The Economics Book

INDUSTRIAL AND ECONOMIC REVOLUTIONS 99

See also: Supply and demand 108–13 ■ Behavioral economics 266–69 ■ Bank 21st-century bubble
runs 316–21 ■ Global savings imbalances 322–25
The Dotcom Bubble, which
Sometimes extraordinary This leads share prices burst in March 2000, was the
conditions occur that to rocket. first of the 21st century. It had
overinflate prices in the classic bubble hallmark of
an industry. prices being driven purely by
speculation rather than by
The situation is widely News of this unusual changes in real value (based
discussed in the media and state of affairs reaches on output or assets). Investors
the general public. assumed that the world was
at informal gatherings. about to be changed forever
by the internet, so investing in
Many believe the Crowds breed e-commerce seemed to be a
escalation will continue, collective insanity. once-in-a-lifetime opportunity.

and get very excited. The new companies had no
trading history, very low sales,
Prices become They buy hugely and virtually no profits, yet
unsustainably high, overpriced shares they attracted hundreds of
confidence is destroyed, and billions of dollars in investment.
the market crashes. (or the overpriced The crowd believed that every
product itself). firm was potentially the next
AOL, a firm whose clients
jumped from 200,000 to one
million in two years, and then
climbed at around a million
new users each month. Greed
overcame fear and people
rushed to invest. Between
March 2000 and October 2002,
more than $7 trillion was
wiped off the market value
of dotcom shares.

tulips, their appeal diminished, and because they expect prices to rise VALUE
people realized the folly could not still further before they eventually
continue. Selling became more crash. Since prices cannot rise 1994 1998 2002 2006
frantic, confidence plummeted, and forever, this involves the irrational
the price of tulips collapsed. For belief “that the guy you will sell to is The Dotcom Bubble peaked in
those who had borrowed money to dumber [than you] and will not see 2000. Price rises were so extreme
invest, it was disastrous. the crash coming.” However, Garber that people everywhere discussed
believes sometimes there are real them at dinner tables—a sure sign
How bubbles form reasons behind the price rises— that a bubble is about to burst.
US economist Peter Garber claimed such as a fashion for ladies in
that speculators in these situations France to wear rare tulips on their
buy an asset in the full knowledge dresses. Nonetheless, in any bubble,
that the price is far above any the advice remains the same:
“fundamental value” but do so “Let the buyer beware.” ■

LET THE RULING

CLASSES TREMBLE AT A

COMMUNIST

REVOLUTION

MARXIST ECONOMICS



102 MARXIST ECONOMICS

IN CONTEXT of the 19th century, when Karl In June 1848, workers in Paris rose up
Marx (p.105) wrote his critique against the government and manned
FOCUS of capitalism. barricades. The uprising was part of
Economic systems a wave of failed revolutions across
While Marx’s influence is Europe. It was quickly suppressed.
KEY THINKER popularly seen as political, he was,
Karl Marx (1818–83) perhaps more than anything else, in economic progress, replacing
an economist. He believed that the systems that he considered to
BEFORE economic organization of society be outmoded: feudalism (where
1789 Revolution sweeps away forms the basis for its social and peasants were legally tied
the old feudal regime and political organization; economics, to their local land-owning lord),
aristocracy in France. therefore, drives social change. and mercantilism (in which
Marx saw history not in terms of governments control foreign trade).
1816 German thinker Georg war or colonialism, but as a He almost admiringly described
Hegel explains his dialectics progression of different economic how it had driven technological
in The Science of Logic. systems, which gave birth to new innovation and industrial efficiency.
forms of social organization. But ultimately he believed that
1848 Revolutions spring up capitalism was only a passing
throughout Europe, led by With the rise of the market stage and an imperfect system
disaffected members of the came merchants, and with the whose flaws would inevitably lead
middle and working classes. factory, an industrial proletariat. to its downfall and replacement.
Feudalism had been replaced by
AFTER capitalism, which in turn would be At the heart of his analysis is
1922 The USSR is established supplanted by communism. In his the division of society into the
on Marxist principles under 1848 Communist Manifesto, Marx “bourgeoisie,” a minority who own
Vladimir Lenin. said that this would be brought the means of production, and the
about by revolution. To explain “proletariat,” the majority who make
1949 Mao Zedong becomes what he saw as the inevitability up the workforce. For Marx this
the founding father of the of this change, he analyzed the division characterizes capitalism.
People’s Republic of China. capitalist system and its inherent
weaknesses in the three-volume Exploiting the workers
1989 The fall of the Berlin Wall Das Kapital (Capital). With the advent of modern industry
symbolizes the collapse of the bourgeoisie had effectively
Eastern Bloc communism. However, Marx was not become the ruling class, because
absolutely critical of capitalism. ownership of the means of
A lthough much of He viewed capitalism as a
economics is concerned historically necessary stage
with free market
economies, it should not be
forgotten that for a large part of the
20th century up to a third of the
world was under some form of
communist or socialist rule. These
states had centralized, or planned,
economies. Political philosophers
were looking for an alternative to
capitalism even as the modern free
market economies emerged.
However, a truly economic
argument for communism was
not formulated until the middle

INDUSTRIAL AND ECONOMIC REVOLUTIONS 103

See also: Property rights 20–21 ■ The labor theory of value 106–07 ■ Collective bargaining 134–35 ■
Central planning 142–47 ■ The social market economy 222–23 ■ Shortages in planned economies 232–33

production gave them the upper Under capitalism…
hand over the majority of the
population, the proletariat. While … the means of production … greed for profit leads to
workers produced goods and are privately owned overproduction of goods in
services in return for a wage, by a minority. demand, causing slumps
the owners of capital—the
industrialists and factory owners— in the economy.
sold those goods and services for
profit. If, as Marx believed, a The minority exploits Capitalism constantly
commodity’s value is based on the labor of the majority to falters; the economy suffers
the labor needed to produce it,
capitalists must price the finished make profits. an endless series of
goods by first adding the price of economic crises.
labor to the initial commodity
cost, then adding profit. In a But they inadvertently Economic instability
capitalist system the worker make the workers more leads to unrest.
must produce more value than skilled and educated.
he receives in wages. In this way
capitalists extract a surplus value
from the workers—this is profit.

