decisions and the total, or economywide, levels of spending and production.
Table 4-2 classifies the different transactions between firms and households in the economy. Households own the firms, which in turn own machines, buildings and equipment, and raw materials and other goods used for production.
Goods and services useful in production are called factors of production. They include, in particular, labor, machines, office and factory buildings, and land. Ultimately, all factors of production are owned by households, either indirectly through firms or directly as in the case of labor.
Table 4-2 provides a simplified picture of the transactions in the economy. Here are some of the simplifications. First, we have omitted the government, which is neither a household nor a firm but does play a role in the economy.
(… omitted)
Second,we show firms selling goods to other firms, flow of services of factors of production. For instance-,IBM sells computers to other firms matched by income not only to households. Third,we have not specified whether we are talking about the firms or households paying from their incomes.
All these points matter,but fortunately they are easily accounted for once we have the simple straight ideas about flows of goods and incomes. In Table 4-2 the top two entries describe the fact that households ultimately own all factors of production and that firms use those factors to produce goods and services. The middle entries show that in exchange for providing factors of production for use by the firms, the households receive incomes,primarily as wages and profits. The households in turn use their incomes to buy the goods produced by the firms,which therefore can pay for the factors of production they use. Figure 4-1 shows the interactions between households and firrns.First we draw attention to the flow of the services of factors of production from households to firms, from which the households receive incomes in exchange. … (10 lines omitted)
Figure 4-1 is called a circular flow diagram, because in each loop there is a circular flow starting at any point and coming back to it. …The top half shows how the economy willing to work cannot find services of factors of production to produce goods and services. If the firms cannot find buyers then the shelves are filled with unsold goods.

The firms are unable to continue production as before and hire fewer people. People lose their jobs and become unemployed.
What happens next? The economy has to find some way to put people back to work. There is a problem here because the people who have lost their jobs will have less income to spend, as we see fţom Figure 4-1. Thus firms will be able to sell even less, and that seems to make the unemployment problem worse.
Here we face a basic question of macroeconomics. If people become unemployed because firms cannot sell all the goods they are producing, what gets the economy back on track? How do we avoid a continuing fall in production and employment? We shall see that there are mechanisms ‘that get the economy back on track; including changes in wages and prices, and govemment policies, but that these mnechanisms may work quite slowly..
Unemployment is, of course, a problem for the people who cannot get jobs. But it is also a problem for society, because it means society is wasting its scarce labor. Figure 4-2 showed the production possibility frontier that was introduced in Chapter l. When there is unemployment, society is not on the production possibility frontier but rather is operating at an inefficient point; such as G, inside the frontier. One of the basic questioms in macroeconomics is why society sometimes has very high unemployment and thus wastes resources.
Although the term “unemploymerit” is usually reserved for labor, other factors of production such as machinery and factories are sometimes not used even though they are available for production. They too can be described as unemployed. The basic macroeconomic question of why society sometimes has high unemployment of labor extends also to the question of why society sometimes (usually at the same times that labor is uriemployed) wastes resources

FIGURE 4-2 UNEMPLOYMENT AND THE PRODUCTION POSSIBILITY FRONTIER. The frontier shows combinations of output at which the economy is fully employing its labor. When there is unemployment, the economy is producing at some point such as G and wasting resources. One of the basic questions in macroeconomics is why the unemployed are not put very quickly back to work producing goods and services that people would like to consume.
Suppose that the firms in the economy are producing a given amount of goods and that everyone is working. The economy is producing on the production possibility frontier. Now consumers decide that they would like to spend more than they used to. They demand more goods from the firms. Firms cannot produce more goods because all resources in the economy are fully employed.
Something has to give. To start with, firms may put “sold-out” signs in the windows or put customers on waiting lists. But they will also raise prices, trying to reconcile the scarcity of goods with the households’ increased demand for goods. Inflation here results as firms raise prices in response to households’ demands for more goods than can be produced.
The decisions of firms and households, affecting one another through their interactions are described in Figure 4-1.

The essential difference between macroeconomics and microeconomics consists in the interactions described in Figure 4-1. The fact that firm and household decisions are made independently is not unique to macroeconomics. Going back to the supply-demand analysis of the fish market in Chapter 3, we see that the decisions about how much to supply and how much to demand are made independently by suppliers and demanders. But macroeconomics is different in that firms’ decisions about how much to produce determine the incomes of households and therefore their spending. Those interactions, or feedbacks, which are unimportant in microeconomics, are the essence of macroeconomics; they are illustrated by the circular flow diagram in Figure 4-1.
We follow up this overview of macroeconomics problems with a look at the facts. The following sections present definitions and a discussion of recent experience with inflation, growth, and unemployment.

In Chapter 2 we introduced price indices as measures of the oost of buying a specified basket of commodities. In particular, the CPI represents the price of a basket of 224 goods and services, each of which receives a weight that was determined by studying the spending behavior of more than 20;000 families. Weights for broad categories of goods were given in Table 2-7. Table 4-3 shows the CPI, with base 1967 =100, for selected years.
In 1981, for example, the value of the CP,I -was 272.4. With the base year 1967 =100, this means the cost of buying the basket of goods and services in the CPI…
was 2.724 times as high in 1981 as in 1967. Prices had, on average, nearly tripled. Similar comparisons can be made with earlier years. For instance, looking back to 1929, which is not shown in the table, we find the CPI equal to 51.3. With the CPI at 100 in 1967 and 51.3 in 1929, the costs of goods bought by the typical consumer about doubled from 1929 to 1967. Thus we see that prices of goods in general have risen threefold since 1967 and sixfold since 1929.
In Chapter 2 we also discussed the inflation rate.
The inflation rate is the percentage rate per period that prices are increasing. Normally we talk about annual inflation, but we can also look at inflation rates between months, quarters, or decades. Table 4-3 reports the annual inflation rates of the prices of the goods represented by the CPI.
We briefly recall how ţhe inflation rate is calculated. Suppose we want to figure out the inflation rate, or the growth rate of prices, between 1979 and 1980. This inflation rate is reported in the table as the entry for 1980. Inflation for 1980 is the percentage change in prices, or the growth rate of prices, from 1979 to 1980. It is calculated as in equation (1)
The 1929 index does not measure the cost of exactly the same basket of goods as the current index, but the costs of goods bought by consumers can still be approximately compared from CPI values at different dates.

Lectures following Rüdiger Dornbusch’ works (9)
Growth, unemployment, inflation
(Introduction to macroeconomics continued)
The unemployment rate is one of the chief indicators of how well the economy is doing. When the unemployment is high and rising, the economy is performing poorly; human resources, instead of being used productively, are wasted.
The labor force consists of people who are either
working or unemployed. The criterion for being counted as unemployed is that a person was available for work in the currentweek, did not actually work, and had made an effort in the preceding 4 weeks to find a job. Also included are people who are not working but are waiting to be called back to their jobs or are waiting to report to a new job the next month.
Table 4-7 shows the unemployment rates for different groups in 1980 and 1981 (omitted). Note the large differences. Unemployment tends to be much higher among nonwhite people and young people. Note the fact that unemployment increased in every group. We shall link inflation, and unemployment to low growth and recession in the following.
Inflation and growth
FIGURE 4-7 RECESSIONS AND INFLATION,1967-1981. The diagram shows the rate of CPI inflation in the United States (omitted). The shaded areas correspond to periods of recession. The evidence is that recessions slow inflation but do not stop it for good. (Source: See Figure 4-4.)
In a recession firms have trouble selling goods. They therefore pro duce less, and growth slows. At the same time, unemployment rises as firms need less labor and because firms are having trouble selling. Their prices rise less rapidly or even fall. In brief, the argument is that recession, low growth, high unemployment, and slower inflation go together. In contrast, when households want to increase their purchases, firms try to produce more goods and hire more labor. Growth increases, and unemployment falls. At the same time, because the demand for their goods has risen,firms raise prices more. Thus we expect a boom, high growth,low unemployment, and more rapid inflation to go together.
Some of these relationships can be seen in the data. Figure 4-7 (omitted) shows the rate of in flation again, except this time we have shaded in periods of recession, or falling output. We observe that when the economy is in a recession and shortly thereafter, inflation falls. Thus both in 1975 and again in 1980 recessions slowed inflation.
Some economists believe that there are no very good reasons for people to worry much about inflation and that therefore society should not do so either. Others argue that there are reasons, including increased uncertainty, why people get upset about inflation. We shall review the arguments later.But it is clear that whether or not there are good reasons, people regard inflation as a
serious problem.
Unemployment and growth
A second strong relationship exists between unemployment and growth. When  the economy grows rapidly, unemployment rates fall. When the economy grows very  slowly or even moves into recession, unemployment rates increase. This means that several years of successive high growth bring unemployment rates to very low levels as more and more people find jobs while production is increasing. In contrast, when real GNP is not growing much or is even falling, firms increase their employment of labor slowly, and unemployment rates increase. The high unemployment rates in 1982 are a reflection of the very low  growth rates of real GNP.
(Average Annual Percentage Rate)
Inflation :
1960-1973 3.2 5.1 3.3 6.1
1973-1981 9.4 15.4 4.9 9.0
1960-1973 5.0 2.9 0.8 1.3
1974-1981 6.9 6.3 3.2 1.2
Growth rate of real GNP:
1960-1973 4.2 3.2 4.8 1 0.5
1973-1981 2.4 0.5 2.0 4.0
Source: Economic Report of the President, 1982, pp. 355-357.

(by Dornbusch, 1982)
l Macroeconomics is the study of the operation of the whole. The major macroeconomic issues are inflation, unemployment and growth and whether there is anything the governments can do about them.
2 Macroeconomics is distinguished from microeconomics by
the interactions between the decisions made by firms and households
as summarized in Figure 4-1. Households supply the factors of production to firms, which use them to produce goods and services. In return for the services of the factors of production firms pay incomes to households, which are used by the households to buy the goods and services produced by the firms.
3 A reduction in purchases of goods by households can reduce employment of labor, reducing households’ incomes, thereby reducing spending on goods and services. An important question to be studied is what mechanisms exist to prevent these from developing into major problems.
4 Growth is an increase in the production of goods and services. Growth may occur either when unemployed resources are put to work so that the economy moves from inside the PPF to it when the PPF itself shifts out. The PPF may shift either by using more factors of production or because existing factors come more productive.
5 The inflation rate is the rate at which prices of goods and services are rising. In the United States the inflation rate started out around 1 percent in the sixties and have been above 13 percent since then. By international standards American inflation has been low. Prices may also fall sometimes, in that case there is deflation.
6 A country that has faster growth than another country will eventually have a larger real GNP, however far behind it was earlier.
7 Unemployment in the U.S. economy has risen on from the late seventies. In 1982 it stood at the highest level in the post II WW period. Unemployment rates differ sharply among different countries. Youths and blacks have particularly high unemployment rates.

Lectures following Rüdiger Dornbusch’ works (10)
National accounting
(shortened version)
Gross national product (GNP) is the total value of the economy’s output or production in a given period, such as a year. GNP is widely used as the basic measure of the performance of the economy in producing goods and services.
The circular flow diagram (Figure 4-1) showed that the economy’s output of goods and services generates the incomes received by owners of factors of production, because payments for purchases of goods and services eventually end up as wages and profits for the people who produce the goods . National income is the total income received by the economy’s factors of production. We study national income accounting in part because it provides us with definitions and measures of GNP and national income. But we also study it because it is necessary for our analysis of the determination of the levels of output, income, and employmentin later chapters. The tasks of this chapter is to show how national income is related to GNP.
This chapter starts by carefully deflning GNP and describing how it is measured. Then we focus on two important sets of relationships. First, there are the links between GNP, or output, and the incomes earned in the economy. Second, there are the links between expenditures on goods and services and the value of output produced. These relationships, too, are shown in Figure 4-1. The accounting relationships between output and income and between expenditures and output are the foundation for our first model of income and output determination, which will be set out in Chapter 6.
The measurement of GNP and the links among GNP, income, and spending take up most of this chapter. We also want to know how accurate our measurements are and for what purposes they are used. The chapter ends with a discussion ofthe uses made of GNP data, emphasizing the distinction between nominal and real (inflation-corrected) GNP and mentioning some shortcomings of GNP as a measure of the economy’s total output.

Gross national product is the market value of the goods and services produced within a given period by domestically owned factors of production.
We avoid double counting by focusing  on each firm’s value added. Value added is the increase in the value to be counted in GNP. But some of goods resulting from production output is not sold. Value added is calculated by deducting  from the value of the firm’s production the cost of the bought produced goods or raw materials and other inputs.
Table 5-1 illustrates this for the case of an automobile producer. Total sales by that producer were, say, $10 billion.  (Tire producer in parentheses)
$4 billion represents the value of the steel, tires, plastics, electricity, and other produced goods that were bought by the carmaker for use in automobile production; these are also called intermediate owners’ services goods. Deducting the cost of the intermediate goods, we see that the automobile producer’s value added was $6 billion.
AUTOMOBILE PRODUCER                                        (  TIRE PRODUCER
Value of goods produced $10 billion                     Value of production $350 million
Less: Cost of purchased                                                Less: Cost of purchased produced inputs
produced inputs
(steel, tires, (rubber, cord
electricity, etc.) 4 billion                                              150 million
Equals: Value added $ 6 billion                                  Equals: Value added $200 million)
Volunteer services, the value of housework, and do-it-yourself activities are not included because it is difficult to estimate the value of production located in the domestic economy, whoever owns them. Also excluded from GNP is the
value of illegal activities, such as illegal  gambling, and production that is concealed to avoid taxes. For instance, when a handyman asks to be paid in cash, it is quite likely  that the value of the service he performed will never be counted in GNP because he  will not report the payment as income. Such activities are part of what is called the underground economy, or the part of the economy that escapes the official statistics. Some  economists have estimated that the output of the underground economy is as much as  one-quarter of official GNP, but most estimates are closer to 3 to 5 percent of GNP.
Another point to note is that it is the value of goods currently produced that is part of GNP. Transactions in existing assets, for instance, houses, are not included. The value of an old house when it is sold is not a current productive activity of the economy, and so the value of the house is not included  in GNP. We would, though, include the
value of any brokerage services associated with the purchase and sale of the house, since the broker adds to the current output  of the economy by bringing buyer and seller  together. By comparison, when a new house is built, the value of the house is counted in GNP.
Finally, GNP measures the value of output produced by domestically owned factors of production. Part of the GNP is produced abroad. For instance, the income earned by an American working in Paris is part of U.S. GNP. Similarly, when an American company owns a factory in Germany and receives profits from its operation, those profits count as part of U.S. GNP. By the same argument, the income earned in the United States by factors of production owned abroad is not part of U.S. GNP.
(Thousands of 1979 Dollars)
GNP statistical estimates are made in two ways.One is obtained from the produce value,the other is obtained from the incomes earned by people.We recall from Figure 4-I that production and the value are closely related.
Bangladesh 90
China 260
EI Salvador 670
Syria 1,030
Argentina 2,230
Hungary 3,850
Italy 5,250
United States 10,630
Switzerland 13,920
Kuwait 17,100
Source: World Bank, World Development Report, 1981,
pp. 134-135.
Some of the numbers are hard to believe. Whereas per capita income in the United States was above $10,600 in 1979
in Bangladesh it was only $90. Americans could not live on so low an income. Probably the value of output produced in Bangladesh is above $90, because some output is produced by farmers who consume their own crops. But the GNP is so
low that people starve, and ill health leads to early  death. At the other end of the scale is Kuwait, whose oil production leads to per capita GNP being 60 percent higher than that in the United States.
l Macroeconomics is the study of the operation of the whole. The major macroeconomic issues are inflation, unemployment and growth and whether there is anything the government can do about them.
2 Macroeconomics is distinguished from microeconomics by taking into account the interactions between the decisions made by firms and households as summarized in Figure 4-1. Households supply the factors of production to firms, which use them to produce goods and services. In return for the services of the factors of production firms pay incomes to households, which are used by the households to buy the goods and services produced by the firms.
3 A reduction in purchases of goods by households can reduce employment of labor, reducing households’ incomes
thereby reducing spending on goods and services.  a most  important question to be studied is what mechanisms exist to prevent these from developing into major problems.
4 Growth is an increase in the production of goods and services. Growth may occur either when unemployed resources are put to work so that the economy moves from inside the PPF to tl when the PPF itself shifts out. The PPF may shift either when there are more factors of production or because existing factors come more productive.
5 The inflation rate is the rate at which prices of goods are rising. In the United States in the last 20 years prices have arisen. The inflation rate started out around 1 percent and has been above 13 percent since then. By international standards inflation has been low. Prices may also fall sometimes, in this case there is deflation.
6 A country that has faster growth than another will eventually have a larger real GNP, however far behind it started.
7 Unemployment in the U.S. economy has risen on from the seventies. In 1982 it stood at the highest level in the post
II WW period. Unemployment rates differ sharply among different countries. Youths and blacks have particularly high unemployment rates.

