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Published by norzamilazamri, 2022-05-12 01:11:15

The Economics Book

The Economics Book

LONDON, NEW YORK, MELBOURNE,
MUNICH, AND DELHI

DK LONDON DK DELHI First American Edition, 2012

PROJECT ART EDITORS SENIOR ART EDITOR Published in the United States by
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CONTRIBUTORS

NIALL KISHTAINY, CONSULTANT EDITOR JAMES MEADWAY

Niall Kishtainy teaches at the London School of Economist James Meadway works at the New
Economics and specializes in economic history and Economics Foundation, an independent British
development. He has worked for the World Bank and think tank. He has also worked as a policy adviser
the United Nations Economic Commission for Africa. for the UK Treasury.

GEORGE ABBOT CHRISTOPHER WALLACE

George Abbot is an economist who worked in 2012 on Christopher Wallace is Head of Economics
Barack Obama’s presidential reelection campaign. He at the UK’s prestigious Colchester Royal Grammar
previously worked with Compass, the influential UK School. He has been teaching economics for more
think tank, on strategic documents such as Plan B: than 25 years.
A New Economy for a New Society.
MARCUS WEEKS
JOHN FARNDON
Marcus Weeks studied philosophy and worked as a
John Farndon is the author of many books on teacher before embarking on a career as an author.
contemporary issues and the history of ideas, He has contributed to many books on the arts and
including overviews of the booming economies popular sciences.
of China and India.

FRANK KENNEDY

Frank Kennedy worked for over 25 years in
investment banking in the City of London as a
top-ranked investment analyst and as a managing
director in capital markets, where he led a European
team advising financial institutions. He studied
economic history at the London School of Economics.

CONTENTS

10 INTRODUCTION THE AGE 66 Divide up pin
OF REASON production, and you
LET THE TRADING get more pins
BEGIN 1770–1820 The division of labor

400 BCE–1770 CE 52 Man is a cold, rational 68 Population growth
calculator keeps us poor
20 Property should be Economic man Demographics
private Property rights and economics
54 The invisible hand
22 What is a just price? of the market 70 Meetings of merchants
Markets and morality brings order end in conspiracies to
Free market economics raise prices
24 You don’t need to barter Cartels and collusion
when you have coins 62 The last worker adds
The function of money less to output than 74 Supply creates its
the first own demand
26 Make money from money Diminishing returns Gluts in markets
Financial services
63 Why do diamonds cost 76 Borrow now, tax later
30 Money causes inflation more than water? Borrowing and debt
The quantity theory of money The paradox of value
78 The economy is a yo-yo
34 Protect us from 64 Make taxes fair Boom and bust
foreign goods and efficient
80 Trade is beneficial
Protectionism and trade The tax burden for all
Comparative advantage
36 The economy can be
counted Measuring wealth

38 Let firms be traded
Public companies

39 Wealth comes from
the land

Agriculture in the economy

40 Money and goods flow
between producers and
consumers The circular
flow of the economy

46 Private individuals never
pay for street lights
Provision of public goods
and services

INDUSTRIAL AND WAR AND
ECONOMIC DEPRESSIONS
REVOULTIONS
1929–1945
1820–1929
154 Unemployment is not
90 How much should I a choice Depressions and
produce, given the
competition? unemployment
Effects of limited competition
126 Companies are price 162 Some people love risk,
92 Phone calls cost takers not price makers others avoid it
more without
competition The competitive market Risk and uncertainty
Monopolies
130 Make one person better off 164 Government spending
98 Crowds breed collective without hurting the others boosts the economy by
insanity Efficiency and fairness more than what is spent
Economic bubbles The Keynesian multiplier
132 The bigger the factory,
100 Let the ruling classes the lower the cost 166 Economies are embedded
tremble at a communist Economies of scale in culture
revolution Economics and tradition
Marxist economics 133 The cost of going to the
movies is the fun you’d 168 Managers go for perks,
have had at an ice rink not their company’s profits
Opportunity cost Corporate governance

106 The value of a product 134 Workers must improve 170 The economy is a
comes from the effort their lot together predictable machine
needed to make it
The labor theory of value Collective bargaining Testing economic theories

108 Prices come from supply 136 People consume to 171 Economics is the science
and demand be noticed of scarce resources
Supply and demand
Conspicuous consumption Definitions of economics
114 You enjoy the last
chocolate less than 137 Make the polluter pay 172 We wish to preserve
the first External costs a free society
Utility and satisfaction Economic liberalism
138 Protestantism has made
116 When the price goes up, us rich 178 Industrialization creates
some people buy more Religion and the economy sustained growth
Spending paradoxes The emergence of modern
140 The poor are unlucky, economies
118 A system of free markets not bad The poverty problem
is stable 180 Different prices to different
Economic equilibrium 142 Socialism is the abolition people Price discrimination
of rational economy
Central planning

124 If you get a pay raise, 148 Capitalism destroys the
buy caviar not bread old and creates the new

Elasticity of demand Creative destruction

POST-WAR CONTEMPORARY
ECONOMICS ECONOMICS

1945–1970 1970–PRESENT

186 In the wake of war 262 It is possible to invest
and depression, nations without risk
must cooperate
International trade and Financial engineering
Bretton Woods
220 Policies to correct markets 266 People are not
188 All poor countries need can make things worse 100 percent rational
is a big push The theory of the second best Behavioral economics
Development economics
222 Make markets fair 270 Tax cuts can increase
194 People are influenced by The social market economy the tax take
irrelevant alternatives Taxation and
Irrational decision making 224 Over time, all countries economic incentives
will be rich
196 Governments should do Economic growth theories 272 Prices tell you everything
nothing but control the Efficient markets
money supply
Monetarist policy 226 Globalization is not 273 Over time, even the
inevitable Market integration selfish cooperate with
202 The more people at work, others Competition
the higher their bills 232 Socialism leads to and cooperation
Inflation and unemployment empty shops Shortages in
planned economies 274 Most cars traded will
204 People smooth be lemons
consumption over their 234 What does the other man Market uncertainty
life spans Saving to spend think I am going to do?
Game theory 276 The government’s
206 Institutions matter promises are incredible
Institutions in economics 242 Rich countries impoverish Independent central banks
the poor Dependency theory

208 People will avoid work if 244 You can’t fool the people
they can Market information Rational expectations
and incentives
248 People don’t care
210 Theories about market about probability
efficiency require many when they choose
assumptions Paradoxes in decision making
Markets and social outcomes
250 Similar economies can
214 There is no perfect voting benefit from a single
system Social choice theory currency Exchange rates
and currencies
216 The aim is to maximize
happiness, not income 256 Famine can happen
The economics of in good harvests
happiness Entitlement theory

278 The economy is chaotic 302 Businesses pay more 316 Pessimism can destroy
even when individuals than the market wage healthy banks
are not Incentives and wages Bank runs
Complexity and chaos
303 Real wages rise during 322 Savings gluts abroad
280 Social networks are a recession fuel speculation at home
a kind of capital Sticky wages Global savings imbalances
Social capital
304 Finding a job is like 326 More equal societies
281 Education is only a finding a partner or a grow faster
signal of ability house Searching and Inequality and growth
Signaling and screening matching
328 Even beneficial economic
282 The East Asian state 306 The biggest challenge reforms can fail
governs the market for collective action is Resisting economic change
Asian Tiger economies climate change
Economics and 330 The housing market
288 Beliefs can trigger the environment mirrors boom and bust
currency crises Housing and the
Speculation and 310 GDP ignores women economic cycle
currency devaluation Gender and economics
332 DIRECTORY
294 Auction winners pay 312 Comparative advantage
over the odds is an accident 340 GLOSSARY
The winner’s curse Trade and geography
344 INDEX
296 Stable economies contain 313 Like steam, computers
the seeds of instability have revolutionized 351 ACKNOWLEDGMENTS
Financial crises economies
Technological leaps

314 We can kick-start poor
economies by writing
off debt
International debt relief

INTRODU

CTION

12 INTRODUCTION

F ew people would claim workplace or over the dinner table. seem to be at the mercy
to know very much about So to some extent, we do all take of risk-taking banks and big
economics, perhaps seeing an interest in economics. The corporations, do we know how
it as a complex and esoteric arguments we use to justify our they came to be so powerful or
subject with little relevance to opinions are generally the same understand the reasons for their
their everyday lives. It has been as those used by economists, so a original and continued existence?
generally felt to be the preserve of better knowledge of their theories The discipline of economics is at
professionals in business, finance, can give us a better understanding the heart of questions such as these.
and government. Yet most of us of the economic principles that
are becoming more aware of its are at play in our lives. The study of management
influence on our wealth and well- Despite the importance and
being, and we may also have Economics in the news centrality of economics to many
opinions—often quite strong Today, with the world in apparent issues that affect us all, economics
ones—about the rising cost economic turmoil, it seems more as a discipline is often viewed with
of living, taxes, government important than ever to learn suspicion. A popular conception is
spending, and so on. Sometimes something about economics. Far that it is dry and academic, due to
these opinions are based on an from occupying a separate section its reliance on statistics, graphs,
instant reaction to an item in the of our newspaper or making up a and formulas. The 19th-century
news, but they are also frequently small part of the television news, Scottish historian Thomas Carlyle
the subject of discussions in the economic news now regularly described economics as the
makes the headlines. As early as “dismal science” that is “dreary,
In economics, hope and faith 1997, the US Republican political desolate, and, indeed, quite abject
coexist with great scientific campaign strategist Robert Teeter and distressing.” Another common
pretension and also a deep noted its dominance, saying, “Look misconception is that it is “all
at the declining television about money,” and while this has a
desire for respectability. coverage [of politics]. Look at the grain of truth, it is by no means the
John Kenneth Galbraith declining voting rate. Economics whole picture.
and economic news is what moves
Canadian-US economist (1908–2006) the country now, not politics.” So, what is economics all about?
The word is derived from the
Yet how much do we really Greek word Oikonomia, meaning
understand when we hear about “household management,” and it
rising unemployment, inflation, has come to mean the study of the
stock market crises, and trading way we manage our resources, and
deficits? When we’re asked to more specifically, the production
tighten our belts or pay more taxes, and exchange of goods and
do we know why? And when we services. Of course, the business