To maximize profit, it is clearly
in the interests of the capitalist to
keep wages at a minimum but also
to introduce technology to improve
efficiency, often condemning
the workforce to degrading or
monotonous work, or even
unemployment. This exploitation
of the workforce, seen by Marx as
a necessary feature of capitalism,
denies workers both an adequate
financial reward and job ❯❯

The workers realize A revolution occurs,
their position and where the workers
want to shake off overthrow the ruling
their oppression. class and take control of
the means of production.

By the mid-19th century new Let the ruling
technology and the specialization classes tremble
of labor were making industry more at a communist
efficient. The result, Marx argued,
was an exploited, alienated workforce. revolution.

104 MARXIST ECONOMICS

With nothing to lose but his chains, proletariat would be swelled contains its own antithesis (the
a worker symbolically breaks free of his by the former bourgeoisie and exploited workers). The oppression
oppressors in a poster commemorating the unemployed. and alienation of the workers,
the 1917 Russian Revolution—an event combined with the inherent
directly inspired by Marx’s ideas. Marx saw competition as the instability of a capitalist economy
cause of another failing of the lurching from crisis to crisis, would
satisfaction, alienating them from capitalist system: the desire to result in massive social unrest.
the process of production. Marx jump into markets where profits are A proletarian revolution was both
argued that this alienation would increasing encourages increased inevitable and necessary to usher
inevitably lead to social unrest. production, sometimes regardless in capitalism’s successor in the
of demand. This overproduction historical progression (the
Competition and monopoly leads not only to waste but also to synthesis)—communism. Marx
Another essential element of stagnation and even decline of the encouraged revolution in the
capitalism is competition between whole economy. By its nature closing words of the Communist
producers. To compete in a market, capitalism is unplanned and ruled Manifesto: “The proletarians have
a firm must try not only to reduce only by the complexities of the nothing to lose but their chains.
production costs but also to market—economic crises are an They have a world to win. Working
undercut its competitors’ prices. inevitable result of the mismatch men of all countries, unite!”
In the process some producers fail of supply and demand. Therefore,
and go bankrupt, while others take growth in a capitalist economy Revolution
over an increasing portion of the is not a smooth progression but is Marx predicted that once the
market. The tendency, as Marx saw interrupted by periodic crises, bourgeoisie had been overthrown,
it, was toward fewer and fewer which Marx believed would the means of production would be
producers controlling the means of become more and more frequent. taken over by the proletariat. At
production and a concentration The hardship created by these first this would amount to what
of wealth in the hands of an ever crises would be especially felt Marx called a “dictatorship by the
smaller bourgeoisie. In the long by the proletariat. proletariat:” a form of socialism
term this would create monopolies where economic power was in the
that could exploit not only the To Marx these apparently hands of the majority. However, this
workers but also consumers. At insurmountable weaknesses in the would be only a first step toward
the same time the ranks of the capitalist economy would lead to the abolition of private property in
its eventual collapse. To explain favor of common ownership in a
how this would come about, he communist state.
used an idea proposed by the
German philosopher Georg Hegel, The bourgeoisie…
which showed how contradictory compels all nations,
notions are resolved in a process of on pain of extinction,
dialectic: every idea or state of to adopt the bourgeois
affairs (the original “thesis”), mode of production.
contains within it a contradiction
(the “antithesis”), and from this Karl Marx
conflict a new, richer notion (the Friedrich Engels
“synthesis”) arises.

Marx saw the inherent
contradictions within economies –
personified in the conflicts between
different groups or classes—as
driving historical change. He
analyzed the exploitation and
alienation of the proletariat by the
bourgeoisie under capitalism as an
example of a social contradiction,
where the thesis (capitalism)

INDUSTRIAL AND ECONOMIC REVOLUTIONS 105

In contrast to his exhaustive inefficient such planned economies Karl Marx
analysis of capitalism, Marx wrote would be. Today, only a handful of
relatively little about the details of communist-planned economies Born in Trier, Prussia, in 1818,
the communist economy that (Cuba, China, Laos, Vietnam, and Karl Marx was the son of a
would replace capitalism, except North Korea) have survived. There lawyer who had converted
that it should be based on common is debate over just how “Marxist” from Judaism to Christianity.
ownership and a planned economy the communism of these states Marx studied law but became
to ensure matching supply and was under the leadership of the likes interested in philosophy, in
demand. Insofar as it removed of Stalin and Mao, but the collapse which he gained a PhD from
all the iniquities and instability of communism in the Eastern bloc Jena University. In 1842,
of capitalism, he regarded and the liberalization of the Marx moved to Cologne and
communism as the culmination Chinese economy have been seen started work as a journalist,
of a historical progression. His by many economists as evidence but his socialist views soon
criticism of the capitalist economy that Marx’s theories were flawed. led to censorship, and he fled
was met, unsurprisingly, with to Paris with his wife, Jenny.
hostility. Most economists at the Mixed economies
time saw the free market as a In the decades following World It was in Paris that he met
means of ensuring economic War II Western Europe developed the German-born industrialist
growth and prosperity, at least for a “third way” between communism Friedrich Engels, with whom
a certain class of people. But Marx and capitalism. Many European he wrote the Communist
was not without his supporters, Union states still operate mixed Manifesto in 1848. He moved
mainly among political thinkers, economies with varying degrees of back to Germany briefly the
and his prediction of communist state intervention and ownership, following year, but when
revolution proved correct— although some, most notably Great the revolutions were quashed,
although not where he expected, Britain, have moved away from he left for London, where he
in industrialized Europe and mixed economies toward a more spent the rest of his life.
America, but in rural countries laissez-faire economic policy, There, he devoted his time
such as Russia and China. where the state plays a smaller to writing, notably Capital,
role. However, with communism and died in poverty in 1883,
Marx did not live to see the largely discredited, and the despite continual financial
establishment of communist states collapse of capitalism apparently assistance from Engels.
such as the USSR and the People’s no nearer than in Marx’s time, it
Republic of China, and he could not would appear that his theory of Key works
have envisaged the reality of how capitalist dynamism leading to
crisis and revolution were wrong. 1848 Manifesto of the
In 1959, Fidel Castro’s revolutionaries Nevertheless, Marxist economic Communist Party (with
seized power in Cuba. At first primarily theory has maintained a following, Friedrich Engels)
a nationalist revolution, it soon became and recent financial crises have 1858 Contribution to the
a communist one when Castro allied prompted a reappraisal of his ideas. Critique of Political Economy
himself with the Soviet Union. Increasing inequality, concentration 1867, 1885, 1894 Capital: A
of wealth in a few large companies, Critique of Political Economy
frequent economic crises, and the
“credit crunch” of 2008 have all
been blamed on the free market
economy. While not going so far
as to advocate revolution or even
socialism, a growing body of
thinkers—not all of them from
the political Left—is taking
elements of Marx’s critique of
capitalism seriously. ■