The focus in the growth debate has not been on increasing the number of workers as much as it has been on capital and technical change.
The Role of Capital
How much can be expected of capital growth as a means of increasing the growth rate of output? Studies of the rate of return to capital in the United States show it to be about 12 percent for the economy as a whole. That means a dollar invested today will return 12 cents per year (after adjusting for inflation) in later years. Equivalently, if I percent of GNP is added to the capital stock, output next year should be higher by 0.12 percent of GNP. Thus if 4 percent of GNP is added to investment, output will be higher by about 0.5 percent of GNP.
Given that the GNP growth rate fell 1.5 percent in the last half of the seventies, it seems that investment could do a lot to improve the situation, taking us back toward the better growth performance ofthe sixties.But first we have to ask how large 4 percent of GNP is. The answer is that it would take a lot to get the share of investment in GNP to rise 4 percent. Gross investment in plant and equipment is now about 10 to 12 per cent of GNP. Thus an increase equal to 4 percent of GNP means increasing investment by nearly 40 percent. This is a very large increase that would be difflcult to achieve.
The message on investment, then, is mixed. There is no doubt that increased investment increases the economy’s growth rate, but it would take a lot of investment to get the growth rate to increase rapidly. That certainly does not mean that policies to encourage investment are wrong or would not increase growth. It does mean, though, that the role of investment should not be exagegerated. More investment would increase growth, but it is not a magical process.


Costs, profits, inequality, efficiency

Fixed and Variable Cost
Variable costs are costs that can be varied flexibly as conditions change. In the John Bates Clark model of the firm, labor costs are the variable costs. Fixed costs are the costs of the investment goods used by the firm, on the idea that these reflect a long-term commitment that can be recovered only by wearing them out in the production of goods and services for sale.
The idea here is that labor is a much more flexible resource than capital investment. People can change from one task to another flexibly (whether within the same firm or in a new job at another firm), while machinery tends to be designed for a very specific use. If it isn’t used for that purpose, it can’t produce anything at all. Thus, capital investment is much more of a commitment than hiring is. In the eighteen-hundreds, when John Bates Clark was writing, this was pretty clearly true. Over the past century, a) education and experience have become more important for labor, and have made labor more specialized, and b) increasing automatic control has made some machinery more flexible. So the differences between capital and labor are less than they once were, but all the same, it seems labor is still relatively more flexible than capital. It is this (relative) difference in flexibility that is expressed by the simplified distinction of long and short run.
Of course, productivity and costs are inversely related, so the variable costs will change as the productivity of labor changes.

Opportunity Cost
What is the connection between the distinction we have just made — fixed vs variable costs — and opportunity cost, the key concept in some earlier units?
In economics, all costs are included — whether or not they correspond to money payments. If we have opportunity costs with no corresponding money payments, they are called implicit costs. The implicit costs (as well as the money costs) are included in the cost analysis.
There is some correlation between implicit costs and fixed or variable costs, but this correlation will be different in such different kinds of firms as
a factory owned by an absentee investor
This is the easiest case to understand. All of the labor costs to the absentee investor are money costs, including the manager’s salary. If the investor has borrowed some of the money he invested in the factory, then there are some money costs of the capital invested — interest on the loan. However, we must consider the opportunity cost of invested capital as well. The investor’s own money that he has used to buy the factory is money that she could have invested in some other business. The return she could have gotten on another investment is the opportunity cost of her own funds invested in the business. This is an implicit cost, and in this case the implicit cost is part of the cost of capital and probably a fixed cost.

a “mom-and-pop” store
A “mom-and-pop” store (family proprietorship or partnership) is a store in which family members are self-employed and supply most of the labor. Typically, “Mom” and “Pop” don’t pay themselves a salary — they just take money from the till when they need it, since it is their property anyway. As a result, there are no money costs for their labor. But their labor has an opportunity cost — the salary or wages they could make working similar hours in some other business — and so, in this case, the implicit costs include a large component of variable labor costs.
a large modern corporation

The corporation has relatively few implicit costs, but generally will have some. All labor costs will be expressed in money terms (though benefits and bonuses have to be included), since the shareholders don’t supply labor to the corporation as “Mom and Pop” do in a family proprietorship. It will pay interest to bondholders and dividends to shareholders. But the dividends aren’t really a cost item — they include profits distributed to the shareholders. Moreover, the typical corporation will retain some profits and invest them within the business, a “plowback” investment. Conversely, shareholders may take a large part of their payout in appreciation of the stock value — and plowback investment is one reason for the appreciation. Thus we would say that the corporation has a net equity value, that is, that the corporation “owns” a certain amount of capital that it invests in its own business (very much like the absentee owner in the first example). This capital has an opportunity cost, and that opportunity cost is an implicit cost. The stockholders, who own the corporation, ultimately receive (as dividends or appreciation) both the opportunity cost of the equity capital and any profit left over after it is taken out.

The average fixed costs decline as the fixed costs are “spread over more units of output.” For large outputs, however, average variable costs rise pretty steeply. The idea is that with a limited capital plant and thus limited productive capacity — in the short run — costs would rise much more than proportionately to output as output goes beyond “capacity.” The average total cost, dominated by fixed costs for small output, declines at first, but as output increases, fixed costs become less important for the total cost and variable costs become more important, and so, after reaching a minimum, average total cost begins to rise more and more steeply.

Marginal cost for a firm change together with average cost as output varies. The marginal cost rises to cross average cost curve at its lowest point.

Maximization of Profits

We can now give another rule for the maximization of profits. The rule we state in terms of price and costs. It is the equimarginal principle. The question is: “I want to maximize profits. How much output (C) should I sell, at the given price?” The answer is: increase output until p=MC . (M= marginal cost.)
The point is illustrated by the following table, which extends the marginal cost table to show the price and the profits for an example firm.












Profits are greatest (at 32516.25) when the marginal cost is almost exactly equal to the price of $100. This occurs at an output of 3625, with marginal cost at 99.01. The profit-maximizing output would be very slightly more than 3625.

Marginal cost and firm supply
So, we have discovered the principle of supply for the individual firm. Supply is the relation between the price and the quantity that people want to sell. For an individual firm, that is: the relation between the price and the quantity the firm wants to sell. So we ask: at a given price, how much will a (profit- maximizing) firm want to sell? The answer: enough so that the price is equal to marginal cost. In other words, the marginal cost curve is the supply curve for the individual firm.

Shutting down and bankruptcy
As long as the firm produces something, it will maximize its profits by producing “on the marginal cost curve.” But it might produce nothing at all. When will the firm shut down?
The answer goes a bit against common sense. The firm will shut down if it cannot cover its variable costs. So long as it can cover the variable costs, it will continue to produce.
This is an application of the opportunity cost principle. Just because fixed costs are fixed, they are not opportunity costs in the short run — so they are not relevant to the decision to shut down. Even if the company shuts down, it must pay the fixed costs anyway. But the variable costs are avoidable — they are opportunity costs! So the firm will shut down it it cannot meet the variable (short run opportunity) costs. But as long as it can pay the variable costs and still have something to apply toward the fixed costs, it is better off continuing to produce.
It is important not to confuse shut-down with bankruptcy. They are two different things. If a company cannot pay its interest and debt payments (usually fixed costs), then it is bankrupt. But that doesn’t mean it will shut down. Bankrupt firms are often reorganized under new ownership, and continue to produce — just because they can cover their variable costs, and so the new owners do better to continue producing than to shut down.

Effects of Wages and Working Conditions on Productivity

The supply-and-demand approach as we have seen it here assumes that the marginal productivity curve remains unchanged as wages and working conditions change. But there is some evidence that a change in wages or working conditions can shift the marginal productivity curve upward or downward, changing the relationship between the number of units of labor employed and the marginal productivity of labor. In particular, a cut in wages may shift the marginal (and average) productivity downward.
In very poor countries, lower wages may lead to reduced nutrition and worse health for the employees, and thus to lower productivity.
In richer countries, a wage above the employee’s alternative (that is, above the supply curve) can limit the turnover of the work force. Turnover is costly in itself, and with less turnover the employees have more opportunity to learn to work well together, increasing productivity.
Wages above the supply curve can also increase the incentive to work hard and to “work smart.” If wages are only on the supply curve, then the worker has less to lose if she or he is dismissed on grounds of not working hard enough.
The perceived fairness of a wage above the supply curve may also make the employees more willing to work hard and to “work smart.”
Now, suppose that an employer cuts the wages (starting above the supply curve of labor) in the hope of cutting overall costs and so increasing profits. Let’s call that the direct cost effect. At the same time, the lower wages shift the marginal and average productivity downward. This increases costs, offsetting the wage cut. Let’s call that the productivity effect. Profits may either increase or decrease, depending on whether the direct cost effect is bigger than the productivity effect. Some economists argue as follows: when wages are very high, the direct cost effect will be greater than the productivity effect; but as wages drop the productivity effect will increase and the direct cost effect will decline, so that there is a particular wage (above the supply curve of labor) that gives maximum profits. This is called the “efficiency wage.”
If market wages are often efficiency wages, then labor markets could behave quite differently than the John Bates Clark supply and demand approach suggests.

Criticism of the Supply-and-Demand Approach to Labor Markets

Not all economists would accept the supply-and-demand analysis of labor markets, employment and wages. There are several criticisms of the supply-and-demand model of labor markets and the John Bates Clark model of the business firm. Each of the criticisms could lead to an alternative analysis of labor markets. Since this is not a text of labor economics, we will just mention the criticisms, but not attempt to sketch the alternative analyses. Critics mention the following points, among others:
Wages and income distribution may be influenced or determined by bargaining power.
Labor unions can create bargaining power for employees
Employers may limit wages because of and by means of wage discrimination. limited competition for employees
Perceptions of fairness may influence wages and working conditions.
Productivity itself may be influenced by wages and working conditions.
The Marxist view is that employment is a social relationship based on exploitation, and that wages and labor cannot be understood except in those terms.

As we observed, the marginal productivity approach originated with John Bates Clark.Clark was especially concerned with the division of income between labor and property, with income distribution. The marginal productivity approach to the demand for labor is the basis of his discussion.
The Labor Market and the Distribution of Income
In the idealized market society that John Bates Clark envisioned, the wage is determined by the supply and demand for labor. The demand for labor is the Value of the Marginal Product of labor in the society as a whole. The supply of labor is determined by the population and the preferences of workers with respect to more income and consumption versus more holidays and shorter work hours.

Functional and Personal Distribution

This John Bates Clark theory of the distribution of income pertains to what economists call the “functional distribution of income.” Economists distinguish two concepts of the distribution of income:
The functional distribution of income
The functional distribution of income is the distribution between groups in society who own different factors of production, i.e. the proportion of income going to employees, landowners, and owners of capital respectively.
The personal distribution of income
The personal distribution of income is the distribution of income among individuals, families or households, regardless of what factors of production they own.
Of course, the personal distribution depends partly on the functional distribution, but it also depends on who owns what.
This is important if we are concerned about inequality in the distribution of income. Generally, income from land and capital is much less equally distributed than income from labor. In the idealized John Bates Clark world, income from labor would be absolutely equally distributed among those who work the same hours, because labor is assumed to be homogenous. But that’s a simplifying assumption. In the real world, people who have better skills or stronger bodies may be able to earn a higher wage. This makes for some inequality in labor income. But the ownership of land and capital is much more unequally distributed than the capacity to earn wages, so income from property is much more unequally distributed among persons.

Visualizing the Personal Distribution of Income
We can visualize the personal distribution of income using a Lorenz curve for the American economy in 1994.
The Lorenz curve tells us that the poorest 20% of the population earned only 3.6% of the income, the poorest 40% of the population earned 12.5 percent of income, and so on. similarly, the least well off 95% of the population earned 78.8% of the income, leaving 21.2% for the richest 5% of income for the richest 5%.
If income were distributed with perfect equality, then the poorest 20% of the population would earn exactly 20% of income, the poorest 40% of the population would earn 40% of income, and the richest 5% of the population would earn exactly 5% of income. As a result, the Lorenz curve for an equal distribution would be a forty-five degree diagonal line. The curvature of the Lorenz curve, as it droops below the 45 degree line, shows the inequality of the income distribution.
The data for these examples were supplied by the census bureau.

Measuring Inequality in Income Distribution
The Lorenz Curve construction also gives us a rough measure of the amount of inequality in the income distribution. The measure is called the Gini Coefficient. For a perfectly equal distribution, there would be no area between the 45 degree line and the Lorenz curve — a Gini coefficient of zero. For complete inequality the Gini coefficient would be one. Real economies have some, but not complete inequality, so the Gini coefficients for real economic systems are between zero and one.
The Gini coefficient for the United States in 1994 (according to the Census Bureau) was 0.456.

Changing Income Inequality in The United States
Income inequality in the United States has increased in recent decades, and this has recently become a concern to some economists and others interested in economic and political issues. Lorenz curves and Gini Coefficients for the United States for 1970, 1980, 1990, and 1994 are as follows:

We observe a steady, and perhaps accelerating, tendency toward increased inequality over this period. This can also be observed when we look at the Gini Coefficients for the four years, shown in the third row of the table. We see that the over-all increase is about sixteen percent, or one-sixth.

The Functional Distribution
We can check that explanation against the facts. Did the shares in income in fact shift away from labor in the last 25 years?
It seems that they did. Here are some data on labor incomes and property incomes. Labor incomes include all wages and other labor compensation, while property incomes include interest, rent, and dividends, as reported by the census bureau. The incomes are before taxes and do not include government subsidies, either. The following table shows the fraction of the total labor and property incomes that were labor incomes, in the second row, and property incomes in the third row. the fourth row shows the breakdown between labor and property incomes as a “pie chart.”

labor incomes
property incomes

We see the share of property income getting consistently larger through the first two periods. That’s consistent with the explanation that greater inequality is a result of a shift of the functional distribution of income toward a greater proportion of property incomes. In 1994, however, we see a slight shift back toward a larger share for labor incomes, although the inequality continued to increase from 1990 to 1994. It would seem that other factors became more important in the four years 1990-1994.
What the evidence suggests is that shifts in both the functional distribution of income and the inequality of wages are factors in the increase in inequality since 1970. In general, we will find the John Bates Clark model is a good starting point, but only gives us part of the story.