INTRODUCTION 13

of producing goods and providing laws that govern how the economy as “the science which studies
services is as old as civilization, behaves, in the same way that human behavior as a relationship
but the study of how the process scientists had discovered the between ends and scarce means
works in practice is comparatively physical laws underlying natural which have alternative uses.” This
new. It evolved only gradually; phenomena. Economies, however, broad definition remains the most
philosophers and politicians are man-made and are dependent popular one in use today.
have expressed their opinions on on the rational or irrational
economic matters since the time behavior of the humans that act The most important difference
of the ancient Greeks, but the first within them, so economics as a between economics and other
true economists to make a study of science has more in common sciences, however, is that the
the subject did not appear until the with the “soft sciences” of systems it examines are fluid.
end of the 18th century. psychology, sociology, and politics. As well as describing and
explaining economies and how
At that time the study was Economics was perhaps best they function, economists can
known as “political economy,” defined by British economist Lionel also suggest how they ought to be
and had emerged as a branch Robbins. In 1932, he described it constructed or can be improved.
of political philosophy. However, in his Essay on the Nature and
those studying its theories Significance of Economic Science The first economists
increasingly felt that it should be Modern economics emerged as
distinguished as a subject in its The first lesson of economics a distinct discipline in the 18th
own right and began to refer to it is scarcity: there is never century, in particular with
as “economic science.” This later the publication in 1776 of The
became popularized in the shorter enough of anything to satisfy Wealth of Nations, written by the
form of “economics.” all those who want it. great Scottish thinker Adam Smith.
However, what prompted interest
A softer science The first lesson of politics in the subject was not so much
Is economics a science? The is to disregard the first the writings of economists as the
19th-century economists certainly lesson of economics. enormous changes in the economy
liked to think so, and although Thomas Sowell itself with the advent of the
Carlyle thought it dismal, even Industrial Revolution. Previous
he dignified it with the label of US economist (1930– ) thinkers had commented on the
science. Much economic theory management of goods and services
was modeled on mathematics and within societies, treating questions
even physics (perhaps the “-ics” that arose as problems for moral
ending of “economics” helped to or political philosophy. But with
lend it scientific respectability), the arrival of factories and mass
and it sought to determine the producers of goods came a new ❯❯

14 INTRODUCTION

era of economic organization that in terms of output and income, and brought and advocated a “hands-off”
looked at the bigger picture. This its policies for international trade, or laissez-faire approach to allow the
was the beginning of the so-called taxation, and controlling inflation competitive market to create wealth
market economy. and unemployment. In contrast, and stimulate technological
what we now call “microeconomics” innovation. Others were more
Smith’s analysis of the new looks at the interactions of cautious in their estimation of the
system set the standard with a individual people and firms within market’s ability to benefit society
comprehensive explanation of the economy: the business of and identified failings of the system.
the competitive market. Smith supply and demand, buyers and They thought these could be
suggested that the market is guided sellers, markets and competition. overcome by state intervention and
by an “invisible hand,” where the argued for a role for governments
rational actions of self-interested New schools of thought in providing certain goods and
individuals ultimately give the wider Naturally, there were differences services and in curbing the power
society exactly what it needs. Smith of opinion among economists, and of the producers. In the analysis
was a philosopher, and the subject various schools of thought evolved. of some, notably the German
of his book was “political economy” Many welcomed the prosperity that philosopher Karl Marx, a capitalist
—it stretched beyond economics to the modern industrial economy economy was fatally flawed and
include politics, history, philosophy, would not survive.
and anthropology. After Smith a Economics is, at root,
new breed of economic thinkers the study of incentives: The ideas of the early “classical”
emerged who chose to concentrate how people get what they economists such as Smith were
entirely on the economy. Each of want, or need, especially increasingly subjected to rigorous
these built upon our understanding when other people want examination. By the late 19th
of the economy—how it works and or need the same thing. century economists educated in
how it should be managed—and science were approaching the
laid the foundations for the various Steven D. Levitt subject through the disciplines
branches of economics. Stephen J. Dubner of mathematics, engineering, and
physics. These “neoclassical”
As the discipline evolved, US economists (1967– and 1963– ) economists described the economy
economists identified specific areas in graphs and formulas, and
to examine. One approach was to proposed laws that governed the
look at the economy as a whole, workings of the markets and
either at a national or international justified their approach.
level, which became known as
“macroeconomics.” This area By the end of the 19th century
of economics takes in topics economics was beginning to
such as growth and development, develop national characteristics:
measurement of a country’s wealth centers of economic thinking had

INTRODUCTION 15

grown as university departments agreed. Although the majority again shifting, and no doubt new
were established, and there were of economists had faith in the economic thinking will evolve to
distinguishable differences stability, efficiency, and rationality help manage our scarce resources.
between the major schools in of the markets, there were some
Austria, Britain, and Switzerland, who had doubts, and new One prominent casualty of the
particularly on the desirability of approaches arose. recent economic crises is Greece,
some degree of state intervention where the history of economics
in the economy. Alternative approaches started, and where the word
In the late 20th century new areas “economics” comes from. In 2012,
These differences became even of economics incorporated ideas protesters in Athens pointed out
more apparent in the 20th century, from disciplines such as psychology that democracy also comes from
when revolutions in Russia and and sociology into their theories, the Greeks but is in danger of
China brought almost a third of the as well as new advances in being sacrificed in the search
world under communist rule, with mathematics and physics, such for a solution to a debt crisis.
planned economies rather than as game theory and chaos theory.
competitive markets. The rest of These theorists also warned of It remains to be seen how the
the world, however, was concerned weaknesses in the capitalist world economy will resolve its
with asking whether the markets system. The increasingly severe and problems, but, armed with the
alone could be trusted to provide frequent financial crises that took principles of economics outlined
prosperity. While continental Europe place at the beginning of the 21st in this book, you will see how we
and Britain argued about degrees of century reinforced the feeling that got into the present situation, and
government intervention, the real there was something fundamentally perhaps begin to see a way out. ■
battle of ideas was fought in the wrong in the system; at the same
US during the Great Depression time scientists concluded that our The purpose of studying
after the Wall Street Crash of 1929. ever-increasing economic wealth economics is …to learn how
came at a cost to the environment
In the second half of the 20th in the form of potentially disastrous to avoid being deceived
century the center of economic climate change. by economists.
thought shifted from Europe to
the US, which had become the As Europe and the US begin to Joan Robinson
dominant economic superpower deal with perhaps the most serious
and was adopting ever more economic problems they have ever UK economist (1903–83 )
laissez-faire policies. After the faced, new economies have
collapse of the Soviet Union in emerged, especially in Southeast
1991, it seemed that the free market Asia and the so-called BRIC
economy was indeed the route countries (Brazil, Russia, India, and
to economic success, as Smith China). Economic power is once
had predicted. Not everyone

LET TRA
BEGIN

400 BCE–1770 CE

DING

18 INTRODUCTION

Plato describes his Thomas Aquinas Bills of exchange The British East
ideal state, where argues that the price of become a standard India Company, an
property is owned by a product is “just” only method of payment international trading
if profit is not excessive in European trade, company and the world’s
all and labor is and there is no deception first global brand,
specialized. redeemable by
involved in the sale. merchant banks. is established.

C.380 BCE 1265–74 CE C.1400 1599

C.350 BCE 1397 1492 C.1630

Aristotle argues in The Medici Bank is Christopher Thomas Mun
favor of private founded in Florence, Columbus arrives in advocates a
Italy—one of the first the Americas; soon mercantilist policy,
property but against gold is flowing into using foreign exports
accumulating money of the financial Europe, increasing as a way of increasing
institutions built on the money supply. a nation’s wealth.
for its own sake. international trade.

A s civilizations evolved in specialty producers providing Aquinas considered the morality of
the ancient world, so too products for the common good. prices, arguing for the importance
did systems for providing However, his pupil Aristotle of “just” prices, where no excessive
goods and services to populations. defended the concept of private profit was made by the merchant.
These early economic systems property, which could be traded in
emerged naturally as various trades the market. These are arguments The ancients lived in societies
and crafts produced goods that that have continued to the present where labor was composed largely
could be exchanged. People began day. As philosophers Plato and of slaves, and medieval Europe ran
to trade, first by bartering and later Aristotle thought of economics as a on a feudal system—where
with coins of precious metal, and matter of moral philosophy: rather peasants were protected by local
trade became a central part of life. than analyzing how an economic lords in exchange for labor or
The business of buying and selling system worked, they came up with military service. So the moral
goods operated for centuries before ideas for how it should work. This arguments of these philosophers
it occurred to anyone to examine kind of approach is said to be were somewhat academic.
how the system worked. “normative”—it is subjective and
looks at “what ought to be” the case. Rise of the city-states
The ancient Greek philosophers A major change occurred in the
were among the first to write about The normative approach to 15th century, as city-states developed
the topics that came to be known economics continued into the in Europe and became wealthy
collectively as “economics.” In Christian era, as medieval through international trade. A new,
The Republic, Plato described the philosophers such as Thomas prosperous class of merchants
political and social makeup of an Aquinas (p.23) attempted to define replaced the feudal landowners
ideal state, which he said would the ethics of private property and as the important players in the
function economically, with trading in the marketplace. economy, and they worked hand-in-

LET TRADING BEGIN 19

A speculative William Petty Gregory King François Quesnay and
bubble in the Dutch shows how the compiles a statistical his followers, the
economy can be
market for tulips measured in summary of the physiocrats, argue that
bursts, leaving Quantulumcunque trade of England in land and agriculture
thousands of Concerning Money. the 17th century. are the only sources of
investors ruined.
economic prosperity.