106

THE VALUE OF A
PRODUCT COMES
FROM THE EFFORT
NEEDED TO MAKE IT

THE LABOR THEORY OF VALUE

IN CONTEXT Natural resources come Adding labor to
free from nature. natural resources
FOCUS creates raw materials.
Theories of value
Adding labor to Adding labor to raw
KEY THINKER machines and materials creates machines
Karl Marx (1818–83) commodities creates goods.
and commodities.
BEFORE
1662 English economist The value of a product
William Petty argues that land comes from the effort
is a free gift of nature, and so
all capital is “past labor.” needed to make it.

1690 English philosopher T he importance of labor in that had been carved in a morning.
John Locke argues that determining the value of However, the issue became much
workers deserve the fruits goods has a history that more complicated with the
of their labors. can be traced back to the ancient emergence of modern industrial
Greek philosophers. For about 200 societies in the 18th century. The
AFTER years from the mid-17th century, it classical economists Adam Smith
1896 Austrian Economist dominated economic thought. In (p.61) and David Ricardo (p.84) had
Eugen von Böhm-Bawerk primitive, preindustrial societies each developed a theory of value
publishes Karl Marx and the role of labor in determining the connected to labor, but it was
the Close of his System, rate at which one good could the German philosopher Karl
summarizing the criticisms of be exchanged for another was fairly Marx (p.105) who set out the most
Marx’s labor theory of value. simple. If it took a man a week to famous description of the labor
make a fishing net, he was unlikely theory of value in his magnum
1942 Radical US economist to exchange it for a wooden spoon opus Capital.
Paul Sweezy publishes The
Theory of Capitalist
Development, defending
Marx’s labor theory of value.

INDUSTRIAL AND ECONOMIC REVOLUTIONS 107

See also: Agriculture in the economy 39 ■ The paradox of value 63 ■ Marxist economics 100–05 ■ Utility and satisfaction
114–15 ■ Supply and demand 108–13 ■ Opportunity cost 133 ■ Central planning 142–47

All commodities, costing $12.50—into the pair of When the labor theory of value
as values, are realized scissors. The same reasoning can dominated economic thought, it faced
be applied to explain why the lump a number of critiques based on
human labor. of steel cost $12.50, tracing time paradoxical questions:
Karl Marx and costs for producing steel from
iron ore. It is possible to trace the If sandcastles are made by labor,
Labor and cost expenditure on all the intermediate why don’t they have any value?
Marx’s idea was that the amount inputs until we arrive back at the Marx’s response was that not
of labor used to produce a good is original natural resources, which everything made by labor has
proportional to its value. The theory are free—so all the value has been value—labor can still be wasted
is often justified by the following created by labor. on goods no one wants.
argument. If a haircut involves half
an hour of labor, at $40 per hour, Marx pointed out that it is too How can an artistic masterpiece
the haircut has $20 of value. If it difficult to calculate the value of be valued from the amount of
also needs the use of scissors and any good in this way, so value labor hours used to make it?
brushes that cost a total of $60, and should be determined by the The defense to this critique is that a
lose $1 of their value (through wear) “congealed” lump of labor that the great work of art is an exception to the
on each haircut, the total value of good contains. He also said that rule because it is unique. Therefore,
the haircut is $21. Of the tools the value is determined by the “normal” there is no average quantity of labor
scissors themselves cost $20 amount of labor we expect its from which to derive a price.
because they took 45 minutes of production to take. An inefficient
labor to forge from a lump of steel— hairdresser may take an hour to cut How do vintage wines stored for
someone’s hair, but the haircut’s 10 years increase in value without
Happiness in work cost should not then rise by $20. any additional labor input?
Marx did not deny that supply and The defense here is that an additional
Karl Marx argued that people demand in the marketplace would cost does accrue to labor—that of
are driven by a desire to be influence the value or price of waiting for the wine to mature.
connected to other humans, and goods in the short run, but said that
this is what makes us happy. We in the long run the basic structure
show this desire through work. and dynamics of the value system
must come from labor. ■
When a person makes
something, that product Capitalism destroys this essence
represents his or her personality. of humanity, Marx claimed,
When someone else buys that because it alienates the workers
item, the maker is happy from what they produce. People
because not only has he or she no longer control their output;
satisfied the need of another they are merely hired to produce
person, but the buyer has also a product in which they have
confirmed the “goodness” of the had little creative input and are
personality of the producer. unlikely to consume or even
trade. The cooperative nature
of society is lost because people
are isolated in the competition
for jobs. Marx argued that it is
this separation from our work
that makes us unhappy.