Concluding generalizations

For making generalized conclusions one has to explorthe meaning of “efficiency.” We have defined “efficiency” in terms of costs and benefits. By this standard, the output of machines (or any other good or service) is efficient if the benefits from its production and use, net of the costs, are maximized.
In a hypothetical country that produces only two goods the benefits are maximized (the quantity produced is efficient) when marginal cost is equal to marginal benefit.
We have to recall that the demand curve is the marginal benefit curve and, if markets are perfectly competitive, the supply curve is the marginal cost curve. Thus, when supply is equal to demand, marginal cost is equal to marginal benefit. This leads to the “fundamental principle of microeconomics:”
All goods, services and resources are paid for by those who benefit from them, and
the payment is at P-Competitive equilibrium prices,
output quantities are efficient.
This is a powerful argument that markets, supply and demand promote efficiency — in fact, an ideal plan could do no better. But this argument is fallible. It is only as good as the assumptions on which it is based. When these assumptions are untrue, the Fundamental Principle of Microeconomics cannot be applied, at least not without modification and qualification.

Marginal Productivity and the Equimarginal Principle

This is a quite general principle, which we may state as follows.
When the same product or service is being produced in two or more units of production, in order to get the maximum total output, resources should be allocated among the units of production in such a way that the marginal productivity of each resource is the same in each unit of production.
This example may also be a little clearer example of what we mean by “efficient allocation of resources.” In the example, we have a tiny economy, consisting of one farmer and two plots of land. When the marginal productivities on the two plots are equal, this tiny economy has an “efficient allocation of resources.” Of course, real economies are more complex, but the principles governing the efficient allocation of resources are the same.
This rule has a name: it is the Equimarginal Principle. The idea is to make two things equal “at the margin” — in this case, to make the marginal productivity of labor equal on the two fields. As we will see, it has many applications in economics. In more complicated cases, we will have to generalize the rule carefully. In this example, for instance, we are allocating resources between two fields that produce the same output. When the different areas of production are producing different kinds of goods and services, it will be more complicated. But a version of the Equimarginal Principle will still apply.

We have seen that the concept of marginal productivity and the law of diminishing marginal productivity play central parts in both the efficient allocation of resources in general and in profit maximization in the John Bates Clark model of the business firm.
The John Bates Clark model and the principle of diminishing marginal productivity provide a good start on a theory of the firm and of supply. In applying the marginal approach and the equimarginal principle to profit maximization, it extends our understanding of the principles of efficient resource allocation. Some key points in the discussion have been
the distinction between marginal productivity and average productivity
the “law of diminishing marginal productivity”
the rule for division of a resource between two units producing the same product: equal marginal productivities
the diagnostic formula VMP=wage, that tells us the input and output are adjusted to maximize profits in the business firm, in the short run
In the long run, there may be increasing, decreasing, or constant returns to scale. Increasing returns to scale will complicate things somewhat for the marginal productivity approach.
This has given us a start on the theory of the business firm. But we will want to reinterpret the model of the firm in terms of cost — since the cost structure of the firm is important in itself, and important for an understanding of supply.



The conduct and performance of an industry will depend to some extent on its structure. Among four major types of structures recognized by economists we have focused on the P-Competitive — sometimes called Perfectly or Purely Competitive — structure as the one corresponding most closely to the supply and demand model. This structure can be described by four basic characteristics:
Many buyers and sellers
A homogenous product
Sufficient knowledge
Free entry
All of these characteristics push an industry toward predominant price competition, so P-competitive could also stand for “price-competitive.” In the short run, the P-competitive industry’s supply curve is its marginal cost curve. In the long run, entry of new firms and exit of firms already in the industry will lead to a price corresponding to average cost, inclusive of the opportunity costs of capital and other resources. In other words, there are no “economic” profits. We also have found that the P-competitive model defines a kind of ideal in which rational self-interest leads to an allocation of resources in which given quantities of outputs are produced by enterprises of an efficient cost-minimizing scale. This remarkable finding is one modern counterpart to Adam Smith’s conception of the “invisible hand.”

Changing returns to scale

In microeconomics, we think of diminishing returns as a short run thing. In the long run, all inputs can be increased or decreased in proportion. Reductions in the marginal productivity of labor, due to increasing the labor input, can be offset by increasing the tools and equipment the workers have to work with. How will that come out, on net? The answer is — “it all depends!”
In the long run we define three possible cases:
Decreasing returns to scale
If an increase in all inputs in the same proportion k leads to an increase of output of a proportion less than k, we have decreasing returns to scale. Example: If we increase the inputs to a dairy farm (cows, land, barns, feed, labor, everything) by 50% and milk output increases by only 40%, we have decreasing returns to scale in dairy farming. This is also known as “diseconomies of scale,” since production is less cheap when the scale is larger.
Constant returns to scale
If an increase in all inputs in the same proportion k leads to an increase of output in the same proportion k, we have constant returns to scale. Example: If we increase the number of machinists and machine tools each by 50%, and the number of standard pieces produced increases also by 50%, then we have constant returns in machinery production.
Increasing returns to scale
If an increase in all inputs in the same proportion k leads to an increase of output of a proportion greater than k, we have increasing returns to scale. Example: If we increase the inputs to a software engineering firm by 50% output and increases by 60%, we have increasing returns to scale in software engineering. (This might occur because in the larger work force, some programmers can concentrate more on particular kinds of programming, and get better at them). This is also known as “economies of scale,” since production is cheaper when the scale is larger.
Efficiency and Reasonable Dialog

As usual, we will want to put this in the context of the reasonable dialog among economists over the last few centuries.
The Fundamental Theorem of Microeconomics gives us an argument against government intervention in markets, but, as usual, it isn’t a conclusive argument, but it puts the burden of proof on those who want to argue in favor of government intervention.
Nevertheless, the burden of proof may be met in some cases. The argument against government intervention can be undercut in some cases if we can show that the assumptions underlying the Fundamental Theorem of Economics are untrue in a particular case. Adam Smith’s Lighthouse, and pure public goods in general, are such a case.
That would shift the burden of proof back on those who oppose government intervention. Again, they might be able to respond by undercutting the public good theory in some way. One common way is to argue that government, by its nature, is so inefficient that we are better off without it, even when markets are not efficient. If you are persuaded by that claim, the conclusions of the public goods theory are undercut — but since this is more a matter of political science than of economics, we will not pursue it here.
Market provision can also be efficient for quasipublic goods, but because they are more complex, arguments based on quasipublic goods will generally be easier to undercut.
Public and quasipublic goods are not the only exceptions that undercut the Fundamental Theorem of Economics. There is another category, probably more important in quantitative terms but a little more complex still: externalities.


In the case of “public goods,” it is practically impossible to charge people for the benefits they get from the “public good,” and that creates a problem. Since the beneficiaries of the public good do not pay for the benefits they get, a profit-oriented market economy will not supply the public good, and that is inefficient. That point can be generalized somewhat. In general, when there are goods, services, and resources that people can get without paying for them at a market equilibrium price, inefficiency will be the result.
The term for this in economics is “externality.”

External Costs and Benefits
Economists define “externalities” and “external costs and benefits” as follows: Definitions:
When some people bear costs that they are not paid or compensated for, these costs are said to be external costs.
When some people get benefits that they do not pay for, these benefits are said to be external benefits.
In general, if there are either external benefits or external costs, we say that there are externalities.
The idea is that the decision-maker, who does not pay for the costs nor get paid for the benefits, doesn’t take them into consideration in deciding how resources shall be allocated. He has no motive to produce benefits that he doesn’t get, nor to cut back on costs that he doesn’t pay. The benefits and costs are “external” to his maximization of his own net benefits.
In general, if there are “external” costs or benefits or both, we say that there are “externalities,” and we can expect markets to be inefficient when there are “externalities.”

Public Goods and Externality
In the case of public goods, there are two reasons why markets do not give an efficient allocation of resources: indivisibility and externality. Since it is not practically possible for people to be charged for the benefit from the lighthouse (for example), these benefits are “external.” In addition, the costs of the public good is indivisible, a condition that could create problems in itself. But — when government provides the public good, for free — the externality just balances the indivisibility and free provision is efficient.
In general, unfortunately, it’s a bit more complicated.
Nevertheless, this illustrates an important point. Government action is itself a source of externalities, since routinely government charges some people (taxpayers) and benefits others without much direct connection between the two. The best we can hope for is that one externality may balance another, as it does in the case of free provision of public goods.
Perhaps this balancing act should be no surprise, since we live in an imperfect world. But this balancing sets a pretty high standard for government, and some economists (and others) doubt that real governments are capable of meeting the standard.

Social Costs and Benefits

Again, external costs and benefits are the costs and benefits that decision-makers do not take account of, so market decisions on the allocation of resources do not reflect the external costs and benefits. But, of course, external costs and benefits are only part of the total costs and benefits of any decision.
The costs and benefits that decision-makers do take account of, because they pay the costs and enjoy the benefits, are called private costs and benefits. These are the kinds of costs and benefits we have discussed in earlier chapters in this series.
In turn
Social costs are the sum of private and external costs
Social benefits are the sum of private and external benefits.
Let’s sum up this terminology in a table:
External and Social Costs and Benefits:

doesn’t pay
beneficiary pays
total of both
loser isn’t
loser is
total of both
Social costs and benefits are so-called because they are the total costs and benefits for everybody in society. Economists do not think of society as an independent actor that can gain benefits or suffer costs. Rather, the social costs are the sum total of all costs to individuals in society, regardless of whether the costs are paid by the person who decides whether they will be incurred. Similarly, social benefits are the sum total of all benefits to individuals in society, regardless of whether the beneficiaries decide how much benefit will be produced.

Social Optimum 2

Recall the rule for the The rule for a socially optimal allocation of resources is still the equimarginal rule, MB=MC. However, we now have two kinds each of costs and benefits. We will abbreviate
marginal social cost
marginal social benefit
marginal private benefit
marginal private cost
Using these definitions, we can state the rule for a social optimum, and the problem of externality, more precisely. The rule for a socially optimal allocation of resources is
and the problem is that rational self-interested decision-makers operate according to a different rule
So now let’s look at some examples — practically important ones.

A Fish Story 1

Fish have been in the news, recently, as major world fisheries have been overexploited and are now very unproductive. In the North Atlantic Region, in particular, many fishermen have been thrown out of work in the 1990’s because there are just not enough fish to catch.
Of course, this is an evironmental problem and a biological problem, but first and foremost, it is an economic problem, a problem of resource allocation. Here is what I mean.
When a fisherman catches a fish and sells it, that fisherman gets a private benefit — the revenue from selling the fish. But there is a cost — because there are fewer fish to reproduce, there will be less fish caught (ceteris paribus) in the next and future years. This cost is spread out over all the fishermen and consumers of fish, and thus is “external” to the individual fisherman’s decision how many fish to take. The individual fisherman does not take into account the influence of his fishing on the fish that will be available to other fishermen in the future — it he isn’t going to catch them, why should he care? The result is that he does not limit his catch in such a way as to conserve the fish population to reproduce, and this is why fisheries are overexploited.
In effect, when a fisherman cuts back on his catch to leave fish in the water so that the fish can reproduce, the fisherman is investing. He is creating a capital resource: breeding fish. But since he doesn’t get (most of) the benefits of this investment, the fishing industry as a whole doesn’t invest enough in breeding fish. The world as a whole has allocated too little to investment in breeding fish, and too much to other purposes. This is a problem of misallocation of resources.
A Fish Story 2

As usual, we will express some of these ideas with diagrams. Starting from an industry marginal cost (supply) diagram, we will change the diagram to reflect the difference between private and social cost. As usual we have the quantity of output on the horizontal axis. In this case the quantity of output is measured in tons of fish caught. On the vertical axis we have the marginal cost per ton of fish caught. Here is the picture.
In the diagram, the difference between MPC and MSC is the market value of fish that might be caught in the future (discounted to present value) if one less fish were taken this year. This opportunity cost is the marginal external cost of fish caught and therefore the difference between the marginal private cost and the marginal social cost.

A Fish Story 3

Now let’s put “supply” and “demand” together. We will add a marginal benefit curve to the last diagram.
In the diagram, the marginal benefit, MB, is also the demand curve for fish and the marginal private and marginal social benefit. Applying the equimarginal principle, MC=MB, the socially optimal output is Q1. However, fishermen — balancing marginal private benefit against marginal private cost, MPC — choose Q2. “Too many” fish are caught, and society as a whole has overallocated resources to fishing.
That would be inefficient in itself. But unfortunately the story does not stop here. Leaving fish in the ocean to reproduce is an investment decision, and as a result of this externality, the fishing industries are underinvesting. Underinvestment will cause the cost curves to shift back toward the left, making the problem worse as time goes on. This process has led to the deterioration in fisheries production we have seen.
Now let’s look at an example with external benefits.

Commuters 1

In many cities streets are congested — inconveniently, and, perhaps, inefficiently. This inefficient congestion is itself a result of an externality. The cost of congestion is (mostly) external to the car commuter, and so he does not take it adequately into account, and too much resources are allocated to car commuting. But this is not what we are directly concerned with.
On the other side of it, when a commuter chooses public transportation instead of a private car, that choice decreases congestion. One less car, a bit less congestion — but the benefit of the decrease in congestion goes to the commuters who continue to use their cars, not to the public transportation commuter. The benefit of decreased street congestion is an external benefit, from the point of view of the public transportation commuter.

Commuters 2

Once again we’ll adapt a good old-fashioned supply and demand diagram by making the new distinction between private and social benefits. On the horizontal axis we have the quantity demanded — in this case, the number of riders on the public transportation service. On the vertical axis we have marginal benefits per rider. Here’s the picture:

The difference between MSB, marginal social benefit, and MPB, marginal private benefit, is the external benefit of street decongestion — faster car trips to work and less gasoline burned, and less wear and tear on cars. However, the demand for public transportation is the marginal private benefit curve, since self-interested riders do not the external benefits into account when they decide to take the public transportation service rather than taking their cars.

Commuters 3

Now let us add a marginal cost curve to the diagram, and see how the market equilibrium contrasts with the efficient output of public transportation. Here is the picture:
In this problem, we assume that marginal private cost is identical to marginal social cost, i.e, public transportation commuters pay the full cost of their ride. The optimum number of commuters on public transportation is Q1, where MSB=MC (=MSC). However, only Q2 commuters ride public transportation, where MPB-MC(=MPC). Thus, the market production of public transportation is less than the efficient production.
What we see here is that public transportation generates an external benefit by bringing people out of their cars and off the congested streets. This reduces street congestion. The beneficiaries are the people who drive on the less-congested streets.
In any case, it is time to go on to consider some proposed solutions, in the form of government actions.