1637 1682 1697 1756
1668 1689 1752 1758

Josiah Child describes John Locke argues that David Hume argues Quesnay produces
free trade—he wealth is derived that public goods his Economic Table,
not from trade, but should be paid for the first analysis for the
advocates increasing from labor. by governments.
imports as well workings of a
as exports. whole economy—the
“macroeconomy.”

hand with dynasties of bankers, As trade increased, it moved beyond which prized rationality above
who financed their trading and the hands of individual merchants all, took a scientific approach to
voyages of discovery. and their backers. Partnerships and “political economy.” Economists
companies were set up, often with attempted to measure economic
New trading nations replaced government backing, to oversee activity and described the working
small-scale feudal economies, and large trading operations. These firms of the system, rather than looking
economic thinking began to focus began to be split into “shares” so only at moral implications.
on how best to control the exchange they could be financed by many
of goods and money from one investors. Interest in buying shares In France a group of thinkers
country to another. The dominating grew rapidly in the late 17th century, known as the physiocrats analyzed
approach of the time, known as leading to the establishment of the flow of money around the
mercantilism, was concerned with many joint-stock companies and economy and effectively produced
the balance of payments—the stock exchanges, where the shares the first macroeconomic (whole-
difference between what a country could be bought and sold. economy) model. They placed
spends on imports and what it agriculture rather than trade or
earns from exports. Selling goods A new science finance at the heart of the economy.
abroad was seen as good because The huge increase in trading also Meanwhile, political philosophers
it brought money into the country; prompted a renewed interest in the in Britain shifted the emphasis
importing goods was seen as working of the economy and led to away from mercantilist ideas of
damaging because money flowed the beginnings of the discipline of trade, and toward producers,
out. To prevent a trade deficit and economics. Emerging at the consumers, and the value and
protect domestic producers against beginning of the 18th century, the utility of goods. The framework
foreign competition, mercantilists so-called Age of Enlightenment, for the modern study of economics
advocated the taxing of imports. was beginning to emerge. ■

20

PROPERTY
SHOULD BE
PRIVATE

PROPERTY RIGHTS

IN CONTEXT W e learn about ownership potential for personal gain—there is
and personal property no reason even to enter the market.
FOCUS from our earliest There is, in effect, no market.
Society and the economy childhood tussles over toys. This
concept is often taken for granted, Types of property
KEY THINKER yet there is nothing inevitable “Property” encompasses a wide
Aristotle (384–322 BCE) about the idea. Private property range of things, from material
is fundamental to capitalism. Karl goods to intellectual property (such
BEFORE Marx (p.105) noted that the wealth as patents or written text). It has
423–347 BCE Plato argues in generated by capitalism presents entered realms that even free
The Republic that rulers should societies with “an immense market economists would not
hold property collectively for collection of commodities” that are defend, such as slavery—where
the common good. privately owned and may be traded people were viewed as commodities.
for profit. Businesses are also
AFTER privately owned and operated for Historically, material property
1–250 CE In classical Roman profit in a free market. Without the has been organized three different
law the sum of rights and idea of private property, there is no ways. First, everything can be held
powers a person has over a in common and used by everyone
thing is called dominium. Defending private ownership is as they wish, on the basis of mutual
important in capitalist countries. This trust and custom. This was the case
1265–74 Thomas Aquinas house in Warsaw, Poland, is the most in tribal economies, and it is still
argues that owning property is secure home ever built; it turns into a practiced by the Huaorani people of
natural and good, but private steel cube at the touch of a button. the Amazon. Second, property can
property is less important than be held and used collectively; this
the public good. is the essence of the communist
system. Third, property can be held
1689 John Locke states that in private, with each person free to
what you create by your own do with it as they choose. This is the
labor is yours by right. concept at the heart of capitalism.

1848 Karl Marx writes the Modern economists tend to
Communist Manifesto, justify private property on pragmatic
advocating the complete grounds, arguing that the market
abolition of private property. simply can’t operate without some
division of resources. Earlier
thinkers made more of a moral case

See also: Markets and morality 22–23 ■ Provision of public goods and LET TRADING BEGIN 21
services 46–47 ■ Marxist economics 100–05 ■ Definitions of economics 171
How private?
When property … it prevents
is held in people from acting In every modern society some
common… things are shared as collective
benevolently property, such as streets and
(people cannot be parks. Others, such as cars,
generous if they are private property. Property
don’t have anything rights, or legal ownership,
normally confers on the owner
to give away). exclusive rights over a
particular resource, but this
… it provides is not always the case.
little incentive for The owner of a house in a
individuals to trade historic district, for instance,
might not be allowed to knock
and invest. it down and replace it with
a skyscraper or a factory,
… no one maintains Property should or even change the use of
it (everyone will be private. the current building. The
governments of every country
act self-interestedly in the world reserve the right
and assume to override private ownership
when this is deemed necessary,
someone else will for reasons varying from the
do the work). needs of infrastructure to
national safety issues. Even in
the US, a staunchly capitalist
nation, the government may
force a property owner to
relinquish his or her rights.
However, the 14th amendment
to the Constitution softens
this blow by stating that the
owner must be compensated
with the market price.

for private property. The Greek dominion over our own bodies, we It is clearly better that property
philosopher Aristotle argued that also have dominion over the things should be private, but the
“property should be private.” He we make. The German philosopher use of it common; and
pointed out that when property Immanuel Kant (1724–1804) later the special business of the
is held in common, no one takes argued that private property is a
responsibility to maintain and legitimate expression of the self. legislator is to create in men
improve it. Moreover, people can this benevolent disposition.
only become generous if they have Another German philosopher,
something to give away. however, rejected the notion of Aristotle
private property entirely. Karl Marx
A right to property insisted that the concept of private
In the 17th century all land and property is nothing but a device by
housing in Europe was effectively which the capitalist expropriates
owned by monarchs. The English the labor of the proletarian, keeps
philosopher John Locke (1632–1704), him in slavery, and excludes him.
however, spoke out for individual The proletariat is effectively locked
rights, saying that as God gave us out of the select group that controls
all wealth and power. ■

22

WHAT IS A
JUST PRICE?

MARKETS AND MORALITY

IN CONTEXT M any people know what it people are prepared to pay. For
is like to be exploited or market economists there is no
FOCUS “ripped off” by a vendor, moral dimension to price at all—
Society and the economy such as when buying overpriced pricing is simply an automatic
ice-creams at a tourist venue. Yet function of supply and demand.
KEY THINKER according to prevailing economic Merchants who appear to be
Thomas Aquinas (1225–74) theory, there is no such thing as a overcharging are simply pushing
rip-off. The price of anything is the price to its limits. If they push
BEFORE simply the market price—the price their price further than people are
C.350 BCE In Politics, Aristotle
says that all goods must be What is a just price?
measured in value by one
thing—“need.” The market needs goods. Traders will only supply
goods if there is a
529–534 CE Roman courts reward (a profit).
protect landowners from being
forced to sell land below the But there is a moral
just price, at “great loss.” dimension too. To avoid prices

AFTER being “unjust”…
1544 The Spanish economist
Luis Saravia de la Calle argues … profit should … no deception … the buyer must
that price must be set by not be excessive, can be involved in freely accept
“common estimation” founded setting the value the price.
on quality and abundance. because avarice
is a sin. of the goods.
1890 Alfred Marshall proposes
that prices are automatically
set by supply and demand.

1920 Ludwig von Mises
argues that socialism cannot
work because prices are the
only way to establish need.

LET TRADING BEGIN 23

See also: Property rights 20–21 ■ Free market economics 54–61 ■ Supply and
demand 108–13 ■ Economics and tradition 166–67

Medieval communities felt strongly simply the price the buyer freely Thomas Aquinas
about the prices merchants charged. agrees to pay, given honest
In 1321, William le Bole of London was information. The vendor is not St. Thomas Aquinas was one
punished for selling underweight bread obliged to make the buyer aware of the greatest scholars of the
by being dragged through the streets. of facts that might lower the price Middle Ages. He was born in
in the future, such as the shiploads Aquino, Sicily, in 1225, to an
prepared to pay, people stop of cheap spice due to dock shortly. aristocratic family, and began
buying, so the merchants are forced his education at the age of
to bring down their prices. Market The issues of price and morality five. At the age of 17 he
economists consider the marketplace are very much alive today, since decided to leave worldly
to be the only way to establish both economists and the public wealth behind and join an
price, as nothing—not even gold— discuss “the just price” of a CEO’s order of poor Dominican
has an intrinsic value. bonus or the minimum wage. Free monks. His family was so
market economists, who reject shocked that they kidnapped
A price freely accepted interference in the market, and him on his way to join the
The idea that the marketplace those who advocate government order and held him captive for
should set prices seems to contrast intervention—whether for moral two years. His determination,
sharply with the view expressed by or economic reasons—continue to however, remained unbroken,
Sicilian scholar Thomas Aquinas argue about the rights and wrongs and eventually the family gave
in his Summa Theologica, one of of imposing restrictions on pricing. ■ in, letting him go to Paris,
the first studies of the marketplace. where he came under the
For Aquinas, a scholar monk, price No man should sell tutelage of the scholar monk
was a deeply moral issue. Aquinas a thing to another man Albert the Great (1206–80).
recognized avarice as a deadly sin, for more than its worth. Aquinas studied and taught in
but at the same time he saw that if France and Italy, and in 1272,
a merchant is deprived of the profit Thomas Aquinas founded a studium generale (a
incentive, he would cease to trade, type of university) in Naples,
and the community would be Italy. His many philosophical
deprived of goods it needed. works were hugely influential
in paving the way to the
Aquinas concluded that a modern world.
merchant may charge a “just price,”
which includes a decent profit, but Key works
excludes excessive profiteering,
which is sinful. This just price is 1256–59 Disputed Questions
on Truth
1261–63 Summa contra
Gentiles
1265–73 Summa Theologica

24

YOU DON’T NEED TO
BARTER WHEN YOU
HAVE COINS

THE FUNCTION OF MONEY

IN CONTEXT I n many parts of the world The Tiwa tribal people of Assam,
people are increasingly moving India, exchange goods through barter
FOCUS towards a cashless society in during the Jonbeel Mela, an age-old
Banking and finance which goods are bought with credit festival to preserve harmony and
cards, electronic transfers, and brotherhood between tribes.
KEY EVENT mobile-phone chips. But dispensing
Kublai Khan adopts fiat with cash does not mean that money
money in the Mongol Empire is not used. Money remains at the
during the 13th century. heart of all our transactions.