PRICES COME FROM

SUPPLY AND

DEMAND

SUPPLY AND DEMAND



110 SUPPLY AND DEMAND

IN CONTEXT S upply and demand are Price at Demand Supply
among the fundamental equilibrium
FOCUS building blocks of economic
Theories of value theory. The interplay between the Equilibrium
amount of a product available on
KEY THINKER the market and the eagerness of PRICE
Alfred Marshall (1842–1924) consumers to buy that product
creates the foundation of markets. 0 Quantity at
BEFORE QUANTITY equilibrium
c.1300 Islamic scholar The importance of supply and
Ibn Taymiyyah publishes a demand in economic relationships This graph, known as the Marshallian
study of the effects of supply was studied as long ago as the Cross, shows the relationship between
and demand on prices. Middle Ages. The medieval supply and demand. The point at
Scottish scholar Duns Scotus which the supply and demand curves
1691 English philosopher John recognized that a price must be fair intersect gives the price.
Locke argues that commodity to the consumer but must also take
prices are directly influenced into account the costs incurred in a consumer gains or loses from
by the ratio of buyers to sellers. production and therefore be fair having more or less of a product
to the producer. Subsequent affects both demand and price.
1817 British economist David economists studied the effects
Ricardo argues that prices are of supply-side costs on eventual British economist Alfred
influenced mainly by the cost prices, and economists such as Marshall joined the analysis of
of production. Adam Smith (p.61) and David supply with the new neoclassical
Ricardo (p.84) linked the price of a approach to demand. Marshall saw
1874 French economist Léon product to the labor required in that supply and demand work in
Walras studies the equilibrium its production. This is called the tandem to generate the market
(balance) in markets. classical labor theory of value. price. His work was important
because he illustrated the varying
AFTER In the 1860s new economic dynamics of supply and demand
1936 British economist theories began to develop,
John Maynard Keynes challenging these ideas under the
identifies economy-wide total banner of the neoclassical school.
demand and supply. This school of thought introduced
the theory of marginal utility
(pp.114–15), where the satisfaction

Alfred Marshall Born in London, England, in 1842, former student, in 1877 and
Alfred Marshall grew up in the became principal of University
borough of Clapham before going College, Bristol, UK. In 1885,
to Cambridge University on a he returned to Cambridge as
scholarship. There, he studied professor of political economy, a
mathematics and then post he held until his retirement
metaphysics, concentrating on in 1908. From about 1890 until
ethics. His studies led him to see his death in 1924, Marshall was
economics as a practical means of considered the dominant figure
implementing his ethical beliefs. in British economics.

In 1868, Marshall took up a Key works
lectureship specially created for
him in moral science. His interest 1879 The Economics of Industry
in this continued until a visit to (with Mary Paley Marshall)
the US in 1875 made him focus 1890 Principles of Economics
more on political economy. 1919 Industry and Trade
Marshall married Mary Paley, his

INDUSTRIAL AND ECONOMIC REVOLUTIONS 111

See also: The paradox of value 63 ■ The labor theory of value 106–07 ■ Economic equilibrium 118–23 ■ Utility and
satisfaction 114–15 ■ Spending paradoxes 116–17 ■ Elasticity of demand 124–25 ■ The competitive market 126–29

In every case the more Producers supply goods If goods are not supplied
of a thing is offered for to the market to meet in large enough quantities to
sale in a market, the lower consumer demands. meet demand, prices rise.
is the price at which it
will find purchasers. However, at some Supply is increased
point, supply (producers make more)
Alfred Marshall
surpasses demand. to satisfy demand.

in short-term markets (such At this point, … until the market settles
as those for perishable goods), as prices begin to fall… at a price that balances
opposed to long-term ones (such as supply and demand.
for gold). He applied mathematics
to economic theories and produced Prices come from
the “Marshallian Cross:” a graph supply and demand.
showing supply and demand as
crossing lines. The point at which
they intersect is the “equilibrium”
price, which perfectly balances the
needs of supply (the producer) and
demand (the consumer).

The law of supply no influence over the market (see opposite), where every point
The amount of products a firm price and must accept what the of the curve provides the answer to
chooses to produce is determined market offers. how many units a firm will be
by the price at which it can sell willing to sell at a particular price.
them. If the assorted costs of For example if the costs of
production (labor, materials, producing a computer amount Furthermore, there must be
machines, and premises) amount to to $200, production will be a distinction between fixed and
more than the market is willing unprofitable if the market price variable costs. The above example
to pay for the product, production of the computer drops under $200. assumes that production can be
will be seen as unprofitable and be Conversely, if the market price of increased with the unit cost of
reduced or stopped. If, on the other the computer is $1,000, the firm production remaining stable.
hand, the market price for the item producing it will seek to produce However, this is not the case. If the
is substantially more than the costs as many as possible to maximize computer factory can produce only
of production, the company will profits. The law of supply can be 100 machines per day, yet there is
seek to expand production to make visualized using a supply curve demand for 110, the producer ❯❯
as much profit as possible. The
theory assumes that the firm has

112 SUPPLY AND DEMAND

must judge whether it makes sense When the demand price consumers demand more of the
to open a completely new factory, is equal to the supply product at each price. Given the
with the vast additional costs this price, the amount static position of the supply curve,
incurs, or whether it makes more this drives up the price. Because
sense to sell the computers at a produced has no tendency consumer tastes can be
slightly higher price to reduce either to be increased or manipulated through techniques
demand to only 100 per day. such as advertising, producers can
to be diminished; influence the shape and position
The nature of demand it is in equilibrium. of the demand curve.
The law of demand sees matters Alfred Marshall
from the viewpoint of the consumer Finding an equilibrium
rather than the producer. When the below $5, everyone will be able to While consumers will always seek
price of a good increases, demand afford to buy one, but nobody needs to pay the lowest price they can,
inevitably falls (except for essential more than two or three computers. producers will look to sell at the
goods such as medicines). This is Consumers realize that their money highest price they can. When
because some consumers will no is better spent on something else, prices are too high, consumers lose
longer be able to afford the item, or and demand flattens out. interest and move away from the
because they decide that they can product. Conversely, if prices are
gain more enjoyment by spending Price is not the only factor too low, it no longer makes financial
the money elsewhere. that affects demand. Consumer sense for the producer to continue
tastes and attitudes are also a to make the product. A happy
Using the same example as major factor. If a product becomes medium must be reached—an
previously, if the computer costs more fashionable, the whole equilibrium price acceptable to
only $50, the volume of sales will be demand curve shifts to the right; both consumer and producer. This
high since most people will be able price is found at the point where
to afford one. On the other hand if the supply curve intersects the
it costs $10,000, the demand will demand curve, producing a price at
be very low, since only the very which consumers are happy to pay
wealthy will be able to afford them. and producers are happy to sell.
As prices increase, demand falls.
Many factors complicate these
There is a limit to how low relatively simple laws. The position
prices can fall to stimulate demand. and size of the market are crucial
If the price of the computer falls to in price determination, as is time.
The price at which producers are
happy to sell is not just influenced
by the costs of production.