Let’s consider how regulation would improve the allocation of resources to fishing. Fishermen would be legally limited in how much fish they can catch. There are some real difficulties in making this work. The regulators have to figure out about how large a catch would be efficient and find ways to be sure that the fishermen do not evade the regulations and catch more fish anyway. The objective would be to reduce the catch of fish and still have the limited quantity of fish caught in the least costly manner.
It is difficult to see how regulation could apply to the public transportation example. In any case, regulation has some strong disadvantages — it is inflexible and tends to create problems as well as (perhaps) solve them.
All the same, regulation has been the favorite response of government (perhaps because it is cheap and/or easy to understand) and as a result we have a good deal of experience in making regulations work not too badly.

Taxes and Subsidies

Taxes on a particular econonomic activity discourage that activity. Usually, that’s considered a disadvantage, but if the economic activity has external costs, a tax can be a way of raising the private cost up to the same level as the social cost, and thus moving the activity back toward its optimal level. Conversely, subsidies could be useful if the activity has external benefits. The subsidy would decrease the private cost and bring it into agreement with the social cost, encouraging an efficient increase in the activity. Thus, fishermen would pay a penalty tax to bring the private cost of fishing up to the social cost, and public transportation would be subsidized to bring the cost down and raise ridership toward the optimal level.
Economists have often favored these approaches, because they work more like markets — we like the carrot better than the stick, as a rule — but governments have not been very committed to, or successful at, putting them into practice. This is especially true of penalty taxes, which are, after all politically unpopular.
What about the impact on the government deficit? In principle, the penalty taxes might more or less balance out the subsidies — perhaps even balance out to zero. But it’s hard to imagine a government with the self-discipline this would require. Some economists and many citizens would worry that a tax that started out as a way of discouraging inefficient activity would end up as a government cash cow.

Market-Based Regulation

Economists have proposed that market principles could be put to work by appropriate regulations, and there have been some trials.
For example, the fish catch could be limited by licenses. Each license would entitle the holder to catch a limited number of fish of a certain species.
However, the licenses would be salable, so that larger-scale efficient fishermen could buy up licenses from the smaller fishermen, and fish at an efficient scale.
And at least the little guys would have something — the market price of the license — to apply toward the retirement fund.
A scheme of this kind was actually enacted two years ago in the US, but I’m not sure it has been put into effect. It may have come too late.

Central Planning

Let’s begin with the central planner’s view. Since radicals don’t express themselves in these terms, I will rely on a neoclassical economist’s translation of what he believed a prominent Marxist would have said (about 25 years ago) if he had used the terminology. I won’t quote directly, but it went something like this:
Public goods, quasipublic goods, and externalities are the real world of the market system.
These ‘problems’ are so pervasive that the only hope for an efficient allocation of resources is for the government to take control of the allocation of resources, do the statistical work necessary to discover the social costs and benefits, solve for the optimal allocation of resources, and direct the managers of the economy to realize it.
It’s true that this is very difficult — the Soviet Union clearly never came anywhere close. But even if the plan is pretty far off from the optimum, it can’t be much worse than a market economy riddled with inefficiencies due to externalities and underprovided public goods.
The deterioration of the Soviet economy in its last years makes this last point pretty difficult to swallow, of course, but this is one possible interpretation of public goods and externalities.
The Liberal (or Moderate?) View

Now the middle view. This seems pretty close to the view expressed by economist Paul Krugman in The American Prospect, November-December 1996, pp. 13-15. Krugman considers it a liberal view.
Public goods, quasipublic goods, and externalities are fairly common in the real world.
They are common enough that it is necessary to take proposals for government intervention in the economy on a case-by-case basis. Government action can never be ruled in or ruled out on principle. Only with attention to detail and prudent judgment based on the facts of the case can we hope to approach an optimal allocation of resources.
That means the government will always have a full agenda for reform — and in some cases, as in deregulation, that will mean undoing the actions of government in an earlier generation. This is not evidence of failure but of an alert, active government aware of changing circumstances. “

The Conservative View

While there are at least several varieties of conservatives in the modern world, the free-market view is expressed by the editorial page of The Economist, and I think it corresponds to the core economic ideas of many conservatives.
One cannot deny that there are some public goods, quasipublic goods, and externalities in the real world.
However, government isn’t perfect either. The policies we get when we rely on government are not ‘optimal’ policies, but politically convenient ones. There is little reason to think that they will come closer to an ‘optimal allocation of resources’ than the market will.
At least we know that the market has some forces tending to promote efficient allocation of resources. Government has none, or at best, those forces are far weaker. Thus, government action should be considered only where it is clearly essential — as it will be in a few cases, but very few. In general, better an imperfect market than an imperfect government.”
That’s pretty clearly the most popular of the three positions in the 1990’s.


Politics are always emotional, and there are pitfalls in trying to find a logical classification for such an emotional field. A student said to me that the middle position, which I had described as the liberal position “sounds more like a moderate.” She had a point. Liberals are somewhere between the extremes of central planning and free-market conservatism, but there is really a spectrum of views — not just three points — and whether we call the neutral center “liberal” or “moderate” may be pretty debatable. I made reference to a short piece by Paul Krugman in The American Standard, a liberal magazine. But the editor of the magazine, Robert Kuttner, was critical of Krugman and stated his own, quite different, version of the liberal view:
The problem is … that the increased marketization of economic life, in a global marketplace, undermines the century-old project of devising a regulated or social-democratic form of capitalism.
This seems somewhere on the spectrum between the central-planning position and the middle position.
But our main point here is not to choose up political sides, but to think a little about the different ways we, as a people, might respond to externalities. Does the existence of externalities mean that markets are never really efficient, so that everything needs to be regulated or planned? Or should we treat them as a minor exception to the efficiency of markets, and ignore them as a rule? Or do we need to consider every individual case separately? I don’t suppose that any political movement is really very consistent in its choice among them. Are you? Am I? Well, I try ….
Summary on the Role of Government

We have considered a family of cases in which the assumptions underlying the Fundamental Theorem do not apply. What all these cases have in common is that it is practically impossible for people to be charged (in the market) for the benefits they gain or to be compensated for the costs they bear. This means that market equilibrium will be inefficient in these cases.
There are four major cases.
Public Goods
Free provision by government is efficient.
Quasipublic goods
The case is less clear, but government provision or support might in some cases improve on market outcomes.
External costs
Markets will overallocate resources. Regulations or penalty taxes to limit this may be in order.
External Benefits
Markets will underallocate resources. Subsidies may be proposed to offset this.



In this chapter we have explored the supply and demand for factors of production, land, labor, and capital. The discussion complements our discussions in Chapter 3 of the supply and demand for consumer products. The basic ideas for this discussion are the marginal productivity of the input and the “value of the marginal product,” that is, marginal productivity times the price.
We began with a discussion of the supply and demand for labor.
The demand for labor is identified with the value of the marginal product” of labor.
The supply of labor depends on the population and on its preferences between earning more income and enjoying more leisure.
The price of labor is the wage, and we see an equilibrium if the wage is just high enough so that the quantity of labor demanded is equal to the quantity supplied.
This leads to an application to minimum wage regulations — and the conclusion that such regulations are likely to put some employees out of work.
Some economists doubt that the supply-and-demand approach really works in labor markets, and propose alternative approaches. But in many cases the alternative approaches incorporate marginal productivity along with other influences on wages and employment.
We next discussed the supply and demand for land and natural resources.
Here again, demand is identified with the value of the marginal product.
The supply, however, is given by nature.
But different parcels of land have different fertility, so that demanders have to pay “differential rent.”
The supply and demand for capital were next discussed.
We think of the interest rate as the price of capital.
The demand is again identified with the value of the marginal product of capital.
We then applied the marginal productivity approach to explain the distribution of income and its trends in recent years. The marginal productivity approach gives us a theory of the functional distribution of income, which is one aspect of the distribution among persons. We find that the recent trends in income distribution do “make sense” when we apply the marginal productivity approach to them. But is that the only explanation? The criticisms of markets for labor can be applied also to the marginal productivity approach as a whole, and to this application, so there may be other aspects, or even a completely different approach, that will make better sense.
However, we have come to the limit of what this book can say about the marginal productivity approach and the alternatives to it. Students who are interested in alternative approaches, or a deeper discussion of this approach, will find it in more advanced textbooks.


(Discussion details omitted)

We have seen that the concept of marginal productivity and the law of diminishing marginal productivity play central parts in both the efficient allocation of resources in general and in profit maximization in the John Bates Clark model of the business firm.
The John Bates Clark model and the principle of diminishing marginal productivity provide a good start on a theory of the firm and of supply. In applying the marginal approach and the equimarginal principle to profit maximization, it extends our understanding of the principles of efficient resource allocation. Some key points in the discussion have been
the distinction between marginal productivity and average productivity
the “law of diminishing marginal productivity”
the rule for division of a resource between two units producing the same product: equal marginal productivities
the diagnostic formula VMP=wage, that tells us the input and output are adjusted to maximize profits in the business firm, in the short run
In the long run, there may be increasing, decreasing, or constant returns to scale. Increasing returns to scale will complicate things somewhat for the marginal productivity approach.
This has given us a start on the theory of the business firm. But we will want to reinterpret the model of the firm in terms of cost — since the cost structure of the firm is important in itself, and important for an understanding of supply.


Two Sides of fiscal policy

In our one example of fiscal policy so far, we considered an increase in government purchases as a means of increasing aggregate demand in order to move from an unemployment equilibrium to a full employment equilibrium. That kind of fiscal policy was certainly on the agenda when Keynes was writing, during the Great Depression of the 1930’s, and is probably the kind of policy most widely understood as Keynesian. But the Keynesian approach, and even the Simple Keynesian Model, offers a much wider range of possibilities. Keynes himself, in writing on “How to Pay For The War” (World War II) recognized that the inflationary conditions of wartime would call for quite different policies than the Great Depression.
As we have seen, taxes also have multiplier effects. Since the tax multiplier is negative, a reduction in taxes would increase aggregate demand. In the examples we have been using, every $1 decrease in taxes would increase aggregate demand by $2.33. Advocates of tax cuts often support their position by saying that the tax cuts would stimulate increased demand and therefore increased production. This is pure Keynesian economics and is consistent with the Simple Keynesian Model.
More to the point, a Keynesian (even a very simple one) would not argue for increased aggregate demand in all circumstances. Keynesian economics says that equilibrium can differ from full employment, but the difference could go either way — equilibrium production might be either more or less than full employment production. Thus Keynesian economics recognizes two kinds of gaps between equilibrium production and full employment:
Recessionary Gaps
A recessionary gap exists when production is less than full employment production. It might also be called a “contractionary” gap, since production is “contracted” below full employment. Unemployment is likely to result, and the appropriate policy is one that would “expand” aggregate demand, an “expansionary” policy. “Expansionary” fiscal policies include increases in government purchases and cuts in taxes, or some combination of these. An increase in the size of a balanced government budget would also be expansionary. The example of fiscal policy we discussed a few pages back was a contractionary gap remedied by an increase in government purchases.
Inflationary gaps.
An inflationary gap exists when equilibrium income is greater than full employment income. In such a case, businessmen would compete against one another to get resources with which to produce the output that is demanded, and costs would rise, with prices following them up. An inflationary gap could also be called an expansionary gap. An appropriate policy for an expansionary gap would be a policy that reduces, or “contracts.” aggregate demand. Reductions in government purchases, increases in taxation, and reductions in the size of a balanced budget would be examples of contractionary policy.


{The homepage owner gave a number of conference papers and university lectures on the the topic of the following couple of pages.}


Smith and Malthus were well aware of the importance of capital investment, but they did not think of it as being an independent factor, so it didn’t play the key role in their theories. However, some later nineteenth century economists gave capital and investment a more central role. Later in the nineteenth century, economists learned more about the importance of capital and investment in promoting economic growth.

An economist named Nassau Senior made one of the key advances here. Senior wrote “That the powers of Labor, and of the other instruments that produce wealth, may be indefinitely increased by using their Products as the means of further production.” This is a pretty clear statement that investment, in and of itself, increases output.

It may seem strange to say that someone discovered that investment increases output. From our point of view in the twentieth (almost twenty-first) century, that may seem too obvious to need discovery. But it was not obvious until Senior made it obvious by pointing it out.

But that is only half of the story. In economics, supply and demand are both part of the story. Senior told us why there is a demand for investment capital. There is a demand for investment capital because investment capital increases productivity. But what about supply? What limits the supply of investment capital?

Senior had an answer to that, too. The answer is known to economists as “time preference.” Senior pointed out that people are impatient — people “prefer” to have goods and services now rather than in the future. That’s time preference: the time that people prefer is now, not in the future.

Turning that around, time preference limits the supply of investment funds. Because people prefer to enjoy goods and services now, and because investments only pay off in the future, people will not supply investment funds unless they are rewarded by more goods and services in the future than they can get now.




Senior’s understanding that investment increases output per worker was an important insight, but a somewhat vagrant insight. One might say, very well, investment increases productivity, but why? Why should investment, in and of itself, increase output per worker?

The Austrian economists, such as Eugen von Bohm-Bawerk, had an answer to that. They claimed that “roundabout” production is more productive than direct or simple production. A favorite example of “roundabout” production was taken from the Robinson Crusoe story: rather than trying to catch fish with his bare hands, Robinson first made a fish-net, and then used the net to catch fish, much more productively. Another example (and much more important in practice) is mechanized production, in which resources are first set aside to build machines, and then the machines are used to produce goods and services. In a still more roundabout example, society might first set aside resources for research, design and development to create a more effective technology, then build machines using that technology, then use the machines to produce goods and services.

The “roundaboutness” theory was widely adopted after the “Austrian” school introduced it. It was sometimes criticized as “Robinson Crusoe economics,” the point of the criticism being that Robinson’s isolation from society was fiction, and that in the real world, “roundabout” production is caught up in the division of labor and widespread trade in modern society (and also in the divisions and conflict of classes in modern society) and yet it abstracted from all that. However, the Robinson Crusoe example made the point that roundabout production, in and of itself, can increase productivity.

So: roundabout production proceeds by stages, and produces goods for consumption only at the last stage. And since society has to set resources aside for the earlier stages, investment is necessary in order to allow increased roundaboutness. This gives an answer to “why should investment, in itself, increase productivity? The Austrian economists also adopted the “time preference” theory to explain why the supply of investment funds would be limited.

Inspired by ideas like those of Senior and Bohm-Bawerk, many twentieth-century economists came to see investment as the key to economic growth.

Modern theory of economic growth


Roy Harrod, a British economist, led in the modern work on the . He wrote about two concepts of the rate of economic growth. Seeing that both investment and increasing labor productivity would be necessary to permit economic growth, Harrod treated investment and labor productivity as independent limits on economic growth.

(A Harvard economist, Evsey Domar, also proposed a theory of this kind, so it is often known as “Harrod-Domar growth theory).

Harrod observed that the rate of economic growth would depend on the growth of capital, and thus on the proportion of income saved and invested. Since businessmen are profit-seekers, investment would in turn be limited by profits. In the view of businessmen, investment would be “warranted” (that is, justified or reasonable) only if the businessmen could expect that it would be sufficiently profitable. Businessmen’s expectations of profits would determine one limit on the rate of growth. This would be the “warranted” rate of growth.

On the other hand, the supply and productivity of labor also set a limit to the rate of growth. This — the sum of the rate of growth of population and the rate of growth of labor productivity — is the “Natural Rate of Growth” in Harrod’s thinking. Conversely, in order to keep unemployment from increasing, it would be necessary for demand to grow as fast as the population, plus any increases in labor productivity.