BEFORE The disturbing effects of money
3000 BCE In Mesopotamia are well known, inciting everything
the shekel is used as a unit of from miserliness to crime and
currency: a unit of barley of warfare. Money has been used as a
a certain weight equals a tribute (sign of respect), in religious
certain value of gold or silver. rites, and for ornamentation. “Blood
money” is paid as recompense for
700 BCE The oldest known murder; brides are bought with
coins are made on the Greek “bride money” or given away with
island of Aegina. dowries to enrich their husbands.
Money lends status and power to
AFTER individuals, families, and nations.
13th century Marco Polo
brings promissory notes from A barter economy your new car? Barter depends on
China to Europe, where they Without money, people could only the double coincidence of wants,
are used by Italian bankers. barter. Many of us barter to a small where not only does the other
extent, when we return favors. person happen to have what I want,
1696 The Bank of Scotland is A man might offer to mend his but I also have what he wants.
the first commercial operation neighbor’s broken door in return
to issue bank notes. for a few hours of babysitting, for Money solves all these problems.
instance. Yet it is hard to imagine There is no need to find someone
1971 President Nixon these personal exchanges working who wants what you have to trade;
cancels the convertibility on a larger scale. What would you simply pay for your goods with
of the US dollar to gold. happen if you wanted a loaf of money. The seller can then take the
bread and all you had to trade was money and buy from someone else.

See also: Financial services 26–29 ■ The quantity theory of money 30–33 ■ LET TRADING BEGIN 25
The paradox of value 63
Shelling out
Money is transferable and deferrable China in the 10th century, is money
—the seller can hold on to it and buy that is simply a token of exchange Wampum were strings of
when the time is right. Many argue with no value other than that white and black shell beads
that complex civilizations could assigned to it by the government. treasured by the indigenous
never have arisen without the A paper bank note is fiat money. North Americans of the
flexibility of exchange that money Eastern Woodland tribes.
allows. Money also gives a yardstick Many paper currencies were Before the European settlers
for deciding the value of things. If all initially “promises to pay” against arrived in the 15th century,
goods have a monetary value, we gold held in reserve. In theory dollars wampum was used mainly for
can know and compare every cost. issued by the US Federal Reserve ceremonial purposes. People
could be exchanged for their gold might exchange wampum to
Different kinds of money value. Since 1971, the value of a dollar record an agreement or to pay
There are two kinds of money: has no longer been convertible to tribute. Its value came from
commodity and fiat. Commodity gold and is set entirely by the US the immense skill involved
money has intrinsic value besides Treasury, without reference to its in making it, and in its
its specified worth, for example gold reserves. Such fiat currencies ceremonial associations.
when gold coins are used as rely on people’s confidence in a
currency. Fiat money, first used in country’s economic stability, which When Europeans arrived,
is not always assured. ■ their tools revolutionized
wampum making, and Dutch
With barter a person With money an individual colonizers mass-produced the
can only exchange can buy from anyone beads by the million. Soon,
with someone who they were using wampum to
wants what he or she who is willing to sell. trade and buy things from the
native peoples, who had no
has to offer. With money a seller can interest in coins, but valued
sell to anyone who wants wampum. Wampum soon
But you don’t became a currency with
need to barter if what the seller has. an accepted exchange rate.
you have coins. In New York eight white or
four black wampum equaled
one stuiver (a Dutch coin of
the time). The use and value
of wampum diminished
in the 1670s.

Money can be held until
the time is right to buy.

Money helps us measure This Shawnee shoulder bag is
the value of things. decorated with wampum beads,
which developed into a currency
for some North American tribes.

26 IN CONTEXT

MAKE MONEY FOCUS
FROM MONEY Banking and finance

FINANCIAL SERVICES KEY THINKERS
The Medici family
(1397–1494)

BEFORE
13th century Scholastic
writers condemn usury.

AFTER
1873 British journalist Walter
Bagehot urges the Bank of
England to act as “lender of last
resort” to the banking system.

1930 The Bank for International
Settlements is founded in
Basel, Switzerland, leading
to international rules
of banking regulation.

1992 US economist Hyman
Minsky publishes The
Financial Instability
Hypothesis, which has proved
useful in explaining the
2007–08 financial crisis.

H umans have long engaged
in borrowing and lending.
There is evidence that
these activities took place 5,000
years ago in Mesopotamia (present-
day Iraq) at the very dawn of
civilization. But modern banking
systems did not emerge until the
14th century in northern Italy.

The word “bank” comes from
the Italian word for the “bench” on
which the bankers sat to conduct
business. In the 14th century the
Italian peninsula was a land of city-
states that benefited from the
influence and revenue of the papacy
in Rome. The peninsula was ideally
located for trade between Asia,
Africa, and the emerging nations

LET TRADING BEGIN 27

See also: Public companies 38 ■ Financial engineering 262–65 ■ Market uncertainty 274–75 ■ Financial crises 296–301 ■
Bank runs 316–21

of Europe. Wealth began to to banking today. The first is Merchant bankers of the late 14th
accumulate, especially in Venice “economies of scale.” It is expensive century arranged deposits and loans
and Florence. Venice relied on sea for an individual to draw up a single but also converted foreign currencies
power: institutions were created legal loan contract, but a bank can and watched over the circulation for
there to finance and insure voyages. draw up 1,000 such contracts at signs of forged or forbidden coins.
Florence focused on manufacturing a fraction of the “per-contract”
and trade with northern Europe, and cost. Dealings in money (cash
here merchants and financiers came investments) are suitable for
together at the Medici Bank. economies of scale. The second
is “diversification of risk.” The
Florence was already home to Medicis lowered the risk of bad
other banking families, such as lending by spreading their lending
the Peruzzi and the Bardi, and to geographically. Moreover, because
different types of financial bodies— the junior partners shared in profits
from pawnbrokers, who lent money and losses, they needed to lend
secured by personal belongings, to wisely—in effect they took on some
local banks that dealt in foreign of the Medici risks. The third
currencies, accepted deposits, and concept is “asset transformation.”
lent to local businesses. The bank Merchants might want to deposit
founded by Giovanni di Bicci de’ earnings or borrow money. One ❯❯
Medici in 1397 was different.
Use your wealth to
The Medici Bank financed long- found a bank.
distance trade in commodities such
as wool. It differed from existing Gather deposits and Lend wisely, and
banks in three ways. First, it grew keep enough cash to monitor your loans.
to a great size. In its heyday under cover withdrawals.
the founder’s son, Cosimo, it ran
branches in 11 cities, including Spread your risks across
London, Bruges, and Geneva. Second, different investments.
its network was decentralized.
Branches were managed not by As the bank grows, Make money
an employee but by a local junior average costs fall from money.
partner, who shared in the profits. and profits multiply.
The Medici family in Florence were
the senior partners, watching over
the network, earning most of the
profit, and retaining the family
trademark, which symbolized the
bank’s sound reputation. Third,
branches took in large deposits from
wealthy savers, multiplying the
lending that could be given out for a
modest amount of initial capital, and
so multiplying the bank’s profits.

Economics of banking
These elements of the Medici
success story correspond to three
economic concepts highly relevant

28 FINANCIAL SERVICES

merchant might want a safe place from what has been called the Bills of exchange, such as this one
to store his gold, from where he can “fundamental problem of exchange” from 1713, later developed into the
withdraw it quickly if necessary. —the danger that someone will run common bank check. All types
Another might want a loan—which off with the goods or the money promise to pay the bearer a specific
is riskier for the bank and may tie after a deal has been struck. To amount of money on a certain date.
up money for a longer time. So the solve this problem, the “bill of
bank came to stand between the exchange” was developed. This is its ability to lend wisely, and
two needs: “borrowing short, and was a piece of paper witnessing a then to monitor borrowers to deter
lending long.” This suited everybody buyer’s promise to pay for goods in “moral hazard”—when people
—the depositor, the borrower, and a specific currency when the goods succumb to the temptation not to
of course the bank, which used arrived. The seller of the goods could repay and default on the loan.
customer deposits as borrowed also sell the bill immediately to raise
money (“leverage”), to multiply money. Italian merchant banks Geographical clusters
profits and make a high return became particularly skilled at Banks often cluster together in
on its owners’ invested capital. dealing in these bills, creating an the same place to maximize
international market for money. information and skill. This explains
However, this practice also
makes the bank vulnerable—if a By buying the bill of exchange,
large number of depositors demand a bank was taking on the risk that
their money back at the same time the buyer of the goods would not
(in “a run on the bank”), the bank pay up. It was therefore essential
may be unable to provide it for the bank to know who was
because it will have used the likely to pay up and who was not.
depositors’ money to make long- Lending—indeed finance in
term loans, and it retains only a general—requires specialized,
small fraction of depositors’ money skilled knowledge, because
in ready cash. This risk is a a lack of information (known as
calculated one, and the advantage “information asymmetry”) can
of the system is that it usefully result in serious problems. The
connects savers and borrowers. borrowers least likely to repay are
the ones most likely to ask for loans;
Financing long-distance trade and once they have received a loan,
was a high-risk business in there are temptations not to repay.
14th-century Europe. It involved A bank’s most important function
time and distance, so it suffered