For instance, consider a market
stall selling fresh produce. The
farmer arrives having already paid
for the costs of production, buying
the seeds, the labor involved in
planting and harvesting the crop,
and his transport to the market.
He knows that to make a profit,
he must sell each apple for $1.20.

Fruit sellers may have to throw away
any unsold apples at the end of the day.
The urgency to sell in time is a major
factor in determining the price at
which to sell perishable goods.

INDUSTRIAL AND ECONOMIC REVOLUTIONS 113

Producers of goods such as Coca-
Cola may influence demand through
advertising that promotes the product
and the brand. As demand rises, the
price of the product may also rise.

Therefore, at the start of the day, with an excess of apples that are of the gold is under no time
he decides to market his apples at likely to rot before his next chance pressure to sell. He can be confident
$1.20. If his sales are going well, he to sell them. that it will maintain its value. The
may feel he can make more money larger the market and the more
and raise his price to $1.25. This In this example the costs of widespread the knowledge of the
may cause a slowdown in sales, production are fixed, and the market, the more likely it is that
but if he manages to sell his entire urgency of selling the crop is the the commodity has found its
stock, he will be happy. However, if pressing factor. This is useful in equilibrium price. This makes
the end of the day is nearing and illustrating the differences between any small change in market price
he finds that he still has quite a few short- and long-term markets. The significant, and any change will
apples left, he might decide to drop farmer will decide how many spark a flurry of buying and selling.
his price to $1.15 to avoid being left apples to plant for his next harvest,
based on his sales this time, and Although these examples
The price of any in this way the market should introduce further complexity into
commodity rises or falls eventually arrive at equilibrium. the market, they hold true to the
basic rule that suppliers will only
by the proportion of The farmer’s market is also sell at a price they find acceptable,
the number of buyers and limited by distance. There is only while buyers will only buy at a price
sellers… [this rule] holds a certain radius within which it they find reasonable.
universally in all things that makes economic sense to sell his
are to be bought and sold. products. For instance the cost The examples all relate to a
involved in shipping his apples market in which physical goods are
John Locke overseas would make his prices traded, but supply and demand is
uncompetitive with domestic relevant throughout economic
producers. This means that, reasoning. The model is applicable
to some extent, the farmer is to the labor market, for instance.
at liberty to set his prices slightly Here the individual is the supplier,
higher because his customers selling his or her labor, and
cannot travel to seek alternatives. employers are the consumers,
looking to buy labor as cheaply
The opposite scenario to the as possible. Money markets are also
fruit farmer is the market for a analyzed as a supply and demand
global commodity such as gold. In system, with the interest rate
this long-term market the holder acting as the price.

Economists call Marshall’s
work “partial equilibrium” analysis
because it shows how a single
market reaches equilibrium or
balance through the forces of
supply and demand. However,
an economy is made up of many
different interacting markets. The
question of how all these can come
together in a state of “general
equilibrium” is a complex problem
that was analyzed by Léon Walras
(p.120) in the 19th century. ■

114

YOU ENJOY THE LAST
CHOCOLATE LESS
THAN THE FIRST

UTILITY AND SATISFACTION

IN CONTEXT Demand is inversely A ristotle was the first
related to price: it increases person to observe that too
FOCUS much of a useful thing
Theories of value when the price falls. would be no use. The idea that
the more we consume of a product,
KEY THINKER This means that consumers the smaller the increases in
William Jevons (1835–82) will only buy more of a good satisfaction we receive has become
if the price falls because… enshrined in economic theory as
BEFORE the law of diminishing marginal
1871 Austrian economist Carl … each extra unit consumed utility (DMU). Marginal refers to
Menger is credited with the gives less pleasure than the changes on the “border,” such as
theory of diminishing previous one; for example… eating one more chocolate. Utility is
marginal utility in his book the “pleasure or pain” in the
Principles of Economics. … you enjoy the last decision to consume. In his Theory
chocolate less than of Political Economy (1871), British
AFTER economist William Jevons showed
1890 US economist Alfred the first. that utility could be measured in a
Marshall creates the demand way that relates to the quantity of
curve using marginal utilities the commodity available.
in his Principles of Economics.
Demand curves
1944 US economists John The concept of DMU became more
von Neumann and Oskar important as economists struggled
Morgenstern extend utility to understand what determines the
theory to situations with price of commodities. If everyone
uncertain outcomes. generally agrees that each extra
chocolate adds less utility, then it
1953 In The Behavior of makes sense that we will only
Rational Man at Risk, French demand extra chocolates if the
economist Maurice Allais price falls, because additional
demonstrates how people chocolates will give less pleasure—
behave differently from the so we will only buy them if they
way utility theory predicts. cost less. The resulting demand is
negatively related to price, and this,

INDUSTRIAL AND ECONOMIC REVOLUTIONS 115

See also: The paradox of value 63 ■ The labor theory of value 106–07 ■ Supply
and demand 108–13 ■ Risk and uncertainty 162–63