Harrod believed it would only be a coincidence if the two limits on the rate of growth should agree. In general, he felt, they would disagree. On the one hand, if the natural rate should be greater than the warranted rate, investment would limit the growth of the economy and the growth of the economy, in turn, would limit employment. On the other hand, if the warranted rate were greater than the natural rate, businessmen would have difficulty finding enough opportunities to invest. Either way, an imbalance between the natural and the warranted rate of growth would cause economic problems. Writing in the 1930’s, Harrod believed that problem had played a role in the Great Depression.

The Neoclassical Model


The “neoclassical” theory of economic growth grew out of a criticism of Roy Harrod’s thinking. According to the critics, Harrod had overlooked the principle of diminishing returns. This principle applies just as much to capital as it does to labor, according to the neoclassical view. And this (they said) is what Harrod had missed.

Neoclassical economic theorists stress that the marginal productivity of capital diminishes. That means Harrod’s two limits on economic growth are not independent after all. If capital grows faster than the labor force, its marginal productivity will drop, so the profitability of investment will drop, and that will slow down its growth until capital grows no faster than the labor force.

Because of diminishing returns, the marginal productivity of capital decreases as capital per worker increases. In effect, the neoclassical approach reverses Malthus’ approach, treating labor as the fixed input and capital (per worker) as the variable input.

Here is the point: if capital grows faster than labor (the “warranted rate” is greater than the “natural rate”) then the ratio of capital to labor increases, so the profitability of investment decreases, and investment slows down. This continues until an equilibrium is reached. There exists an interest rate that agrees with the time preference of the investing public. If the interest rate falls below the time preference rate, then (on the average, anyway) investors would no longer be willing to invest. Once the marginal productivity of capital has dropped down to the rate of time preference, capital per worker will no longer increase.

In equilibrium, the warranted rate of growth and the natural rate of growth are the same — that is, the capital stock and the labor force grow at the same rate, and labor productivity does not grow at all.

Innovation and The Neoclassical Model


But this neoclassical theory has gotten us right back to the “stationary state,” in a slightly different form. In this non-Malthusian stationary state, population might grow — that would make it profitable for investors to invest in just enough equipment to keep the additional workers at the same productivity level as the others — but there could be no growth of labor productivity and no increase in standards of living once the equilibrium had been attained. Ironically, these ideas were developed in the 1950’s and 1960’s — a period of the most rapid growth of labor productivity and standards of living in American history, and in most of the rest of the industrialized world, as well.

So what makes people better off, in product-per-capita terms? The neoclassical economists say: innovation.

Neoclassical Growth with Innovation

New techniques of production shift the Marginal Productivity of capital. The technological innovation raises the productivity of labor and standards of living rise with the productivity of labor. But neoclassical economists see innovation not as a once-for-all event, as shown here, but as a continuous process that keeps the growth of labor productivity at a fairly steady rate.

We have already seen this idea — that continuous innovation could sustain continuous improvement in labor productivity and in the standard of living — in the discussion of Malthusian thinking, and a Malthusian would dismiss it as an “act of faith.” But in neoclassical thinking, this “act of faith” becomes a central principle. the neoclassical economist would say that it is not based on faith but on observation: we have observed, historically, that innovation can be a continuous process and has been continuous, in the industrialized societies, since before Malthus’ time. And, of course, generalization based on observation is the essence of science.

All the same, some economists would like to dig a little deeper.

The Residual — and Endogenous Innovation


In the middle of the twentieth century, economists’ thinking about economic growth was dominated by the role of investment in increasing labor productivity. But these studies led to a rather negative conclusion. Where steady economic growth was observed, only a small part of it could be explained by investment. The part that could not be explained by investment was called “the residual,” and it was increasingly clear that “the residual” was the larger and more important part of economic growth.

Neoclassical economists explained “the residual” by technological innovation, but innovation itself remained something of a mystery. Of course, technological innovation could be a result of investment in research and development, but then, investment in research and development is investment — increasing the roundaboutness of production — and if investment is subject to diminishing returns, that would include investment in research and development — wouldn’t it?

Neoclassical economic growth theory came to the conclusion that innovation is the basis of most economic growth, but innovation itself cannot be explained by economics. That may be right, but it isn’t very satisfying and it isn’t very useful.

It isn’t satisfying:
We want to ask, can innovation really be continuous, and if so, how? How is this explained?
It isn’t useful:
We want to put economic theory to work in figuring out how we can improve the standard of living, perhaps by speeding up the process of technical innovation. But the neoclassical theory doesn’t tell us how to do that.

These concerns led, in the 1980’s, to new versions of the “virtuous circle.” Recall, Smith’s optimism was based on a “virtuous circle” in which growth creates the opportunity for more growth. The new economic growth theorists of the 80’s proposed a virtuous circle of innovation: growth in labor productivity might create the conditions for more profitable investment in research and development, which in turn leads to more productivity growth, to more innovation, and so on. In this way, we could explain how innovation can be continuous.

In this sort of growth theory, innovations are a result of economic events. Economists express this by saying they are “endogenous,” so these theories are called “endogenous innovation” or “endogenous growth” theories. Research on this sort of theory is ongoing, and many details remain unsettled.


Economies of Scale


We see the last generation of economic growth theorists creating a new version of Smith’s virtuous circle. But Smith’s own approach was not entirely abandoned. It was developed early in the twentieth century by such great British economists as Alfred Marshall, A. C. Pigou, and Nicholas Kaldor.

For these economists, the key concept of economic growth is “economies of scale.” Suppose all inputs are increased in the same proportion. For example, we increase the quantity of land, labor and capital in use, each by 20%. Will output increase by the same proportion — by 20% — or by more, or by less? Notice that the principle of diminishing returns does not answer that question, since it assumes that one input is fixed (and so the fixed input cannot increase in proportion to the rest). When it is possible to increase all inputs in proportion, the principle of diminishing returns is not applicable.

Here is the terminology:

Economies of scale or increasing returns to scale
output increases more than in proportion to inputs
Constant returns to scale
ouput increases just in proportion to inputs
Diseconomies of scale or decreasing returns to scale
output increases less than in proportion to inputs

Any of the three is possible, and perhaps all could be applied in particular cases. But the British economists mentioned above suggested that economies of scale would be the most important in general. They reasoned from Smith’s principle of the division of labor. They reasoned that as in industry or an industrial economy grows larger, the larger size would allow for increased division of labor. This would increase the productivity of labor, and so output would increase more than proportionately to input.

If economies of scale exist in the economy as a whole, and if they are quite strong, they might overcome the limited quantity of land and allow continuous increases in the division of labor, the productivity of labor, and economic growth. In this way, Smith’s insight on division of labor was extended into the twentieth century.


Learning by Doing
Another kind of virtuous circle came into economic thinking about growth about 1960. It is a “commonsense” idea that was discovered by engineers and introduced into economic thinking by the Nobel Laureate Kenneth Arrow.

It seems that the more practice people have in doing a particular job, the better they get at the job, and labor productivity increases as a result. Everybody knows that “practice makes perfect,” and Adam Smith had pointed out that increasing division of labor means more practice and thus more learning. But in the twentieth century, we found some hard evidence on how much difference it makes. For example:

Building aircraft in World War II
Engineers who studied this process found that the number of hours of labor required to build an aircraft of a particular model would decrease as the number of craft produced increased; so that, for example, the 100th aircraft build required less labor than the 99th, and so on.
The Horndal steel plant
At Horndal in Sweden, a steel plant operated for a decade with no investment or technological change. Labor productivity increased at 1.5% per year, all the same.
Israeli Kibbutzim
Farming settlements in Israel, often founded by people with no experience in farming, experienced gradual increases in labor productivity unrelated to any change in the inputs or technology they used.
Nicaraguan Cotton Farmers
Cotton farming was introduced in Nicaragua in the 1950’s. Records from the government agency that lent them money for the purpose showed predictable increases in productivity in the years after cotton farming was introduced.

These examples suggest that it is new forms of production that usually benefit from learning by doing. In any case, the results are very much like economies of scale: the more we produce by the new method, the cheaper we can produce.


20-eth Century Virtuous Circle Theories

Economies of scale and learning by doing are both “endogenous,” that is, they are instances of labor productivity growth as a result of economic events. In this they are similar to “endogenous innovations,” and the three are often linked together in a common twentieth-century virtuous circle theory:

More and cheaper production leads to larger scale, more learning and innovation, and these lead to more and cheaper production, starting the cycle over.

However, just as the circle has more links, there are more ways the virtuous circle might be broken, causing growth to slow or stop.

The Infant Industry Problem
An industry that is small and new may be unable to compete with more established similar industries in other countries, or even with low-wage industries in the home country, and thus never obtain the resources necessary to grow and take advantage of its economies of scale and learning potential.
The Spillover Problem
According to the endogenous innovation theory, businesses invest money in research and development because it is profitable. But many of the benefits of innovation “spill over” and are of benefit to other companies. For example, the company that invented Visi-Calc, the first computer spreadsheet, paved the way for imitators who made most of the money from spreadsheets.
The Big Business Problem
When we look at industries and whole economies, “economies of scale” means that they will be able to produce more, more cheaply, when they operate on a large scale. But the same may be true of companies: the business that produces and sells on the largest scale produces most cheaply, and so can drive the others out of business. Thus monopolies emerge not because an interfering government created them (as Smith supposed) but because of the economic growth process themselves. But as Smith did suspect, the monopolies break the virtuous circle because, instead of expanding production, they use the increased productivity to push their profit margin up. But with no expansion of production, no increased scale, there is no next round of growth, and the virtuous circle grinds to a halt. The great American economist of midcentury, John Kenneth Galbraith, put stress on that possibility.

The first two of these possibilities has led economists such as A. C. Pigou and many others to suggest that government might need to give special support to industries that — because of their economies of scale, learning potential, and/or innovation spillovers — have special promise for the future. This is the basis of “industrial policy.” On the other hand, the third item, the Big Business Problem, led Galbraith to say that government might need to use its regulatory power to keep big business prices down and the output expanding — whether it is profitable or not.

Like Smith, twentieth century virtuous-circle theorists would rely on good government to assure that the circle is not interrupted; but some of them would have a quite different idea of what kind of government is “good government.”


In over two hundred years, economists have gradually developed two major approaches to explaining and interpreting the growth of real gross domestic product per capita and the coincident improvement in standards of living in many countries. By way of summary, let’s review the troops and say a little about the kind of government policy each would most likely favor.
Virtuous Circle Theories
These theories see increasing labor productivity as “endogenous,” that is, a result of economic events. Smith understood increasing division of labor as the source of increased productivity, while twentieth-century virtuous circle theorists have seen in addition several other sources, all interconnected and to some extent overlapping with one another and with the division of labor:
economies of scale
learning by doing
endogenous innovations
Virtuous circle theorists would all agree with Smith that the government ought not do anything to cause the cycle to be broken, but some of the twentieth-century virtuous circle theorists might call on the government to remove barriers that could arise in the private sector.
Resource Theories
The Malthusian Theory
Malthusian theories see land (and, in the twentieth century, other natural resources) as the ultimate limits to growth. Since growth can only put off the inevitable, Malthus and his followers might call on government to take actions which would slow down growth. For example, Malthus wanted to protect British agriculture from competition from imported grain, which favored industrialization but harmed British agriculture. Some twentieth century Malthusians, who do not share Malthus’ belief that contraception is sinful and vicious, would like to see government policies that favor contraception.
Capital-limit theories
These theories see capital, not land, as the limit to growth. Since capital can be increased by saving and investment, they favor government policies that encourage rather than penalizing saving and accumulation of wealth. Some would have the government go even further and contribute to capital accumulation by raising taxes and running a surplus, making the surplus available to support investment. A few, following Roy Harrod, might call for government action to assure a balance of investment and labor force growth. What sort of government action? We will spend several chapters on that question when we take up Keynesian ideas.
The Neoclassical Theory
The Neoclassical theory is a capital-based resource theory with a special twist: it sees economic growth as a moving balance between diminishing returns to the growing capital resource, on the one hand, and the growth of knowledge of technology, on the other. But since it sees innovations not as endogenous but as the result of events outside the economy — the progress of knowledge — the neoclassical theory has almost the same policy prescriptions as the other capital-based theories. Almost, but not quite: for the neoclassical theorist, saving should be encouraged only up to a point. After all, capital is subject to diminishing returns.
Even after two hundred years, there are still some disagreements to be ironed out! But whichever theory of growth we think is most promising, they all share a broad scale in terms of time. No doubt that is one reason why we are still so much in doubt: for theories such as these, a couple of centuries’ experience still isn’t much. But many important macroeconomic problems come (and sometimes go) much faster, and that is a reason why modern macroeconomics has generally focused on a shorter time-frame. Accordingly, we will next look at some of those problems and our experience of them in the twentieth century.



This chapter has undertaken to survey the industries that don’t seem to fit into either the “P-competitive” or “monopoly” category: oligopolies and monopolistically competitive industries, or, taking both together, imperfectly competitive industries. These industries deviate from one or another of the four characteristics of P-competition, but also involve some competition among two or more firms selling close substitutes, if not the same products.
The two major implications of imperfect competition, by comparison with P-competition, are
increased nonprice competition
Unlike price competition, nonprice competition may be costly and may or may not make consumers better off all in all. Nonprice competition is a mixed bag, but most economists are persuaded that, on the whole, more competition among sellers is better than less.
decreased price competition
Price competition favors customers and promotes efficiency, so decreased price competition is clearly a bad aspect of imperfect competition. But how much will price competition be reduced? Turning to game theory, we learn that there is no one “rational” answer to the choice of price strategies in oligopoly, so the question cannot be given a precise answer. But there is some evidence that the intensity of price competition increases as the number of firms gets larger and their size gets smaller, relative to the industry.
These problems mean that the decisions of imperfectly competitive firms are strategic in a sense that monopoly decisions and the decisions of P-competitive firms are not. Accordingly, we have followed modern economics (and mathematics and other social sciences) in digressing a bit on an important modern theory of strategic choices called “game theory.” Here, too, we find not clear answers but a range of possibilities: the “solutions” to or equilibria in “games” may be cooperative or noncooperative. The noncooperative games sometimes lead to results that nobody wants — such as low prices and zero economic profits in an oligopoly — but we also have to consider the possibility of a cooperative solution with monopoly prices and profits.
Imperfect competition remains a controversial area in economics. Some economists would argue that imperfect competition is the rule, rather than the exception, and they conclude that the “Fundamental Principle of Microeconomics” — however fundamental for theory — has little application in the real world. Other economists would argue that, even if imperfect competition is pretty wide-spread, the deviations from supply-demand pricing in the real world are small, minor and temporary, so that “supply and demand” remains our best guide to prices and outputs in our market economy, with a very few obvious exceptions. This latter view has become more widespread and influential over the past 30 years, and that change has contributed to the political climate that led to deregulation in the years since 1977.