A 21st-century banking crisis

Granting mortgages to “subprime” The global financial crisis, which Significantly, the crisis followed
borrowers (people unable to repay) began in 2007, has led to rethinking a period of banking deregulation.
led to a wave of house repossessions about the nature of banking. A variety of financial innovations
and the financial crisis of 2007–08. Leverage, or borrowed money, lay seemed lucrative in a rising
at the heart of the crisis. In 1900, market. However, they led to
about three-quarters of the assets poor lending standards by two
of a bank might be financed by groups: those providing housing
borrowed money. In 2007, the loans to poor US families, and
proportion was often 95–99 bond investors overly reliant on
percent. The banks’ enthusiasm the advice of credit rating
for placing financial bets on future agencies. These are the issues
movements in the market, known faced by all banks since the
as derivatives, magnified this Medicis: poor information,
leverage and the risks it carried. financial incentives, and risk.

LET TRADING BEGIN 29

A banker is a fellow customers at a time of social Depression. As a result banks need
who lends you his umbrella change. Because the members of to be regulated, and most countries
these organizations checked up on have strict rules about who can
when the sun is shining, each other, and the managers had form a bank, the information they
but wants it back the good local knowledge, they could must disclose, and the scope of
provide the long-term loans that their business activities.
minute it begins to rain. their customers needed. In some
Mark Twain countries, such as Germany, they Finance broadly
thrived. The Dutch bank Rabobank Banking is just the largest part of
US author (1835–1910) is an example of a cooperative finance, but all finance is about
model, as is India’s “micro-finance” connecting people who have more
the development of financial Grameen Bank, which makes many money than they need with people
districts in large cities. Economists loans of small amounts. who need more money than they
call this phenomenon “network have—and will use it productively.
externalities,” which refers to the However, clustering can also Stock exchanges connect these
fact that, as a cluster starts to form, lead to risky competition and needs directly, through equities
all the banks benefit from the crowdlike behavior. It is especially (shares conferring ownership of a
network of deepening skills and important for banks to have a good company), bonds (lending that can
information. Florence was one such reputation because they have an be traded), or other instruments.
cluster. The City of London, with its asset transformation role—they
goldsmiths and shipping experts, transform deposits into loans—and These exchanges are either
became another. In the early their loan-assets are riskier, longer, physical places, such as the New
1800s the remote northern inland and less easy to turn into cash (less York Stock Exchange, or regulated
province of Shanxi became “liquid”) than their deposit-liabilities. markets where trading takes place
China’s leading financial center. through phone calls and computers,
Today, the internet creates new Bad news can lead to panics. like the international bond market.
ways of clustering online. Bank failures can have severe The clustering created by exchanges
consequences for other banks, and makes these long-term investments
The benefit of specialization for government and society, as more liquid: they can easily be sold
explains why there are so many witnessed in the failure of and turned into money. Savings can
different types of banks—covering Creditanstalt Bank in Austria in also be pooled to lower transaction
savings, mortgages, car loans, and 1931, which led to a run on the costs and diversify risks. Mutual
so on. The form a bank takes can German mark, UK sterling, and then funds, pension funds, and insurance
also address information problems. the US dollar, triggering further bank companies all perform this role. ■
Mutual societies and credit unions, runs and contributing to the Great
for instance, which are effectively
owned by their customers, first arose
in the 19th century to increase
trust between the bank and its

The City of London is home to a
dense cluster of banks built over
medieval streets. Today it is the world’s
largest center for foreign-exchange
trading and cross-border bank lending.

30 IN CONTEXT

MONEY FOCUS
CAUSES The macroeconomy
INFLATION
KEY THINKER
THE QUANTITY THEORY OF MONEY Jean Bodin (1530–96)

BEFORE
1492 Christopher Columbus
arrives in the Americas. Silver
and gold flow into Spain.

AFTER
1752 David Hume states that
the money supply has a direct
relationship to the price level.

1911 Irving Fisher develops
a mathematical formula to
explain the quantity theory
of money.

1936 John Maynard Keynes
says that the velocity of money
in circulation is unstable.

1956 Milton Friedman argues
that a change in the amount of
money in the economy can
have a predictable effect on
people’s incomes.

I n 16th-century Europe prices
were rising inexplicably. Some
said that rulers were using an
old practice of “debasing” currencies
by minting coins with ever-smaller
amounts of gold or silver in them.
This was true. However, Jean
Bodin, a French lawyer, argued that
something much more significant
was also happening.

In 1568, Bodin published his
Response to the Paradoxes of
Malestroit. The French economist
Jean de Malestroit (?–1578) had
blamed the price inflation solely on
currency debasement, but Bodin
showed that prices were rising
sharply even when measured in
pure silver. He argued that an

LET TRADING BEGIN 31

See also: The function of money 24–25 ■ The Keynesian multiplier 164–65 ■
Monetarist policy 196–201 ■ Inflation and unemployment 202–03

Money circulates at
a constant speed.

If more money is put … people have more Jean Bodin
into the system… money in their pockets and
wish to buy more goods The son of a master tailor,
Jean Bodin was born in 1530
and services. in Angers, France. He was
educated in Paris, and went
… leading to This results in too on to study at the University
price rises. much money chasing of Toulouse. In 1560, he
became a king’s advocate in
too few goods… Paris. Bodin’s scholarship (he
read law, history, politics,
Money causes inflation. philosophy, economics, and
religion) attracted royal favor,
abundance of silver and gold was waste; greedy merchants able to and between 1571 and 1584,
to blame. These precious metals restrict the supply of goods through he served as aide to the
were entering Spain from its new monopolies; and, of course, the powerful Duke of Alençon.
colonies in the Americas and then rulers adulterating the coins.
spreading throughout Europe. In 1576, he married
The money supply Françoise Trouilliart and
Bodin’s calculations of the Bodin was not the first to point succeeded his brother-in-law
increase in coinage were to the new influence of American as the king’s procurator in
remarkably accurate. Later treasure and the effect of the Laon, northern France.
economists concluded that prices abundance or scarcity of money In 1589, King Henry III was
in Europe quadrupled during the on price levels. In 1556, a Spanish assassinated, and religious
16th century, at the same time as theologian named Martín de civil war broke out. Bodin
the amount of physical silver and Azpilcueta (better known as believed in tolerance, but in
gold circulating in the system Navarrus) had come to the same Laon was forced to declare for
tripled; Bodin had estimated the conclusion. However, Bodin’s essay the Catholic cause, until the
increase in precious metals at more also discussed the demand for and victorious Protestant King,
than 2.5 times. He also highlighted the supply of money, the operation Henry IV, took control of the
other factors behind the inflation: a of these two sides of an economy, city. Bodin died of the plague,
demand for luxuries; a scarcity of and how disturbances to the ❯❯ aged 66, in 1596.
goods for sale due to exports and
Key works

1566 Method for the Easy
Comprehension of History
1568 Response to the
Paradoxes of Malestroit
1576 Six Books of a
Commonwealth

32 THE QUANTITY THEORY OF MONEY

supply of money led to inflation. His will lead to a doubling of prices, but The abundance of gold and
thorough study is considered the not real value. Money will be neutral silver… is greater in this
first important statement of the in its effect on the real, relative value kingdom today than it has
quantity theory of money. of goods and services—for example, been in the last 400 years.
on how many jackets can be bought Jean Bodin
The reasoning behind this theory for the price of a computer.
is partly based on common sense. However, the money they want
Why is the price of a cup of coffee in Real price, nominal price is not nominal money, but “real
a rich part of town so much higher After Bodin, many economists money”—money that can buy more.
than in a poor area? The answer is developed his idea further. They
that customers in the rich part have came to recognize that there is a Fisher’s equation
more money to spend. If we consider distinct separation between the The fullest statement of the
the population of a whole country real side of the economy and the quantity theory of money was made
and double the money in people’s nominal, or money, side. Nominal by the US economist Irving Fisher
pockets, it is natural that they will prices are simply money prices, (1867–1947), who used the
want to use their increased which can change with inflation. mathematical formula MV = PT.
spending power to buy more goods This is why economists focus on Here “P” is the general level of prices,
and services. But goods and services real prices—on what quantity of a and “T” is the transactions that take
are always in limited supply, so there thing (jackets, computers, or time place in a year, so PT (Prices ×
will be too much money chasing too spent working) has to be given up
few goods, and prices will rise. in return for another kind of thing,
no matter what the nominal price
This chain of events shows the is. In the extreme quantity theory,
important relationship between changes in the money supply may
the quantity of money in an economy influence prices, but it has no effect
and the general price level. The on the real economic variables, such
quantity theory of money states that as output and unemployment. What
a doubling of the supply of money is more, economists realized that
will result in a doubling in the value money is itself a “good” that people
of transactions (or income or want to own for its spending power.
expenditure). In the theory’s more
extreme form, a doubling of money

Money circulation Price level 25
25 20 15 10 5 5 10 15 20

Irving Fisher used the analogy of a scale to
illustrate the quantity theory of money. If there is an
increase in the amount of money in circulation, the
bag gets heavier, and the price of goods rises and
moves to the right, balancing the scale.