along with supply, helps to greater welfare for society. If the William Jevons
determine the equilibrium or government was to take $1 from a
“natural” price of a chocolate. very wealthy person and give it to Born in Liverpool, England, in
a very poor person, the total utility 1835, William Jevons was the
There are many notable of society should increase. son of an iron merchant. He
exceptions to the law of DMU, such developed an interest in
as finding the last piece of a puzzle, Utility theory has been economics from his father,
which is very satisfying. Addictive extended to situations in which who wrote about legal and
goods, such as drugs or alcohol, individuals have to make decisions economic matters. In 1855, his
also seem to be exceptions—the in the face of uncertainty and risk. father’s firm collapsed, and
more they are consumed the more In this case they make decisions money worries forced William
they are enjoyed. The principle also on the basis of their preferences to cut short his study of natural
makes certain assumptions, such over goods and their assessments sciences at University College
as “consumption should be of the probability of different London (UCL) and work in
continuous.” Eating a whole box of outcomes. In the 1950s the US Australia as an analyst. Five
chocolates at one time, for instance, mathematician Leonard J Savage years later he returned to UCL
is more likely to demonstrate the showed how different people make and completed his studies.
principle of DMU than eating them different choices—decisions are
spaced out over a day. affected not only by the different In 1863, Jevons became a
levels of utility people attach to tutor in Manchester, where he
Positive contributions commodities, but also by their met and married Harriet Taylor.
DMU has important applications, comfort with risk: risk-averse The family moved to London
not least in justifying a more equal people make choices that minimize in 1876, when Jevons took a
distribution of income to create the level of risk they face. ■ professorship at UCL. Despite
struggling with ill-health, he
The concept of diminishing marginal was a prolific and important
utility is evident in the inverse relationship writer in the fields of economics
of supply and demand. The more of a product and logic. He is famous for
an individual has, the less he or she is creating a logic piano, an early
prepared to pay for each unit of it. mechanical computer that
could analyze the truthfulness
PRICE The first few units Later units of chocolate of an argument. He accidentally
of chocolate can be (eaten within a single drowned in 1882, aged only 47.
sold for a higher price sitting) have lower
because they give lots prices because they Key works
of utility (satisfaction). only give small
increases in utility. 1865 The Coal Question
1871 The Theory of Political
0 Economy
0 1874 Principles of Science
QUANTITY OF CHOCOLATE DEMANDED

116

WHEN THE PRICE
GOES UP, SOME
PEOPLE BUY MORE

SPENDING PARADOXES

IN CONTEXT I n 1895, British economist commodities for which demand
Alfred Marshall (p.110) rises as their prices rise are known
FOCUS demonstrated how supply and as Giffen goods.
Decision making demand create the price of goods.
After he explained the general The original Giffen good was
KEY THINKER rules, such as the greater the bread, the most important staple
Robert Giffen (1837–1910) demand, the smaller the price, he of the poorest section of the British
went on to show how there can be population in the 19th century.
BEFORE an interesting exception. Marshall The poorest of the working classes
1871 Austrian mathematician suggested that a price rise could, spent a large part of their income
Carl Menger demonstrates in some circumstances, create a on bread, a food that was necessary
how the demand for surprising increase in demand. for life but was seen as inferior to
commodities is determined by He attributed the discovery of this the perceived luxury of meat.
their marginal utility. exception to a well-known Scottish Marshall said that as the price of
economist and statistician of the bread rose, the poorest people had
AFTER time, Sir Robert Giffen. Today, to spend more of their income on
1909 British economist bread to get enough calories to
Francis Edgeworth doubts the
existence of Giffen goods in If the price of an … people have to use
Free Trade in Being. essential product, such a greater proportion of

1947 US economist George as bread, rises… their income to buy it.
Stigler dismisses Marshall’s
examples of Giffen goods in … and poorer people This means they
Notes on the History of the are forced to buy have less to spend on
Giffen Paradox. more bread.
better-quality food…
2007 US academics Robert
Jensen and Nolan Miller revive When the price
the argument in Giffen goes up, some people
Behavior: Theory and
Evidence, which reports the buy more.
existence of a Giffen good in
poor, urban areas of China.

INDUSTRIAL AND ECONOMIC REVOLUTIONS 117

See also: Supply and demand 108–13 ■ Elasticity of demand 124–25 ■ Conspicuous consumption 136

survive—they had to buy bread lower demand. However, as the A girl buys rice in Bangladesh,
instead of meat. As a result, if price of bread rises, it also reduces where the government subsidized the
the price of bread increased, so the power to spend on other things, price of staples in 2011 in a drive to
did demand. and because bread is an inferior improve food security for the poor.
good, this lower income will make
Inferior and poor the demand for bread rise. What underlies demand curves. But if
Giffen goods rely on a number of makes the Giffen good so special Giffen goods exist at all, they are
assumptions. First, the commodity is that because the poor spend so rare: evidence comes from special
has to be an inferior good, that is, a much of their income on bread, the contexts, and some of the most
good that people choose to buy less income effect is so large that it famous cases are dubious. Yet
of as their income rises because outweighs the substitution effect, economists continue to search for
there are better alternatives—in and so when the price goes up, them. In a 2007 study Harvard
this case meat in preference to some people buy more. Another economists Robert Jensen and
bread. Second, the consumer must example of a Giffen good is that of Nolan Miller presented evidence of
spend a large portion of their potatoes during the Irish Potato Giffen behavior in the demand for
income on this product, hence the Famine of 1842–53, where rising rice among poor families in China. ■
fact that the example refers to the prices allegedly caused an increase
poorest section of society. Finally, in the demand for potatoes.
there must be no alternatives to the
product. In the case of bread, there Elusive evidence
is no cheaper alternative staple. Marshall came under attack from
Francis Edgeworth (1845–1926),
Given these assumptions, an another British economist, for
increase in the price of bread postulating the existence of a good
creates two effects. It causes that contradicts a basic rule of
people to buy less bread because demand, without any hard
the satisfaction it creates per pound evidence. In theory, Giffen goods
of spending falls compared to other are consistent with consumers’
goods. This substitution effect behavior—the interaction of income
would cause bread to follow the and substitution effects—that
general rule of higher price causing

Veblen goods

A new Rolls Royce limousine goes Veblen goods are named after should not be noticeably higher
on show in Shaanxi Province, China. Thorstein Veblen, a US economist quality than the lower-priced
Economists believe that luxury cars who formulated the theory of equivalents. If the price falls so
are desirable for their high price. “conspicuous consumption” much that it is no longer high
(p.136). They are strange because enough to exclude the less well
demand for them increases as off, the rich will stop buying it.
their price rises. Unlike Giffen
goods, however, which must be There is much evidence of
inferior, these goods must signal this behavior in the markets for
high status. luxury cars, champagne,
watches, and certain clothing
A willingness to pay higher labels. A reduction in prices
prices is to advertise wealth rather might see a temporary increase
than to acquire better quality. in sales for the seller, but then
A true Veblen good, therefore, sales will begin to fall.