When we extend the Simple Keynesian Model to allow for government and taxes, we see that these instruments of government policy can influence the equilibrium level of production. the use of taxes and government spending to influence production and employment is called “fiscal policy.”
Government purchases are a component of autonomous expenditure, and so they will affect equilibirum income through a multiplier effect, very much like investment or net exports. Once we allow for government purchases, of course, we must also allow for taxation. Taxes, however, act indirectly in the model, reducing consumption, and so they have a different multiplier, A further result of this is that a changed in a balanced government budget will have a net effect on equilibrium income, with a multiplier of one.
In all of this, it may help to distinguish between the Keynesian Diagnosis and the Keynesian Prescription. The Keynesian Diagnosis says that macroeconomic problems can occur as a result of insufficient or excessive aggregate demand. This is a question of fact, either true or false, and no less true in inflations than in depressions. The best-known Keynesian prescription is for increased government deficit spending. But that prescription is limited to particular times and circumstances, and even then, is not simply true or false. No prescription is ever just true or false. When a doctor diagnoses a patient’s illness, the diagnosis may suggest a treatment — but there could be good reasons not to prescribe the treatment. For example, the drug might have bad side effects. In such a case, the patient might face a trade-off between the cure and the side effects or considerations that are purely subjective, such as the trade-off between a short, active life and a longer life of disability. The Keynesian prescription is like that. Economists and others debate about how serious its side effects are. Here is the point: even if the Keynesian diagnosis is true, there could be good reasons not to accept the presecription. And, conversely, it is a fallacy to reject the diagnosis because we don’t like the prescription. The diagnosis is either true or false — whether we like it or not, either way! But it is the diagnosis, not the prescription, that is the essence of Keynesian economics. If we don’t like the prescription, we can figure out another one — consistent with the diagnosis that fits the facts.
There are other effects in the real world, some of which will tend to offset the ones we have considered here. We can look at some of them as we bring interest rates and the money supply into the Keynesian model. (See the next division.)

Third Division

Advanced discussion of the above categories as reflected in EB articles of the Nineties



In economics, it is a stock of resources that may be employed in the production of goods and services. In classical economics it is one of the three factors of production, the others being labour and land.

In an accounting sense, the capital of a business firm is that part of the net worth that has not been produced by the operation of the enterprise, or, in other words, the original stock of net assets of the firm before any income is earned.

The economist is more likely to speak of “real” assets, such as plant and equipment, factory and office buildings, and inventories of raw materials and of partly finished and finished goods, regardless of their financial status. Capital may be so broadly defined as to include all possible material, nonmaterial, and human inputs into a productive system, but it is usually more useful to confine the term to material assets in the hands of productive enterprises. In this sense, there are two forms of capital. Money or financial capital is a fluid, intangible form used for investment. Capital goods–i.e., real or physical capital–are tangible items such as buildings, machinery, and equipment produced and used in the production of other goods and services. Money capital is raised by selling stocks and bonds in order to finance the acquisition of real capital or capital goods. Capital goods are similar to savings because both require postponing current consumption to provide for future production and consumption.

Economists of the classical school, beginning with Adam Smith, developed the earliest theory of capital, according to which capital arose out of the excess of production over consumption. The income earned by capital is profit, the counterpart to the wages and rent earned by the other factors of production. No thoroughly satisfactory theory of capital has been presented, and since the 19th century interest in developing such a theory has flagged.

Capital and interest

Capital in economics is a word of many meanings. They all imply that capital is a “stock” by contrast with income, which is a “flow.” In its broadest possible sense, capital includes the human population; nonmaterial elements such as skills, abilities, and education; land, buildings, machines, equipment of all kinds; and all stocks of goods–finished or unfinished–in the hands of both firms and households.

In the business world the word capital usually refers to an item in the balance sheet representing that part of the net worth of an enterprise that has not been produced through the operations of the enterprise. In economics the word capital is generally confined to “real” as opposed to merely “financial” assets. Different as the two concepts may seem, they are not unrelated. If all balance sheets were consolidated in a closed economic system, all debts would be cancelled out because every debt is an asset in one balance sheet and a liability in another. What is left in the consolidated balance sheet, therefore, is a value of all the real assets of a society on one side and its total net worth on the other. This is the economist’s concept of capital. A distinction may be made between goods in the hands of firms and goods in the hands of households, and attempts have been made to confine the term capital structure to the former. There is also a distinction between goods that have been produced and goods that are gifts of nature; attempts have been made to confine the term capital to the former, though the distinction is hard to maintain in practice.

Another important distinction is between the stock of human beings (and their abilities) and the stock of nonhuman elements. In a slave society human beings are counted as capital in the same way as livestock or machines. In a free society each man is his own slave–the value of his body and mind is not, therefore, an article of commerce and does not get into the accounting system. In strict logic persons should continue to be regarded as part of the capital of a society; but in practice the distinction between the part of the total stock that enters into the accounting system, and the part that does not, is so important that it is not surprising that many writers have excluded persons from the capital stock.

Another distinction that has some historical importance is that between circulating and fixed capital. Fixed capital is usually defined as that which does not change its form in the course of the process of production, such as land, buildings, and machines. Circulating capital consists of goods in process, raw materials, and stocks of finished goods waiting to be sold; these goods must either be transformed, as when wheat is ground into flour, or they must change ownership, as when a stock of goods is sold. This distinction, like many others, is not always easy to maintain. Nevertheless, it represents a rough approach to an important problem of the relative structure of capital; that is, of the proportions in which goods of various kinds are found. The stock of real capital exhibits strong complementarities. A machine is of no use without a skilled operator and without raw materials for it to work on.


Marginal efficiency of investment

In economics, expected rates of return on investment as additional units of investment are made under specified conditions and over a stated period of time. A comparison of these rates with the going rate of interest may be used to indicate the profitability of investment. The rate of return is computed as the rate at which the expected stream of future earnings from an investment project must be discounted to make their present value equal to the cost of the project. As the quantity of investment increases, the rates of return from it may be expected to decrease because the most profitable projects are undertaken first. Additions to investment will consist of projects with progressively lower rates of return. Logically, investment would be undertaken as long as the marginal efficiency of each additional investment exceeded the interest rate. If the interest rate were higher, investment would be unprofitable because the cost of borrowing the necessary funds would exceed the returns on the investment. Even if it were unnecessary to borrow funds for the investment, more profit could be made by lending out the available funds at the going rate of interest.

The British economist J.M. Keynes used this concept, but a different term (the marginal efficiency of capital), in arguing the importance of profit expectations rather than interest rates as determinants of the level of investment. Statistical studies since the 1930s have tended to reinforce the idea that interest rates play a small role in investment decisions.


The price paid for the use of credit or money. It may be expressed either in money terms or as a rate of payment. Interest may also be viewed as the income derived from the possession of contractual promises from others to pay sums in the future. The question may be asked, “What is the value today of a promise to pay $100 a year from now?” If the answer is $100, then no interest income is generated. Most people, however, would require an inducement to give up $100 today and for the next year. If $5 were sufficient inducement–that is, if they would buy such a promise for $95–then interest income of $5 has been generated at a rate of just over 5 percent. Various theories have been developed to account for and justify interest. Among the better known are the time-preference theory of the Austrian, or Marginalist, school of economists, according to which interest is the inducement to engage in time-consuming but more productive activities, and the liquidity-preference theory developed by J.M. Keynes, according to which interest is the inducement to sacrifice a desired degree of liquidity for a nonliquid contractual obligation. It may be mentioned that in Marxist theory interest, like capital itself, is a portion of labour expropriated by the capitalist class by virtue of its political power.


The Keynesian critique.

The groundwork for the Keynesian attack on the quantity theory was laid by two historical experiences. One was the British experience after the return to gold in 1925. In order to maintain the parity set for the pound in terms of gold, the Bank of England followed a consistently tight monetary policy. But prices did not move downward sufficiently, and there was persistent unemployment. This raised doubts about the allegedly classical postulate that money was only a veil, that total output was determined by real conditions, and that full employment was the “equilibrium,” or normal, position. The second and even more dramatic experience was the Great Depression. Later study has shown that the severity of the Depression, certainly in the United States, can be attributed to bad monetary policy–a policy that permitted or forced the quantity of money to decline by one-third from 1929 to 1933. This was not known or understood at the time; on the contrary, the Federal Reserve authorities insisted that they were doing everything they could to offset the forces making for depression.

This stimulated the British economist John Maynard Keynes–who had been a highly sophisticated quantity theorist on strictly classical lines–to develop an alternative interpretation of the debacle after 1929 and an alternative prescription for policy. It also produced a sympathetic climate for his new theory, so that the Keynesian revolution swept the economics profession in a remarkably short time.

Keynes did not, of course, deny the validity of the quantity equation. What he maintained was very different: that the right-hand side–Py, or prices times output–was determined by forces largely independent of the left-hand side. P, he argued, was largely an institutional datum, linked to customary nominal rates of wages that were very resistant to change, or at least to decline. Real income or output, y, he argued, was determined by aggregate demand, which depended primarily on the amount of “autonomous spending”–that is, spending that was not linked directly to current income and that consisted mostly of investment expenditures by enterprises and spending by government. The rest of aggregate demand consisted mostly of consumption, which was linked closely to current income. On this view, the key factor determining the level of real income and output, and thereby the level of nominal income, was the strength of investment and of government spending.

How then could the quantity equation hold? Keynes’s answer was that V was so pliable that it would adjust to keep the two sides equal. Let autonomous spending increase without a change in the quantity of money, and V would simply increase in response; let the quantity of money increase without an increase in autonomous spending, and V would decline to offset the increase in M. How did Keynes explain the plasticity of V? He did so by means of a very special explanation of the demand for money, to which he applied the phrase “liquidity preference.” He regarded the quantity of money demanded as divided into two parts, one part, M1, “held to satisfy the transactions and precautionary-motives,” the other, M2, “held to satisfy the speculative-motive.” He regarded M1 as a roughly constant fraction of income, and with respect to this part he accepted a rather rigid form of the quantity theory. He regarded M2, however, as largely independent of income and as highly sensitive to current interest rates and to the expectations of future interest rates. This explained the plasticity of V.

According to Keynes, if current interest rates are above the level many holders of money expect to prevail in the future, people will prefer to hold their speculative balances in bonds instead of money–because they expect a fall in interest rates, which means a rise in bond prices. Conversely, if current interest rates are below the level expected to prevail in the future, they will prefer to hold money. Over short periods, he argued, these expectations are widely and strongly held at about the same level. In the extreme, with everyone holding the same expectations and everyone sensitive, liquidity preference will become, as he termed it, absolute. Under such circumstances, let the monetary authorities try to increase the amount of money by buying bonds. This will tend to raise bond prices and lower interest rates, but even the slightest lowering will lead speculators to absorb the additional money and sell bonds. The result will be a lower V or a higher k for the community as a whole. The converse will hold if the authorities try to reduce the amount of money. Alternatively, if nominal income rises, for whatever reason, without a change in the quantity of money, that will require an increase in M1, but it can and will come out of M2 without any further effects. The conclusion is that under circumstances of absolute liquidity preference income can change without a change in M or in interest rates, and M can change without a change in income or in interest rates. The holders of money are in metastable equilibrium, like a tumbler on its side on a flat surface; they will be satisfied with whatever the amount of money happens to be.

For the long run, Keynes regarded the size of M2 as depending on the level of interest rates for a different reason. The interest rate measures the cost of holding money instead of bonds–it is the price, as Keynes put it, that the holder of money pays for retaining liquidity. If the interest rate is low, the cost of liquidity is low; hence people will hold a large fraction of their wealth in the form of money, and the fraction will be sensitive to small changes in the interest rate–liquidity preference being absolute in the long run as well as in the short run. If interest rates were high, and M2 low–a condition that Keynes expected to hold only at times of full employment–then the quantity theory would “come into its own,” in the double sense that velocity would be constant and that prices rather than output would respond to changes in the quantity of money.

Keynes himself regarded absolute liquidity preference as a strictly “limiting case”; while it “might become practically important in future,” he knew “of no example . . . hitherto.” In practice, however, he treated velocity as if its behaviour frequently approximated this limiting case, and his disciples went much further than he did. If liquidity preference was not absolute, then in the Keynesian view a change in the quantity of money would first affect interest rates in order to induce the community to hold the changed quantity of money. This change in interest rates might in turn affect autonomous spending–a decline encouraging investment and a rise discouraging investment–and in this way aggregate demand, income, and employment. The more sensitive is the quantity of money demanded to interest rates, and the less sensitive is investment to interest rates, the smaller will be the final effect of changes in the quantity of money, and conversely.

The Keynesian revolution swept the economics profession in the late 1930s and early 1940s; by the 1960s Keynesian ideas had become deeply embedded in the thinking of informed intellectuals. The course of events, however, did not follow the pattern that many had expected. Their analysis had predicted a great postwar depression if war spending was not replaced by other government spending. But government spending fell precipitously in the United States and elsewhere without ill effect. The analysis of the Keynesians had called for “cheap money” policies–that is, low interest rates–with a view to stimulating investment and thereby avoiding mass unemployment. Those policies proved in the main to be unnecessary; where they were adopted they were consistently followed by inflation that could be restrained only by abandoning the cheap-money policies. A reexamination of the Great Depression of the 1930s demonstrated that, contrary to general belief, it had been a tragic testament to the great power of monetary policy, not to its impotence. The U.S. Federal Reserve System could have prevented the decline of one-third in the quantity of money that occurred from 1929 to 1933. Had it done so, the evidence indicates, the Depression would have been far milder and briefer. Most important of all, extensive empirical research demonstrated that the velocity of circulation of money, far from moving to offset changes in the quantity of money, has generally moved in the same direction and reinforced the effect of these changes.


process of exchanging income during one period of time for an asset that is expected to produce earnings in future periods. Thus, consumption in the current period is foregone in order to obtain a greater return in the future.

For an economy as a whole to invest, total production must exceed total consumption. Throughout the history of capitalism, investment has been primarily the function of private business; during the 20th century, however, governments in planned economies and developing countries have become important investors. From the standpoint of an individual, two types of investment may be distinguished: investment in the means of production and purely financial investment. Although at the individual level both types may provide a monetary return to the investor, from the standpoint of the entire economy, purely financial investments appear only as title transfers and do not constitute an addition to productive capacity.

Before the 1930s, investment was thought to be strongly affected by the going rate of interest, with the rate of investment likely to rise as the rate of interest fell. Since then, empirical investigation has shown business investment to be less responsive to interest rates and more dependent on businessmen’s expectations about future demand and profit, technical changes in production methods, and the expected relative costs of labour and capital. Because investment increases an economy’s capacity to produce, it is the factor responsible for economic growth. For growth to occur smoothly, it is necessary that savers intend to save the same amount that investors wish to invest during a time period. If intended saving exceeds intended investment, unemployment may result; and if investment exceeds saving, inflation may occur.

Money supply

the liquid assets held by individuals and banks. The money supply includes coin, currency, and demand deposits (checking accounts). Some economists consider time and savings deposits to be part of the money supply because such deposits can be managed by governmental action and are involved in aggregate economic activity. These deposits are nearly as liquid as currency and demand deposits. Other economists believe that deposits in mutual savings banks, savings and loan associations, and credit unions should be counted as part of the money supply. The Federal Reserve Board in the United States and the Bank of England in the United Kingdom regulate the money supply to stabilize their respective economies. The Federal Reserve Board, for example, can buy or sell government securities, thereby expanding or contracting the money supply.