LET TRADING BEGIN 33

This painting by Dutch master Pieter
Bruegel (1559) shows vagrants rubbing
shoulders with the rich during Lent.
Steep price rises in the 15th century
led to much hardship among the poor,
a rise in vagrancy, and peasant revolts.

Transactions) is the total value that there can be one-time changes is used, not just as a medium of
of transactions occurring annually. to M (the supply of money), such as exchange, but also as a “store of
“M” is the supply of money. But the flow of New World treasure into value”—something you can keep,
because PT is a total flow of goods, Europe. With V (velocity) and T either for buying goods, for security
while M represents a stock of money (transactions) fixed, it follows that in case of hard times in the future,
that can be used over and over again, a doubling of money will lead to a or for future investments.
the equation needs something to doubling of prices.
represent the circulation of money. Keynesian economists argue
This circular flow, which causes Combined with the difference that these motives are affected less
money to rotate through the between nominal and real, the by income or transactions (PT in
economy—like the spinning drum quantity theory of money has led to the formula) than by interest rates.
of a washing machine—is “V”, the the notion that money is neutral in A rise in the interest rate will lead
velocity of money. its effect on the economy. to a rise in the velocity of money.

This equation becomes a theory Challenge and restatement In 1956, US economist Milton
when we make assumptions about But is money really neutral? Few Friedman (p.199) defended the
the relationships between the believe that it is neutral in the short quantity theory of money, arguing
letters, which economists do in run. The immediate effect of more that an individual’s demand for real
three ways. First, V, the velocity money in the pocket is for it to be money balances (where money
of money, is assumed to be spent on real goods and services. buys more) depends on wealth. He
constant, since the way in which John Maynard Keynes (p.161) said claimed that it is people’s incomes
we use money is part of habit and it was probably neutral in the long that drive this demand.
custom and does not change much run, but in the short run it would
from year to year (our washing affect real variables such as output Today, central banks print money
machine drum spins at a steady and unemployment. Evidence also electronically and use it to buy
rate). This is the key assumption suggests that money velocity (V) government debt in a process
behind the quantity theory of is not constant. It seems to rise in known as quantitative easing.
money. Second, it is assumed booms when inflation is high and Their aim has been to prevent a
that T, the quantity of transactions falls in recessions when inflation feared fall in the money supply.
in an economy, is driven solely by is low. So far, the most visible effect has
consumers’ demand and producers’ been to reduce interest rates on
technology, which together Keynes had other ideas that government debt. ■
determine prices. Third, we allow challenged the quantity theory
of money. He proposed that money Inflation is always and
everywhere a monetary

phenomenon.
Milton Friedman

34

PROTECT US
FROM FOREIGN
GOODS

PROTECTIONISM AND TRADE

IN CONTEXT A country’s wealth F or the last half century
is its gold. many economists have
FOCUS championed free trade.
Global economy Exports bring in gold. They argue that only by removing
restrictions on trade (such as
KEY THINKER Imports of foreign goods tariffs) can goods and money flow
Thomas Mun (1571–1641) cause gold to be lost. freely around the world and global
markets develop without inhibition.
BEFORE A country should preserve Some disagree, arguing that where
c.1620 Gerard de Malynes its stock of gold by there is a huge imbalance of trade
argues that England should between two countries, it can
regulate foreign exchange to restricting imports. impact jobs and wealth.
stop the nation’s gold and
silver from going abroad. Protect us from A mercantilist view
foreign goods. The argument over free trade dates
AFTER back to the mercantilist era, which
1691 English merchant Dudley began in Europe in the 16th
North argues that the main century and continued until the
spur to increased national late 18th century. With the rise of
wealth is consumption. Dutch and English seaborne trade,
wealth began to shift from southern
1791 US Treasury Secretary Europe toward the north.
Alexander Hamilton argues for
protection of young industries. This was also the age when
nation-states began to emerge,
1817 British economist David along with the idea of the wealth of
Ricardo argues that foreign the nation, which was measured by
trade can benefit all nations. the amount of “treasure” (gold and
silver) it possessed. Mercantilists
1970s US economist believed that the world drew from a
Milton Friedman insists “limited pot,” so the wealth of each
that free trade helps nation depended on ensuring a
developing countries. favorable “balance of trade,” in
which more gold flows into the
nation than out. If an excess of gold

LET TRADING BEGIN 35

See also: Comparative advantage 80–85 ■ International trade and Bretton Woods 186–87 ■ Market integration 226–31 ■
Dependency theory 242–43 ■ Global savings imbalances 322–25

flows out, the nation’s prosperity nations is unrestricted. If left French farmers demonstrated on
declines, wages fall, and jobs are free, Smith insisted, the market tractors in Paris, 2010, to denounce
lost. England sought to cut the would always grow to enrich all a sharp fall in grain prices after import
outflow of gold by imposing countries eventually. quotas were liberalized.
sumptuary laws, which aimed to
limit the consumption of foreign For the last half century Smith’s barriers, as the US, Britain,
goods. For instance, laws were view has dominated, because most Japan, and South Korea did
passed restricting the types of Western economists argue that before they became economically
fabric that could be used for restrictions on trade between powerful. China, meanwhile,
clothes, reducing the demand nations hobble their economies. pursues a trade policy that in
for fine foreign cotton and silk. Today, free trade areas such as many ways echoes Mun’s thinking
the EU (European Union), ASEAN by running large trade surpluses
Malynes and Mun (Association of Southeast Asian and building up a huge reserve
Gerard de Malynes (1586–1641), an Nations), and NAFTA (North of foreign exchange. ■
English expert on foreign exchange, American Free Trade Agreement)
believed that the outflow of gold are the norm, while global amounts of silver, on the
should be restricted. If too much organizations such as the World grounds that this generated
flowed out, he argued, the value Trade Organization (WTO) and the reexport trade. In 1628, the
of English currency would fall. International Monetary Fund (IMF) company appealed to the British
urge countries to reduce tariffs and government to protect their
However, the century’s greatest other trade barriers to allow foreign trade against Dutch competition.
mercantilist theorist, Englishman firms to enter their domestic Mun represented their case to
Thomas Mun, insisted that what markets. The creation of barriers Parliament. He had amassed
matters is not the fact that to foreign trade is criticized now a considerable fortune by the
payments are made abroad, but as protectionism. time he died in 1641.
how trade and payments finally
balance out. Mun wanted to boost However, some economists are Key works
exports and cut imports through concerned that exposure to large
more frugal consumption of global businesses has the potential 1621 A Discourse of Trade
domestic produce. However, he to damage developing countries c.1630 England’s Treasure by
saw no problem in spending gold who are unable to nurture infant Foreign Trade
abroad if it was used to acquire industries behind protective
goods that were then reexported
for a larger sum, ultimately Thomas Mun
returning more gold to the country
than had initially been spent. Born in 1571, Thomas Mun grew
This would boost trade, provide up in a family of wealthy London
work for the shipping industry, merchants. His father died when
and increase England’s treasure. he was three, and his mother
married Thomas Cordell, who
Free trade agreements became a director of the East
In the 18th century Adam Smith India Company, Britain’s largest
(p.61) was to disagree with this trading company. Mun began
view. What matters, he insisted trading as a merchant in the
in The Wealth of Nations, is not Mediterranean. In 1615, he
the wealth of individual nations became a director of the East
but the wealth of all nations. Nor India Company. His ideas were
is the pot fixed; it can grow over developed originally to defend
time—but only if trade between the company’s export of large

36

THE ECONOMY
CAN BE COUNTED

MEASURING WEALTH

IN CONTEXT Wealth includes people Both population and
as well as property. a typical person’s
FOCUS
Economic methods average expenditure
can be estimated.
KEY THINKER
William Petty (1623–87) Deducting an estimated Multiplying average
amount for rents and profits expenditure by the
BEFORE leaves a sum for the total
1620 English scientist Francis population gives
Bacon argues for a new worth of labor. the national income.
approach to science based
on the collection of facts. The economy can be counted.

AFTER T oday we take it for granted work of English scientist William
1696 English statistician that the economy can Petty. His insight was to apply the
Gregory King writes his be measured, and its new empirical methods of science
great statistical survey of expansions and contractions to financial and political affairs—to
England’s population. accurately quantified. But this was use real world data rather than
not always the case. The idea of relying on logical reasoning. He
1930s Australian economist measuring the economy dates back decided to express himself only
Colin Clark invents the idea of to the 1670s and the pioneering “in terms of number, weight, or
gross national product (GNP).

1934 Russian-US economist
Simon Kuznets develops
modern national income
accounting methods.

1950s British economist
Richard Stone introduces
balanced, double-entry
national accounting.