A SYSTEM

OF FREE MARKETS

IS STABLE

ECONOMIC EQUILIBRIUM



120 ECONOMIC EQUILIBRIUM

IN CONTEXT T here has long been Léon Walras argued that the sum of
something appealing all the excess demand in an economy
FOCUS for economists about the equals zero. In an economy with just
Markets and firms idea that the economy may behave apples and cherries, excess demand for
with the same mathematical apples means excess supply of cherries.
KEY THINKER predictability of scientific laws
Léon Walras (1834–1910) such as Newton’s laws of motion. for a fair working wage and the
Newton’s laws reduce the whole most profitable use of land. In
BEFORE complex, teeming, physical France Léon Walras, an academic
1851 Francis Edgeworth universe to three simple, reliable who would later be described as
publishes a mathematical mathematical relationships. “the greatest of all economists,”
assessment of economics in Is it possible to find similar was trying to discover a complete
Mathematical Psychics. relationships in the complex, mathematical, scientific framework
changing world of markets? for the entire discipline. Walras
AFTER was ardent in his conviction
1906 Vilfredo Pareto develops In 1851, a British professor that it was possible to discover
a new theory of equilibrium named Francis Edgeworth economic laws that would make
that takes account of the published Mathematical Psychics, economics a “pure moral science”
compatibility of individual an early mathematical work (describing human behavior) that
incentives and constraints. on economics. He realized that went hand in hand with the “pure
economics deals with relationships natural science” of Newton. His
1930s John Hicks, Oskar between variables, which means
Lange, Maurice Allais, Paul that it can be translated into
A. Samuelson, and others equations. Edgeworth thought
continue to develop the theory about economic benefits in
of general equilibrium. utilitarian terms. In other words
believing that outcomes could
1954 Kenneth Arrow and be measured in terms of units of
Gérard Debreu provide a happiness, or pleasure.
mathematical proof of
general equilibrium. Other economists were
also intrigued by the idea of
a mathematical approach. In
Germany the economist Johann
von Thünen developed equations

Léon Walras Marie Esprit Léon Walras was He had a strong sense of social
born in Normandy, France, in justice and campaigned for land
1834. As a young man he was nationalization as a prelude to
captivated by bohemian Paris, but equal land distribution. In 1892,
his father persuaded him that one he retired to the town of Clarens
of the romantic tasks of the future overlooking Lake Geneva, where
was to make economics a science. he fished and thought about
Walras was convinced—though he economics until he died in 1910.
maintained his bohemian life
until, destitute, he went to Key works
Lausanne as economics professor
in 1870. It was there he developed 1874 Elements of Pure
his theory of general equilibrium. Economics
1896 Studies in Social
Walras believed that the Economics
organization of society was a 1898 Studies in Applied
matter of “art” outside the Economics
scientific realm of economics.

INDUSTRIAL AND ECONOMIC REVOLUTIONS 121

See also: The circular flow of the economy 40–45 ■ Free market economics 54–61 ■ Supply and demand 108–13 ■
Efficiency and fairness 130–31 ■ Markets and social outcomes 210–13 ■ Complexity and chaos 278–79

general equilibrium theory was Shortages of supply in
devised to explain the production, one area of the economy
consumption, and prices across
an entire economy. create surpluses of
supply elsewhere.
Supply and demand
Walras began by focusing on how Where there are shortages, Where there are surpluses,
exchanges worked—how the prices prices rise. prices fall.
of goods, the quantity of goods,
and the demand for goods interact. As prices rise, demand As prices fall, demand
In other words he was trying to falls and supply rises, rises and supply falls,
pin down just how supply and eliminating shortages. eliminating surplus.
demand tally. He believed that the
value of something for sale depends Economies as a whole
essentially on its rareté—which tend toward equilibrium
means “rarity,” but was used
by Walras to express just how as long as they are free
intensely something is needed. to do so.
In this respect Walras differed
from many of his contemporaries, A system
including Edgeworth and William of free markets
Stanley Jevons (p.115), who
believed that utility—either as is stable.
pleasure or usefulness—is the
key to value.

Walras began to construct
mathematical models to describe
the relationship between supply
and demand. These revealed that
as price escalates, demand falls
and supply climbs. Where demand
and supply match, the market is
in a state of equilibrium, or
balance. This reflected the same
kind of simple balancing forces
that were evident in Newton’s
laws of motion.

General equilibrium
To illustrate this equilibrium,
imagine that today the current
market price of mobile phones is
$20. In a local market store owners
have 100 phones for which they
want $20. If 100 buyers visit the
market, each willing to pay $20,
the market for cheap mobiles is in
equilibrium because the supply ❯❯

122 ECONOMIC EQUILIBRIUM

An auctioneer takes bids at a
cattle auction. Walras imagined an
auctioneer who provides perfect
information for the market. He
announces prices, and a sale only
takes place at the point of equilibrium.

and demand are perfectly balanced else also changes. One small way up to an equilibrium just as
with no shortages or surpluses. change in one part of the economy a climber gropes his way up a
Walras went on to apply the idea of can ripple through the entire mountain. He thought about
equilibrium to the whole economy economy. For example, suppose this by imagining a theoretical
in order to create a theory of that a war breaks out in a major “auctioneer” to whom buyers
general equilibrium. This was oil-producing country. Prices of oil and sellers submit information
based on the assumption that across the world will rise, which about how much they would buy
when goods are in surplus in one will have far-reaching effects on or sell goods at different prices.
area, the price must be too high. governments, firms, and The auctioneer then announces
Prices are judged “too high” by individuals—from increased prices the prices at which supply equals
comparison, so if one market’s at gas stations and increased demand in every market, and only
prices are “too high,” there must be heating costs at home, to being then does buying and selling begin.
another where prices are “too low,” forced to cancel a now-expensive
causing a surplus in the higher- vacation or business trip. Flaws in the model
priced market. Walras was quick to point out that
Toward equilibrium this was simply a mathematical
Walras created a mathematical Walras succeeded in reducing model, designed to help
model for the whole economy, his mathematical model of an economists. It was not intended
including goods such as chairs and economy to a few equations to be taken to be a description
wheat and factors of production containing prices and quantities. of the real world. His work was
such as capital and labor. He drew two conclusions from largely ignored by his
Everything was interlinked and his work. The first was that a contemporaries, many of whom
dependent on everything else. He state of general equilibrium is believed that real-world interactions
insisted that interdependency is theoretically possible. The second are too complex and chaotic for a
key; price changes do not take was that wherever an economy true state of equilibrium to develop.
place in a vacuum—they only started, a free market could move
occur because of a change in it toward general equilibrium. So On a technical level Walras’s
supply or demand. Moreover, a system of free markets could be complex equations were too
when prices change, everything inherently stable. difficult for many economists to
master, which was another reason
The equilibrium… Walras showed how this why he was ignored, although his
reestablishes itself might happen through an idea student Vilfredo Pareto (p.131)
automatically as soon he called tâtonnement (groping), later developed his work in new
as it is disturbed. in which an economy “gropes” its directions. In the 1930s, two