Open market operation,

any of the purchases and sales of government securities and sometimes commercial paper by the central banking authority for the purpose of regulating the money supply and credit conditions on a continuous basis. Open-market operations can also be used to stabilize the prices of government securities, an aim that conflicts at times with the credit policies of the central bank. When the central bank purchases securities on the open market, the effects will be (1) to increase the reserves of commercial banks, a basis on which they can expand their loans and investments; (2) to increase the price of government securities, equivalent to reducing their interest rates; and (3) to decrease interest rates generally, thus encouraging business investment.

If the central bank should sell securities, the effects would be reversed.Open-market operations are customarily carried out with short-term government securities (in the United States, frequently Treasury bills). Observers disagree on the advisability of such a policy. Supporters believe that dealing in both short-term and long-term securities would distort the interest-rate structure and therefore the allocation of credit. Opponents believe that this would be entirely appropriate because the interest rates on long-term securities have more direct influence on long-run investment activity, which is responsible for fluctuations in employment and income.

Money market

Every country with a monetary system of its own has to have some kind of market in which dealers in bills, notes, and other forms of short-term credit can buy and sell. The “money market” is a set of institutions or arrangements for handling what might be called wholesale transactions in money and short-term credit. The need for such facilities arises in much the same way that a similar need does in connection with the distribution of any of the products of a diversified economy to their final users at the retail level. If the retailer is to provide reasonably adequate service to his customers, he must have active contacts with others who specialize in making or handling bulk quantities of whatever is his stock-in-trade.

The money market is made up of specialized facilities of exactly this kind. It exists for the purpose of improving the ability of the retailers of financial services–commercial banks, savings institutions, investment houses, lending agencies, and even governments–to do their job. It has little if any contact with the individuals or firms who maintain accounts with these various retailers or purchase their securities or borrow from them.The elemental functions of a money market must be performed in any kind of modern economy, even one that is largely planned or socialist, but the arrangements in socialist countries do not ordinarily take the form of a market. Money markets exist in countries that use market processes rather than planned allocations to distribute most of their primary resources among alternative uses.

The general distinguishing feature of a money market is that it relies upon open competition among those who are bulk suppliers of funds at any particular time and among those seeking bulk funds, to work out the best practicable distribution of the existing total volume of such funds. n their market transactions, those with bulk supplies of funds or demands for them, rely on groups of intermediaries who act as brokers or dealers. The characteristics of these middlemen, the services they perform, and their relationship to other parts of the financial mechanism vary widely from country to country. In many countries there is no single meeting place where the middlemen get together, yet in most countries the contacts among all participants are sufficiently open and free to assure each supplier or user of funds that he will get or pay a price that fairly reflects all of the influences (including his own) that are currently affecting the whole supply and the whole demand. In nearly all cases, moreover, the unifying force of competition is reflected at any given moment in a common price (that is, rate of interest) for similar transactions. Continuous fluctuations in the money market rates of interest result from changes in the pressure of available supplies of funds upon the market and in the pull of current demands upon the market.
Monetary policy

measures employed by governments to influence economic activity, specifically by manipulating the supply of money and credit and rates of interest. Monetary measures are frequently used in tandem with fiscal policy (q.v.) to achieve certain goals. The usual goals of both monetary and fiscal policy are to achieve or maintain full employment, to achieve or maintain a high rate of economic growth, and to stabilize prices and wages. Until after World War II, monetary policy was thought by most experts to be of little use in influencing the economy. Postwar inflationary trends, however, forced governments to adopt monetary measures as a principal means of achieving economic stability. Monetary policy is the domain of a nation’s central bank. In the United States, monetary policy is the responsibility of the Federal Reserve Board (commonly called the Fed), while in Great Britain it is the Bank of England’s responsibility. Although there are some differences between the operations of the Fed and those of the Bank of England, the fundamentals are almost identical. The Fed uses three main instruments in regulating the money supply: open-market operations, the discount rate, and reserve requirements. The first is by far the most important. By buying or selling government securities, the Fed (or a central bank) affects the money supply and interest rates. If, for example, the Fed buys government securities, it pays with a check drawn on itself, which has the effect of creating money in the form of additional deposits by the sellers of the securities in commercial banks; by adding to the cash reserves of the commercial banks, those banks are enabled to increase their lending. The additional demand for government bonds bids up their price and thus reduces their yield (i.e., interest rates).

The rationale of this operation is to ease the availability of credit and reduce interest rates so as to encourage the business sector to invest more and consumers to increase their spending. The selling of government securities by the Fed achieves the opposite effect of contracting money supply and increasing interest rates. The second tool is the discount rate, which is the interest rate at which the Fed (or a central bank) lends to commercial banks. A rise in the discount rate discourages the banks from lending, because of the high rates involved in funding. In most countries the discount rate is used as a signal, and a change in it is followed by a similar change in the interest rates the commercial banks themselves charge to their customers. The third tool is reserve requirements. Commercial banks by law hold a specific percentage of their deposits and required reserves with the Fed (or a central bank), either in the form of reserve accounts or as cash. This reserve requirement acts as a brake on the lending operations of the commercial banks. By increasing or decreasing this reserve-ratio requirement, the Fed can influence the amount of money available for lending, and hence the money supply. The Bank of England and most other central banks have in their armouries a number of other tools, such as “treasury directive” regulation of installment purchasing and “special deposits.” Historically, under the gold standard, monetary policy was primarily directed to the protection of the central banks’ gold reserves.

When a nation’s balance of payments was in deficit, an outflow of gold resulted. In order to stem this drain the central bank raised the bank rate and undertook open-market operations to bring about a reduction in the total quantity of money in the country. This led to a fall in prices, income, and employment and reduced the demand for imports, thus correcting the trade imbalance. The reverse process was used to correct a balance of payments surplus. The stability of the domestic economy was essentially hostage to external market conditions. Domestic considerations assumed a greater importance in the 1930s in response to the massive unemployment problem, but the chief role in combating it was given to fiscal policy. The inflationary conditions of the post-World War II period led to a revival of interest in monetary policy. Many economists were skeptical of monetary policy’s ability to control inflation; they argued that to work, monetary policy must exert a prolonged restraining influence on the rate of consumption and investment expenditures in the private sector and that the cure might prove more damaging than the disease. The consensus in favour of fiscal policy gave way to greater reliance on monetary policy in the second half of the 1970s as inflation in the Western world rose to a level three times the 1950-70 average. The writings of monetarists such as Harry G. Johnson, Milton Friedman, and Friedrich Hayek concentrated on the link between the growth in money supply and accelerating inflation and argued that tight control of money-supply growth was a far more effective way of squeezing inflation out of the system than were demand-management policies. Monetary policy has grown in favour as a means of controlling cyclical fluctuations in the economy.



Simon Kuznets (1901-1985)

Capital in the American Economy. Its Formation and Financing. A
study of the National Bureau of Economic Research, Princeton University Press 1961


Definitions from Chapt. 1: Capital may take the form of goods, tangible assets or
claims, intangible or finanial assets . Claims are offset by obligations within the country, only the net balance of foreign claims remains. Nationwide capital is the stock of goods and net balance of foreign claims.
Current construction, flow of produced durable equipment to users, net additions to inventories of business and other agencies, but not of households – and net changes in claims against foreign countries. (p.389)
Net capital. formation=the above minus current consumption of fixed capital.
Chapter 5.

Internal Financing

Units use not only capital goods, but also capital assets.
Gross retention needs of money for internal financing:
Business: capital consumption and depletion allowances plus
net undistributed income. Households: equity shares in new housing. Government:
capital outlay minus net borrowing. Internal financing in all cases gives more decision power to the owners of assets.

Gross capital consumption allowances financed by internal sources in the
economy as a whole slightly decline.
For corporations there is a slight upward trend, from 0.57 in the 30-ies to 0.67 in 1960. Business sector net retention (corporate savings) to net capital formation has an upward trend, it is around about 35% in 1960.
There is a diversity of trends (between households, government, business, local authorities) but those are parts of a coordinate, operating system(p.415 ) What happens in one, must affect the others. Lines of association are working among the different trends.Government deficit (lowered internal financing) improved the net income position of agriculture. A contradiction concerning the earned capital consumption allowances: they pertain to internal financing. They rise against gross
capital formation, then why the raising of internal financing is so moderate even in business?

External financing

1.Distribution by category of users:
Government: o.o8 in first 3 decades of the XX Century to o.49 in 1930-1955.
For the same two periods: Households: 0.26, 0.35. Corporations: evenly 0.6.
“These trends in the distribution of total external financing among users are due to a combination of the trends of the external financing ratios…with the trends in the shares of the sectors ” (p.417)

2. Share of equity financing…net stock issues…in total financing for the same periods: Nonfinancial corporations: 0.35, 0.27 This decline in external financing is due also to disparity of costs in favor of long term debt, relative to equity money.

3. Long term vs. short term external sources in all external financing (same periods):
022, 038 for all non financial corporations. External financing for the business sector as a whole had an upward trend. For rhe country as a whole it remained unchanged: about 21-22%

4. Financial intermediaries
Their share countrywide: 0,44, 0,65. (with households and government at the same level), but business remained at 0,15.
Commercial banks, saving banks, personal trust shares declined, insurance and retirement funds rose from 1900 to 1955.

(Kuznets received the 1971 Nobel Memorial Prize in Economic Sciences “for his empirically founded interpretation of economic growth which has led to new and deepened insight into the economic and social structure and process of development”. )


Alfred Marshall (1842-1924): Priciples of Economics (1890)


Book IV

The Agents of Production

Land, Labour, and Capital and Organization

Chapter 1


1. The agents of production are commonly classed as Land,
Labour and Capital. By Land is meant the material and the forces
which Nature gives freely for man’s aid, in land and water, in
air and light and heat. By Labour is meant: the economic work of
man, whether with the hand or the head.(1*) By Capital is meant
all stored-up provision for the production of material goods, and
for the attainment of those benefits which are commonly reckoned
as part of income. It is the main stock of wealth regarded as an
agent of production rather than as a direct source of
Capital consists in a great part of knowledge and
organization: and of this some part is private property and other
part is not. Knowledge is our most powerful engine of production;
it enables us to subdue Nature and force her to satisfy our
wants. Organization aids knowledge; it has many forms, e.g. that
of a single business, that of various businesses in the same
trade, that of various trades relatively to one another, and that
of the State providing security for all and help for many. The
distinction between public and private property in knowledge and
organization is of great and growing importance: in some respects
of more importance than that between public and private property
in material things; and partly for that reason it seems best
sometimes to reckon Organization apart as a distinct agent of
production. It cannot be fully examined till a much later stage
in our inquiry; but something has to be said of it in the present
In a sense there are only two agents of production, nature
and man. Capital and organization are the result of the work of
man aided by nature, and directed by his power of forecasting the
future and his willingness to make provision for it. If the
character and powers of nature and of man be given, the growth of
wealth and knowledge and organization follow from them as effect
from cause. But on the other hand man is himself largely formed
by his surroundings, in which nature plays a great part: and thus
from every point of view man is the centre of the problem of
production as well as that of consumption; and also of that
further problem of the relations between the two, which goes by
the twofold name of Distribution and Exchange.
The growth of mankind in numbers, in health and strength, in
knowledge, ability, and in richness of character is the end of
all our studies: but it is an aim to which economics can do no
more than contribute some important elements. In its broader
aspects therefore the study of this growth belongs to the end, if
to any part of a treatise on economics: but does not properly
belong even there. Meanwhile we cannot avoid taking account of
the direct agency of man in production, and of the conditions
which govern his efficiency as a producer. And on the whole it is
perhaps the most convenient course, as it certainly is that most
in accordance with English tradition, to include some account of
the growth of population in numbers and character as a part of
the general discussion of production.
2. It is not possible at this stage to do more than indicate
very slightly the general relations between demand and supply,
between consumption and production. But it may be well, while the
discussion of utility and value is fresh in our minds, to take a
short glance at the relations between value and the disutility or
discommodity that has to be overcome in order to obtain those
goods which have value because they are at once desirable and
difficult of attainment. All that can be said now must be
provisional; and may even seem rather to raise difficulties than
to solve them: and there will be an advantage in having before us
a map, in however slight and broken outline, of the ground to be
While demand is based on the desire to obtain commodities,
supply depends mainly on the overcoming of the unwillingness to
undergo “discommodities.” These fall generally under two heads:
— labour, and the sacrifice involved in putting off consumption.
It must suffice here to give a sketch of the part played by
ordinary labour in supply. It will be seen hereafter that remarks
similar, though not quite the same, might have been made about
the work of management and the sacrifice which is involved
(sometimes, but not always) in that waiting which is involved in
accumulating the means of production.
The discommodity of labour may arise from bodily or mental
fatigue, or from its being carried on in unhealthy surroundings,
or with unwelcome associates, or from its occupying time that is
wanted for recreation, or for social or intellectual pursuits.
But whatever be the form of the discommodity, its intensity
nearly always increases with the severity and the duration of
labour. Of course much exertion is undergone for its own sake, as
for instance in mountaineering, in playing games and in the
pursuit of literature, of art, and of science; and much hard work
is done under the influence of a desire to benefit others.(2*)
But the chief motive to most labour, in our use of the term, is
the desire to obtain some material advantage; which in the
present state of the world appears generally in the form of the
gain of a certain amount of money. It is true that even when a
man is working for hire he often finds pleasure in his work: but
he generally gets so far tired before it is done that he is glad
when the hour for stopping arrives. Perhaps after he has been out
of work for some time, he might, as far as his immediate comfort
is concerned, rather work for nothing than not work at all; but
he will probably prefer not to spoil his market, any more than a
manufacturer would, by offering what he has for sale much below
its normal price. On this matter much will need to be said in
another volume.
In technical phrase this may be called the marginal
disutility of labour. For, as with every increase in the amount
of a commodity its marginal utility falls; and as with every fall
in that desirableness, there is a fall in the price that can be
got for the whole of the commodity, and not for the last part
only; so the marginal disutility of labour generally increases,
with every increase in its amount.
The unwillingness of anyone already in an occupation to
increase his exertions depends, under ordinary circumstances, on
fundamental principles of human nature which economists have to
accept as ultimate facts. As Jevons remarks,(3*) there is often
some resistance to be overcome before setting to work. Some
little painful effort is often involved at starting; but this
gradually diminishes to zero, and is succeeded by pleasure; which
increases for a while until it attains a certain low maximum.
after which it diminishes to zero, and is succeeded by increasing
weariness and craving for relaxation and change. In intellectual
work, however, the pleasure and excitement, after they have once
set in, often go on increasing till progress is stopped of
necessity or by prudence. Everyone in health has a certain store
of energy on which he can draw, but which can only be replaced by
rest; so that if his expenditure exceed his income for long, his
health becomes bankrupt; and employers often find that in cases
of great need a temporary increase of pay will induce their
workmen to do an amount of work which they cannot long keep up,
whatever they are paid for it. One reason of this is that the
need for relaxation becomes more urgent with every increase in
the hours of labour beyond a certain limit. The disagreeableness
of additional work increases; partly because, as the time left
for rest and other activities diminishes, the agreeableness of
additional free time increases.
Subject to these and some other qualifications, it is broadly
true that the exertions which any set of workers will make, rise
or fall with a rise or fall in the remuneration which is offered
to them. As the price required to attract purchasers for any
given amount of a commodity, was called the demand price for that
amount during a year or any other given time; so the price
required to call forth the exertion necessary for producing any
given amount of a commodity, may be called the supply price for
that amount during the same time. And if for the moment we
assumed that production depended solely upon the exertions of a
certain number of workers, already in existence and trained for
their work, we should get a list of supply prices corresponding
to the list of demand prices which we have already considered.
This list would set forth theoretically in one column of figures
various amounts of exertion and therefore of production; and in a
parallel column the prices which must be paid to induce the
available workers to put forth these amounts of exertion.(4*)
But this simple method of treating the supply of work of any
kind, and consequently the supply of goods made by that work,
assumes that the number of those who are qualified for it is
fixed; and that assumption can be made only for short periods of
time. The total numbers of the people change under the action of
many causes. Of these causes only some are economic; but among
them the average earnings of labour take a prominent place;
though their influence on the growth of numbers is fitful and
But the distribution of the population between different
trades is more subject to the influence of economic causes. In
the long run the supply of labour in any trade is adapted more or
less closely to the demand for it: thoughtful parents bring up
their children to the most advantageous occupations to which they
have access; that is to those that offer the best reward, in
wages and other advantages, in return for labour that is not too
severe in quantity or character, and for skill that is not too
hard to be acquired. This adjustment between demand and supply
can however never be perfect; fluctuations of demand may make it
much greater or much less for a while, even for many years, than
would have been just sufficient to induce parents to select for
their children that trade rather than some other of the same
class. Although therefore the reward to be had for any kind of
work at any time does stand in some relation to the difficulty of
acquiring the necessary skill combined with the exertion, the
disagreeableness, the waste of leisure, etc. involved in the work
itself; yet this correspondence is liable to great disturbances.
The study of these disturbances is a difficult task; and it will
occupy us much in later stages of our work. But the present Book
is mainly descriptive and raises few difficult problems.