LET TRADING BEGIN 37

See also: The circular flow of the economy 40–45 ■ Testing economic theories 170 ■
The economics of happiness 216–19 ■ Gender and economics 310–11

measure.” This approach helped the economies and populations William Petty
form the basis of the discipline that of England, Holland, and France.
would become known as economics. He calculated that none had the Born in 1623 to a humble
finances to continue the war they family in Hampshire, England,
In his 1690 book Political were then engaged in—the Nine William Petty lived through
Arithmetick, Petty used real data Years’ War—beyond 1698. His the English Civil War and rose
to show that, contrary to popular figures might have been correct, to high positions in both the
belief, England was wealthier than because the war ended in 1697. Commonwealth government
ever. One of his groundbreaking and then the restored
decisions was to include the value Measures of progress monarchy. As a young man
of labor as well as land and Statistics are now at the heart he worked for the English
capital. Although Petty’s figures of economics. Today, economists political economist Thomas
are open to dispute, there is no generally measure gross domestic Hobbes in Holland. After
doubting the effectiveness of his product (GDP)—the total value returning to England, he
basic idea. His calculations of all the goods and services taught anatomy at Oxford
included population size, personal exchanged for money within a University. A great believer
spending, wages per person, the country in a particular period in the new science, he found
value of rents, and others. He then (usually a year). However, there universities uninspiring, so
multiplied these figures to give a is still no definitive way of left for Ireland, where he made
total figure for the nation’s total calculating national accounts, a monumental land survey of
wealth, creating accounts for an although efforts have been made the entire country.
entire nation. to standardize methods.
In the 1660s he returned
Similar methods were Economists have now begun to England and began the
developed in France by Pierre de to broaden the measurement of work on economics for which
Boisguilbert (p.334) and Sébastien prosperity. They have formulated he is now known. For the
le Prestre (1633–1707). In England new measures such as the genuine remainder of his life he moved
Gregory King (1648–1712) analyzed progress indicator (GPI), which between Ireland and England,
includes adjustments for income both physically and in the
The Battle of La Hogue was fought distribution, crime, pollution, and focus of his work. Petty is
in 1692 during the Nine Years’ War. the happy planet index (HPI), a regarded as one of the first
English statistician Gregory King measure of human well-being and great political economists.
calculated how long each country environmental impact. ■ He died in 1687, aged 64.
involved could afford to fight.
Key works

1662 Treatise of Taxes
and Contributions
1690 Political Arithmetick
1695 Quantulumcunque
Concerning Money

38

LET FIRMS
BE TRADED

PUBLIC COMPANIES

IN CONTEXT M erchant ships have and was borrowing a further
always raised funds for $28 million on bonds. Its annual
FOCUS voyages by promising sales raised up to $10 million.
Markets and firms a share of profits. In the 1500s the
rewards could be huge, but these The idea of the public limited
KEY THINKER high-risk ventures tied up money company—in which shareholders
Josiah Child (1630–99) for years before a profit was are protected from liability beyond
realized. The answer was to their investment—developed from
BEFORE share the risk, and so joint-stock joint-stock companies. The selling
1500s Governments grant companies were formed, where of shares is an important way of
merchants the monopoly of investors injected money into a raising funds. Some argue that
trade within specific regions. company in return for becoming shareholders’ power to sell shares
joint holders of its trading stock, leads to a lack of commitment, but
1552–71 The Bourse in and a right to a proportional share the joint-stock company remains
Antwerp and Royal Exchange of the profits. at the heart of capitalism. ■
in London are set up for
shareholders to buy and sell East India Company The high-risk, high-reward potential
stock in joint-stock companies. An early joint-stock company, of merchant shipping was shared by
formed in 1599, was the East joint-stock companies. Vessels such
AFTER India Company (EIC), launched as the John Wood, seen here in Bombay
1680 London stock “brokers” to develop trade between Britain in the 1850s, brought home the goods.
meet in Jonathan’s Coffee and the East Indies. Its rights to
House to arrange share deals. free trade were so ably defended
by the “father of mercantilists,”
1844 The Joint Stock London merchant Josiah Child,
Companies Act in the UK that it became a global
allows firms to be incorporated phenomenon. By the time of his
more quickly and easily. death the company had about
3,000 shareholders, subscribed
1855 The idea of limited to a stock of more than $14 million,
liability protects investors in
joint-stock companies from See also: Economic equilibrium 118–23 ■ Corporate governance 168–69 ■
scams such as the South Sea Institutions in economics 206–07
Bubble of 1720 (p.98).

LET TRADING BEGIN 39

WEALTH COMES
FROM THE LAND

AGRICULTURE IN THE ECONOMY

IN CONTEXT I n recent years bankers have If we knew the economics
sometimes been characterized of agriculture, we would
FOCUS as parasites, living off wealth know much of the economics
Growth and development created by the labor of others.
François Quesnay (p.45), a French of being poor.
KEY THINKER farmworker’s son and one of the Theodore Schultz
François Quesnay great minds of the 18th century,
(1694–1774) might recognize this description. US economist (1902–98)

BEFORE Quesnay argued that wealth lies Many economists, including
1654–56 English economist not in gold and silver, but springs Theodore Schultz, have argued
William Petty conducts a from production—the output of the that agricultural development is
major land survey of Ireland farmer or manufacturer. He argued the foundation for progress in poor
to calculate its productive that agriculture is so valuable countries. In 2008, the World Bank
potential for the English army. because it works with nature— reported that growth in the
which multiplies the farmer’s effort agricultural sector contributes
AFTER and resources—to produce a net more to poverty reduction than
1766 Adam Smith states that surplus. Manufacturing, on the other growth in any other sector. But
labor, not land, is the greatest hand, is “sterile” because the value economists today also recognize
source of value. of its output is equal to the value of that diversification into industry
the input. However, later theorists and services, including finance, is
1879 US economist Henry showed that manufacturing can vital for long-term development. ■
George argues that land also produce a surplus.
should be held in common
by society, and that only The natural order
land should be taxed—not Quesnay’s championing of the
productive labor. value of agriculture was influential,
leading to the development of the
1950s US economist French school of physiocrat thinkers
Theodore Schultz’s “efficient who believed in the primacy of the
farmer” hypothesis places “natural order” in the economy.
agriculture at the heart of
economic development. See also: Demographics and economics 68–69 ■ The labor theory of value 106–07 ■
The emergence of modern economies 178–79 ■ Development economics 188–93

MONEY AND

GOODS FLOW BETWEEN

PRODUCERS AND

CONSUMERS

THE CIRCULAR FLOW OF THE ECONOMY



42 THE CIRCULAR FLOW OF THE ECONOMY

IN CONTEXT Madame de Pompadour (the mistress rights, and low government debt.
of Louis XV) installed Quesnay at Where the mercantilists said that
FOCUS Versailles as her physician. To him wealth came from treasure,
The macroeconomy her lifestyle must have epitomized the Quesnay and his followers viewed
lavish surplus of landowners’ wealth. it as being rooted in what modern
KEY THINKER economists call the “real” economy
François Quesnay wealth from nature, through their —those sectors that create real
(1694–1774) agricultural sector. Their leader, goods and services. They believed
François Quesnay, was surgeon that agriculture was the most
BEFORE and physician to King Louis XV’s productive of these sectors.
1664–76 English economist mistress, Madame de Pompadour.
William Petty introduces the His complicated model of the The physiocrats were influenced
concepts of national income economy was thought by some by the thinking of an earlier French
and expenditure. to reflect the circulation of blood landowner, Pierre de Boisguilbert.
in a human body. He said that agriculture is superior
1755 Irish merchant banker to manufacturing, and
Richard Cantillon’s Essay, first The mercantilist approach consumables are more valuable
published in France, discusses (pp.34–35) dominated economic than gold. He said the more goods
the circulation of money from thinking at the time. Mercantilists consumed, the more money moves
the city to the countryside. thought the state should behave in the system, making
like a merchant, growing business, consumption the driving force in
AFTER acquiring gold, and actively the economy. He also said that a
1885 Karl Marx’s Capital interfering with the economy little money in the hands of the
describes the circulation of through taxes, subsidies, controls, poor (who spend it) is worth far
capital using a model inspired and monopoly privileges. The more to the economy than in the
by Quesnay. physiocrats took the opposite view: hands of the rich (who hoard it).
they argued that the economy was The movement, or circulation,
1930s Russian-American naturally self-regulating and of money is all-important.
economist Simon Kuznets needed only to be protected from
develops modern national bad influences. They favored free The Economic Table
income accounting. trade, low taxes, secure property The physiocratic system of circulation
was set out in Quesnay’s Economic
I n economics one can think Table, which was published and
small—microeconomics—or revised several times between 1758
one can think as large as the and 1767. This is a diagram that
entire system: this is the study of illustrates, through a series of
macroeconomics. In 18th-century crossing and connecting lines, the
France a group known as the flow of money and goods between
physiocrats tried to think big—they three groups in society: landowners,
wanted to understand and explain farmers, and artisans. The goods
the whole economy as a system. are agricultural and manufactured
Their ideas form the foundation products (produced by the farmers
of modern macroeconomics. and artisans). Although Quesnay
used corn as his example of an
The physiocrats agricultural product, he said
Physiocracy is an ancient Greek that this category could include
word meaning “power over nature.” anything produced from the land,
The physiocrats believed that including mining products.
nations gained their economic
Quesnay’s model is best
understood through an example.
Imagine each of the three groups
starts with $2 million. The

LET TRADING BEGIN 43

See also: Measuring wealth 36–37 ■ Agriculture in the economy 39 ■ Free market economics 54–61 ■
Marxist economics 100–05 ■ Economic equilibrium 118–23 ■ The Keynesian multiplier 164–65

landowners produce nothing. They Landowners collect rent
spend their $2 million equally from farmers and buy goods from
between farming and artisan
products, and consume all of them. farmers and artisans.
They receive $2 million in rent from
the farmers—which the farmers can Farmers use this Artisans use this
just afford, since they are the only money to buy goods from money to buy goods from
group to produce a surplus—and so artisans and other farmers. farmers and other artisans.
the landowners end up back where
they started. The farmers are the Those farmers and artisans then use
productive group. From a starting the money to buy goods from yet
point of $2 million they produce more farmers and artisans.
$5 million worth of agricultural
products, over and above what This multi-level buying Money and goods
they consume themselves. Of and selling activity flow between
this $1 million worth is sold to happens continuously. producers and
landowners for their consumption. consumers.
They sell $2 million worth to
artisans, half for consumption and
half as raw materials for the goods
the artisans will produce. This
leaves $2 million worth to be used
toward next year’s growing season.
In terms of production they are
back where they started. However,
they also have $3 million from
sales, of which they spend

$2 million on rent and $1 million they spend their entire revenue
on artisan goods (tools, agricultural on agricultural products:
implements, and so on). $1 million for their own
consumption, and $1 million on
Quesnay referred to any group raw materials. They have
outside the land-based farmers and consumed everything they have.
landowners as “sterile,” because he
believed that they could not produce Quesnay’s model does more
a net surplus. The artisans, in this than present end-of-year results—
instance, use their starting amount it also shows how money and
of $2 million to produce $2 million goods circulate through the year
worth of manufactured goods over and demonstrates why this is so
and above what they consume important. The sale of products
themselves. These are sold equally between the various groups
to landowners and farmers. But continues to generate revenue,
which is then used to buy more
Quesnay’s Economic Table shows products, which produces yet
the zigzag flow of wealth between more revenue. A “multiplier effect”
farmers, landowners, and artisans. occurs (in Quesnay’s diagram it
It was the first attempt to explain appeared as a zigzag series of
the workings of a national economy. lines), similar to that presented ❯❯

44 THE CIRCULAR FLOW OF THE ECONOMY

Let the sum total into their constituent parts and argued that if farmers had to pay
of the revenues be then rigorously analyzing the too much tax, either directly or
annually returned into relationships between the parts. indirectly, they would cut back
and along the entire His model included inputs, outputs, their capital investment in farming
course of circulation. and the interdependencies technology, and production would
François Quesnay of different sectors. Quesnay fall below the level needed for the
suggested that these might exist economy to thrive. This led the
by John Maynard Keynes (p.161) in a state of equilibrium, an idea physiocrats to argue that there
in the 1930s, when he pointed out that was later developed by should be only one tax: on the
the beneficial effects of a Léon Walras (p.120), becoming rental value of land.
government spending money one of the foundations of
in a depressed economy. economic theorizing. Based on his empirical
findings, Quesnay made a host
Analyzing the economy Quesnay’s approach to of other policy recommendations,
The kinds of questions Quesnay quantifying economic laws makes including investment in agriculture,
asked, and the way he went about his Economic Table possibly the the spending of all revenue,
answering them, anticipated first empirical macroeconomic no hoarding, low taxes, and free
modern economics. He was model. The numbers in his Table trade. He thought capital was
one of the first to attempt to were the result of a close study especially important because
uncover general abstract laws that of the French economic system, his entrepreneur-farmers needed
govern economies, which he did giving them a firm empirical basis. to borrow cheaply in order to pay
by breaking economies down This study indicated that farming for land improvements.
technology was sufficient for
farmers to generate a net surplus Classical ideas
of at least 100 percent. In our Quesnay’s idea of sectors being
example this is what they achieve productive or unproductive has
—starting with $2 million of corn, reappeared throughout the history
they receive this back plus a net of economic thought as economists
surplus of $2 million, which is then consider industry versus services,
paid in rent. Modern economists and the private sector versus the
use these kinds of empirical results government. His sole focus on
to think about the impact of policy agriculture may look narrow to
changes, and Quesnay used his modern eyes, since it is now
Table for a similar purpose. He understood that wealth generation
from industry and services is vital
to an economy’s growth. However,
his emphasis on the “real” side of
the economy was an important step
towards modern economic
thinking. He most obviously
anticipated modern national
income accounting, which is used
to assess nations’ macroeconomic
performance. This income
accounting is based on the circular
flow of income and expenditure

According to the physiocrats,
investment in agriculture was key to
ensuring the national wealth of France.
Free export was a way of sustaining
demand and restricting merchant power.

LET TRADING BEGIN 45

The interdependence of consumers and producers was first
illustrated by Quesnay. Consumers rely on producers for goods and
services, who in turn rely on the consumers for sales and labor.

Goods and
services

Consumer
expenditure

Households Wages, rent, Firms François Quesnay
dividends
Born near Paris, France, in
Labor 1694, François Quesnay was
the son of a plowman and the
around the economy. The value of Quesnay’s circular flow, with eighth of 13 children. At
the total product of an economy is its susceptibility to expansion the age of 17 he began an
equal to the total income earned and stagnation. apprenticeship in engraving,
—a notion that was an important but then transferred to the
part of Quesnay’s theory. In the Perhaps most importantly, university, graduating from
20th century much of the analysis Quesnay’s concepts of surplus the college of surgeons in 1717.
of macroeconomies has revolved and capital became key to the
around the Keynesian multiplier way that the classical economists He made his name as a
(pp.164–65). Keynes showed how analyzed economic growth. A surgeon and specialized in
government spending could typical classical model focuses on treating the nobility; in 1749,
stimulate further spending three factors of production: land, he moved to the royal palace
in a “multiplier effect.” This labor, and capital. Landowners at Versailles, near Paris, as
idea has obvious links to receive rent and spend wastefully physician to Madame de
on luxuries; laborers accept a low Pompadour. In 1752, he saved
This system… is, perhaps, wage, and if it rises, they produce the king’s son from smallpox
the nearest approximation more children. However, and was awarded a title and
to truth that has yet been entrepreneurs earn profit and enough money to buy an estate
published on the subject re-invest it productively in industry. for his own son.
So profit drives growth, and
of political economy. economic performance depends on His interest in economics
Adam Smith sectors of the economy generating began in the early 1750s, and in
surpluses. Thus, Quesnay 1757 he met the Marquis de
anticipated later ideas about Mirabeau, with whom he
the growth of economies formed les Economistes—the
and inspired Karl Marx (p.105), physiocrats. He died in 1774.
who produced his own version
of the Economic Table in 1885. Key works
Marx said of Quesnay that
“never before had thinking in 1758 Economic Table
political economy reached such 1763 Rural Philosophy
heights of genius.” ■ (with Marquis de Mirabeau)
1766 Analysis of the
Arithmetic Formula for the
Economic Table

46

PRIVATE INDIVIDUALS
NEVER PAY FOR
STREET LIGHTS

PROVISION OF PUBLIC GOODS AND SERVICES

IN CONTEXT Street lights are an
example of a public
FOCUS
Decision making good because…

KEY THINKER … it is difficult to stop … one person’s use of
David Hume (1711–76) people from benefiting street lighting does not

BEFORE from street lighting. diminish another’s
c.500 BCE In Athens indirect enjoyment of it.
taxes are used to finance
city festivals, temples, and Private firms do not provide
walls. Occasional direct taxes street lights since they can't stop
are levied at times of war.
non-payers from using them.
1421 The first patent is
granted to Italian engineer Essential public goods … private
Filippo Brunelleschi to are usually provided by the individuals never
protect his invention of
hoisting gear for barges. government, because… pay for street
lights.
AFTER
1848 The Communist E ven within a well-functioning freely available to all, or where it
Manifesto advocates collective market economy, there are would be difficult to prevent their
ownership of the means of areas in which markets fail. use by non-payers. These goods,
production by the workers. One important example of market which include things such as
failure is in the provision of public national defense, are difficult for
19th century Public street goods—goods that are to become a private firm or individual to
lighting is introduced
in Europe and America.

1954 US economist Paul
Samuelson develops a modern
theory of public goods.

LET TRADING BEGIN 47

See also: Free market economics 54–61 ■ External costs 137 ■ Markets and
social outcomes 210–13

Lighthouses are a public good non-rivalry, meaning that one David Hume
from which it is hard to exclude person’s consumption of the good
non-payers, and which many people does not diminish the ability of The epitome of the “Scottish
can use at the same time. They are others to consume it. A classic Enlightenment,” David Hume
invariably provided collectively. example is street lighting; it would was one of the most influential
be almost impossible to exclude British philosophers of the
supply profitably. This problem, non-payers from enjoying its benefits, 18th century. He was born in
known as “free-riding” (where and no individual’s use of it detracts Edinburgh in 1711, and from
consumers enjoy the goods without from that benefit to other users. an early age showed signs of
paying for them) means that there a brilliant mind: he entered
is no profit incentive. However, As industrial economies Edinburgh University at the
there is a demand for these goods, developed in the 19th century, age of 12, studying first law
and because private markets countries had to overcome the and then philosophy.
may not be able to satisfy this problem of free-riding in areas such
demand, public goods are usually as intellectual property. Intangible In 1734, Hume moved to
provided by governments and goods, such as new knowledge and France, where he set out his
funded through taxation. discoveries, have the attributes of major philosophical ideas in
non-excludability and non-rivalry, A Treatise of Human Nature.
A failure of the market to provide and so are at risk of being He then devoted much of his
these goods was recognized by undersupplied by the market. This time to writing essays on
the philosopher David Hume in the could discourage the development literary and political subjects
18th century. Influenced by Hume, of new technologies unless they and struck up a friendship
Adam Smith (p.61), an ardent can be protected in some way. To with the young Adam Smith,
advocate of the free market, do this, countries developed laws who had been inspired by his
conceded that a government’s role granting patents, copyright, and writings. In 1763, Hume was
was to provide those public goods trademarks to protect the returns given a diplomatic role in
that it would not be profitable for from new knowledge and Paris, where he befriended
individuals or firms to produce. inventions. Most economists the revolutionary French
acknowledge that government has philosopher Jean-Jacques
There are two distinguishing a responsibility to provide public Rousseau. He settled in
characteristics of public goods that goods, but debate continues about Edinburgh again in 1768,
cause them to be undersupplied by the extent of that responsibility. ■ where he lived until his death
the markets: non-excludability, in 1776, aged 65 years.
meaning that it is difficult to Where the riches are
prevent people who don’t pay for engrossed by a few, Key works
the goods from using them; and these must contribute very
largely to the supplying of 1739 A Treatise of Human
the public necessities. Nature
1748 An Enquiry Concerning
David Hume Human Understanding
1752 Political Discourses

THE AGE
OF REAS

1770–1820


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