1. Labour is classed as economic when it is “undergone partly or
wholly with a view to some good other than the pleasure directly
derived from it.” See p. 65 and footnote. Such labour with the
head as does not tend directly or indirectly to promote material
production, as for instance the work of the schoolboy at his
tasks, is left out of account, so long as we are confining our
attention to production in the ordinary sense of the term. From
some points of view, but not from all, the phrase Land, Labour,
Capital would be more symmetrical if labour were interpreted to
mean the labourers, i.e. mankind. See Walras, Économie Politique
Pure, Leçon 17, and Prof. Fisher, Economic Journal, VI, p. 529.

2. We have seen (p. 124) that, if a person makes the whole of his
purchases at the price which he would be just willing to pay for
his last purchases, he gains a surplus of satisfaction on his
earlier purchases; since he gets them for less than he would have
paid rather than go without them. So, if the price paid to him
for doing any work is an adequate reward for that part which he
does most unwillingly; and if, as generally happens, the same
payment is given for that part of the work which he does less
unwillingly and at less real cost to himself; then from that part
he obtains a producer’s surplus. Some difficulties connected with
this notion are considered in Appendix K.
The labourer’s unwillingness to sell his labour for less than
its normal price resembles the unwillingness of manufacturers to
spoil their market by pushing goods for sale at a low price; even
though, so far as the particular transaction is concerned, they
would rather take the low price than let their works stand idle.

3. Theory of Political Economy, Ch. V. This doctrine has been
emphasized and developed in much detail by Austrian and American

4. See above III, iii, section 4.


Böhm-Bawerk: Capital and Interest


Böhm-Bawerk: Capital and Interest
Book VII


Our attention has been too long fixed on individual theories. Let us, in conclusion, consider the subject as a whole. We have seen the rise of a motley array of interest theories. We have considered them all carefully and tested them thoroughly. No one of them contains the whole truth. Are they on that account quite fruitless? Taken all together, do they form nothing but a chaos of contradiction and error, that leaves us no nearer the truth than when we started? Is it not rather the case that, through the tangle of contradictory theories, there runs a line of
development which, if it has not itself led to the truth, has at least pointed the way in which truth is to be found? And how runs the line of this development?

I cannot better introduce the answer to this last question than by asking my readers once more to put clearly before their minds the substance of our problem. What really is the problem of interest?
The problem is to discover and state the causes which guide into the hands of the capitalists a portion of the stream of goods annually flowing out of the national production. There can be no question then that the interest problem is a problem of distribution.
But in what part of the stream is it that the current branches off into different arms? On this point the historical development of theory has brought to light three essentially distinct views, and these views have led to three as distinct fundamental conceptions of the whole problem.
Let us keep for a moment to the figure of the stream: it will serve very well to illustrate the subject. The source represents the production of goods; the mouth the ultimate division into incomes whereby human needs are satisfied; the course of the stream represents that stage between source and ultimate division where goods pass from hand to hand in economic transactions, and receive their value by human estimation.
Now the three views are the following. One view has it that the capitalist’s share is already separated out from the first. Three distinct sources — nature, labour, and capital — each in virtue of its inherent productive power, bring forth a definite quantity of goods, with a definite quantity of value, and just the same amount of value as has flowed from each source is discharged into the income of those persons who own the source. It is not so much one stream as three streams, that flow together for a long time in the same bed. But their waters do not mingle, and at the mouth they divide again in the same proportion as when they came out of the separate sources. This view transfers the whole explanation to the source of wealth; it treats the problem of interest as a problem of production. It is the view of the Naive Productivity theories.
The second view is directly opposed to the first. It finds the division first and exclusively in the discharge. There is only one source, labour. Out of it pours the whole stream of wealth, one and undivided. Even the course of the stream is undivided; in the value of goods there is nothing to prepare the way for a division of them among different participants, for all value is measured simply by labour. It is just at the mouth, just where the stream of wealth is about to pour out, and should pour out into the income of the workers who produce it, that, from each side, the owners of land and the owners of capital thrust out a dam into the stream, and forcibly divert a part of the current into their own property. This is the view of the socialist Exploitation theory. It denies interest any previous history in the earlier stages of the career of wealth. It sees in it simply the result of an inorganic, accidental, and violent taking. It treats the problem as purely one of distribution or division in the most offensive sense of the word.
The third view lies midway between the two. According to it there are two, perhaps even three springs in the source out of which flows the undivided stream of wealth. But in its course this stream comes under the influences that create value, and under these influences it immediately begins to branch asunder again. That is to say, in their calculation of use values (and of exchange values based on these) men put a value on the importance they attach to various goods and classes of goods, taking into consideration the amount and intensity of their needs on the one hand, and the quantity of means available to satisfy them on the other, and thus come to make division between goods and goods; they raise one kind and lower another. Thus emerge complicated differences of level, complicated tensions and attractions, under the influence of which the stream of goods is gradually forced asunder into three branches, of which each has its particular mouth. The one mouth discharges into the income of the owners of the land; the second into that of the workers; the third into that of the capitalists. But these three branches are neither identical with the two or three springs, nor do they even correspond with them in force. What decides the force of each branch at its mouth is not the strength of each spring at its source, but the amount which the formation of values has forced from the united stream into each of the three branches.
This then is the view in which all the remaining theories of interest agree. They find the final division already suggested in the stage of the formation of values, and therefore they consider it their duty to carry back their theory into this sphere. They supplement and widen out the distribution problem of interest into a problem of value.
Which of these three fundamental conceptions is the right one? To any moderate and candid observer the answer cannot remain doubtful.
It certainly is not the first view. Not only is capital not an original source of wealth, — since it is at all times the fruit of nature and labour, — but, as we have sufficiently proved, there is no power whatever in a factor of production to turn out its physical products with a definite value attached to them. In the production of goods neither value in general, nor surplus value in particular, nor interest on capital comes ready-made into the world. The problem of interest is not a simple problem of production.
But neither can the second conception be the correct one. The facts are against it. It is not for the first time in the distribution of goods, but before that, in the formation of value, that a foreign element intrudes itself by the side of labour. An oak tree a hundred years old, which during its long growth has only required the attention of a single day’s labour, has a hundred times higher value than the chair which another day’s labour has made out of a pair of boards. In this case the oak trunk, the product of one day’s labour, does not at once become a hundred times more valuable than the chair which costs one day’s labour. But day by day, year by year, the growing value of the oak diverges from the value of the chair. And as it is with the value of the oak, so is it with the value of all those products the production of which costs, not only labour, but time.
Now it is the same quiet and stubborn working forces as, step by step, separated the value of the oak from that of the chair, that have at the same time produced interest on capital. These forces, effective long before goods come to division, have marked out the future limiting line between wage of labour and interest on capital. For labour can be paid on no other principle than “like wages for like work.” But if the value of goods produced by similar labour becomes dissimilar through the action of these forces, the similar level of wages cannot everywhere be maintained and coincide with the dissimilar rise in the value of goods. It is only the value of goods not thus favoured that falls in level, and is appropriated by the general rate of wages which it determines. All goods that are favoured rise above this level in proportion as they have been favoured by the formation of value, and could not be appropriated by the general rate of wages. When then the final division comes, after all the workers have received like wages for like work, these favoured goods must of themselves leave something over which the capitalist can and may appropriate. They leave this something over, not because at the last moment the capitalist, by his sudden snatch at the spoil, artificially forces down the level of wages under the level of the value of goods, but because, long previously, the tendencies of the formation of value had raised the value of those goods which cost labour and time above the value of those other goods which cost only labour producing its result at once; — the value of which latter labour, as it must be sufficient to satisfy the labour of its production, forms at the same time the standard for the general rate of wages.
So speak the facts. The conclusions which they force us to draw are clear. The problem of interest is a problem of distribution. But the distribution has a previous history, and must be explained by that previous history. The sums of wealth do not start away from each other on a sudden; the diverging lines which they follow were quietly and gradually cut out in previous stages of their career. Whoever wishes really to understand the distribution, and truly to explain it, must go back to the origin of the quiet but distinct grooving of these lines of division, and this will lead him to the sphere of value. This is where the principal work is to be done in the explanation of interest. Whoever treats the problem as a simple problem of production breaks off his explanation before he has come to the principal point. Whoever treats it as a problem of distribution, and distribution only, begins it after the principal point is passed. It is only the economist who undertakes to clear up those remarkable rises and falls of value, where the rises are surplus value, who can hope, in explaining them, to explain interest in a really scientific way. The interest problem in its last resort is a problem of value. If we keep this in view we shall easily find the order of merit into which these various groups of theories fall, and we shall ascertain where runs the upward line of the development.
Two theories have entirely mistaken the character of the interest problem; together — the one forming the counterpart of the other — they constitute the lowest step in the development. These are the Naive Productivity theory and the socialist Exploitation theory. It may seem strange to mention these two in the same breath. How widely the two diverge in the results at which they arrive! How much superior the adherents of the Exploitation theory consider their arguments to the naive assumptions of the Productivity theorists! How proudly they proclaim their own advanced critical attitude! The association, however, is justified. First, the two theories agree in what they do not do. Neither of them touches on the distinctive problem. Neither of them wastes words in explaining those peculiar waves which are thrown up by the value of goods, and out of which surplus value comes. The Productivity theory contents itself with saying, in regard to these waves of value, that they have been produced. The Exploitation theory, almost more culpably, does not even notice them; for it they do not exist; for it, however the facts of the economical world may run contrary, the level of the value of goods agrees simply with the level of the labour expended on them.
But not only negations, but positive ideas bind these two theories more closely together than could well be believed. They are in truth fruit of one and the same bough; children of one and the same naive assumption that value grows out of production like the blade out of the field.
This assumption has an important history of its own in economic literature. In constantly changing shapes it has, for a hundred and thirty years, ruled our science, and by forcing the explanation of the fundamental phenomenon in a wrong direction has hindered its progress. First it appears in the physiocrat doctrine that land creates all surplus of value by its own fruitfulness. Adam Smith took the strength away from the assumption. Ricardo entirely uprooted it. But, before the first phenomenal form of it had quite disappeared, Say introduced it for a second time into the science in a new and extended form. Instead of the one productive power of the physiocrats appear three productive powers, which produce values and surplus values exactly in the same way as formerly the physiocrats had produced the produit net. Under this form the assumption held the science under its ban for ten long decades. At length the spell was broken, for the most part through the passionate but praiseworthy criticism of the socialist theorists. But still its tough vitality asserted itself. Giving up the form, not the substance, it managed to save itself under a new disguise, and by a strange freak of fortune found its new home in the writings of those who had most bitterly opposed it, the Socialists. The value-creating powers were gone; the value-creating power of labour remained, and with it the old fatal weakness that, instead of the subtle syntheses of the formation of value which should be the work and the pride of our science to unravel, there was nothing left but a stout assumption, or, so far as an assumption would not pass, a still more stout denial.
Thus the naive theory of the Productivity of capital and the emancipated theory of the socialists are twin systems. So far as the latter aspires to be a critical theory, well and good; it is really so; but it is also obviously a naive doctrine. It criticises one naive extreme only to fall into an opposite extreme that is no less naive. It is nothing else than the long-delayed counterpart of the Naive Productivity theory.
In comparison with it the remaining theories of interest may take credit to themselves for standing a step higher. They seek for the solution of the interest problem on the ground where the solution is really to be found, the ground of value. The respective merits of these theories, however, are different.
Those which seek to explain interest by the external machinery of the theory of costs have to carry a heavy handicap in the assumption that value grows out of production. Their explanation always leaves something over to explain. Just as certain as is the fact that the fundamental forces which set in motion all economical efforts of men are their interests, egoistic or altruistic, so certain is it that no explanation of the economical phenomena can be satisfactory where the threads of explanation do not reach back unbroken to these fundamental and undoubted forces. This is why the cost theories fail. In thinking that they find the principle of value, — of that guide and universal intermediate motive of human economical affairs, — not in a relation to human welfare, but in a dry fact of the external history of the manufacture of goods, in the technical conditions of their production, they follow the thread of explanation into a cul-de-sac, from which it is impossible to find a way to the psychological interest-motive to which every satisfactory explanation must go back. This condemnation applies to the majority of the interest theories we have been considering, however different the individual theories may have been.
Lastly, one step higher in rank stand those theories which have quite cut themselves adrift from the old superstition that the value of goods comes from their past instead of from their future. These theories know what they wish to explain, and in what direction the explanation is to be sought. If they have, notwithstanding, not discovered the entire truth, it is rather the result of accident; while their predecessors, cut off from the right way of its seeking by a wall of assumption, sought it in a wrong direction, and so sought it in vain. The higher step of the development is indicated in certain individual formulations of the Abstinence theory, but principally in the later Use theories; and here it is the theory of Menger which, to my mind, appears the highest point of the development up till now. And that not because his positive solution is the most complete, but because his statement of the problem is the most complete — two things, of which, as is often the case, the second may perhaps be more important and more difficult than the first.
On the foundation thus laid I shall try to find for the vexed problem a solution which invents nothing and assumes nothing, but simply and truly attempts to deduce the phenomena of the formation of interest from the simplest natural and psychological principles of our science.
I may just mention the element which seems to me to involve the whole truth. It is the influence of Time on human valuation of goods. To expand this proposition must be the task of the second and positive part of my work.


11 thoughts on “Economics

    1. Ama cikk az itt képviselt gazdaságtani elvek némely hazai megnyilvánulását fejtegeti – ez az egyik kapcsolat. A másik: úgy viszonyul az ittenihez, mint a partikuláris a totálishoz, a különös az általánoshoz.


  1. Most egészítettem ki a Growth Theory alfejezetet annak címétől az illető alfejezet összefoglalásáig terjedő szöveggel. Idáig itt csak a Summary volt olvasható.


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