Léon Walras

INDUSTRIAL AND ECONOMIC REVOLUTIONS 123

There was… a set of prices, Computable economies state of the whole economy as
one for each commodity, Improvements to computers in well as seeing the effects of
the 1980s allowed economists to changing different parameters.
which would equate supply calculate the effects of interactions
and demand for all between multiple markets in Today, analysis of partial
commodities. actual economies. These equilibrium—considering the
Kenneth Arrow computable general equilibrium forces that bring supply and
(CGE) models applied Walras’s demand into balance in a single
decades after Walras’s death, his idea of interdependence to market—is the first thing that
equations came under the scrutiny particular situations to analyze an economics student learns.
of the brilliant Hungarian-born the impact of changing prices Walras’s insights about general
American mathematician, John and government policies. equilibrium also continue to
von Neumann. Von Neumann generate work at the cutting edge
exposed a flaw in Walras’s The attraction of CGE is of economic theory. For most
equations, showing that some that it can be used by large economists equilibrium and the
of their solutions produced a organizations—such as existence of forces that return
negative price—which meant governments, the World Bank, an economy to this state remain
sellers would be paying buyers. and the International Monetary fundamental principles. These
Fund—to make quick and ideas are perhaps the essence of
John Maynard Keynes (p.161) powerful calculations showing the mainstream economic analysis. ■
was particularly damning of
Walras’s approach, arguing that Where prices are judged to be too high in Excess supply
general equilibrium theory is one market, this will lead to an excess in supply in
not a good picture of reality that market. Prices adjust to eliminate excesses
because economies are never in in supply or demand across an economy in a
equilibrium. Keynes also argued process that Léon Walras called tâtonnement.
that there is no use thinking
about a long-term, and potentially Low demand HIGH PRICE
agonizing, drive to equilibrium, Excess demand
because “in the long-run, we
are all dead.” LOW PRICE Low supply

However, Walras’s ideas Demand and supply
have been rescued by the work are balanced
of US economists Kenneth Arrow
and Lionel W. McKenzie and RIGHT PRICE
French economist Gérard Debreu
(p.211) in the 1950s, who
developed a sleeker model
(pp.210–13). Using rigorous
mathematics, Arrow and Debreu
derived conditions under which
Walras’s general economic
equilibrium would hold.

124

IF YOU GET A
PAY RAISE, BUY
CAVIAR NOT BREAD

ELASTICITY OF DEMAND

IN CONTEXT T he “elasticity” of demand Designer clothes are luxury goods
is its responsiveness to that take up a greater proportion of
FOCUS changes in another factor, income as a person’s income rises.
Decision making such as price. British economist Necessities such as bread will take
Alfred Marshall (p.110) is generally a declining proportion of income.
KEY THINKER credited as the first economist to
Ernst Engel (1821–96) define the concept in 1890, but the people on average incomes, demand
German statistician Ernst Engel for a luxury such as caviar is much
BEFORE published a paper five years earlier, more sensitive to price change than
1817 British political showing how changes in income it is among the super-rich, who can
economist David Ricardo alter the level of demand. The afford as much as they like.
criticizes the charging of rent origins of the concept may be
on land because its supply is disputed, but its importance is Engel’s law
unable to respond to price. not. Elasticity of demand quickly Ernst Engel argued that as people
became one of the most widely grow richer, they increase spending
1871 Austrian economist Carl used tools of economic analysis. on food by less than their increase
Menger claims falling marginal in income. Demand for food is
utility (the worth of each extra Marshall had been one of the “income-inelastic”—an idea that
unit) influences demand. first to formalize the idea that became known as Engel’s law.
demand fell as prices rose. It took
AFTER only a small step from this to see
1934 British economist how the demand for different
John Hicks uses the concept products (such as bread and caviar)
of elasticity to measure how varied by differing amounts when
easily products can be the price of those products changed.
substituted for each other. Marshall saw that when prices
changed for necessities such as
1950 Argentine economist bread, demand changed very little.
Raúl Prebisch and German- Bread is very unresponsive to
born British economist Hans changes in price because it has
Singer independently show few substitutes. On the other hand
how the benefits of trade will demand for luxuries might be much
favor richer countries that more responsive to price—such a
produce manufactured goods. product is said to be “price-elastic.”
Marshall recognized that among

INDUSTRIAL AND ECONOMIC REVOLUTIONS 125

See also: Utility and satisfaction 114–15 ■ Spending paradoxes 116–17 ■
Supply and demand 108–13 ■ The competitive market 126–29

Your pay increases and you go shopping. If the product is…

… inferior… … normal… … superior…

… buy less. … buy more. Ernst Engel

If you get a pay raise, buy caviar not bread. Born in Dresden, Germany,
in 1821, Ernst Engel studied
Engel studied the budgets of 199 or goods. The first—normal goods mining at the École Des Mines
households in Belgium and showed —are those where demand rises in in Paris, France, where he
that while demand for basic line with income. Luxuries are a came under the influence of
necessities such as food grew less special type of normal good, known Frédéric Le Play, a pioneer in
quickly as income rose, demand for as a superior good, where demand the study of family budgets.
luxuries—such as vacations—grew rises proportionately more than On his return to Germany
at least as quickly as the increase the rise in income. The second type Engel became the director of
in income. Economists have of goods—inferior goods—see the statistical bureaus of
identified two types of products demand fall as income rises. Saxony and then Prussia,
where he formulated the law
The poorer the household, Some groups of goods, such that was to bear his name.
the larger the proportion as food, contain both luxuries
of its budget dedicated and necessities (such as caviar and In 1881, Engel wrote an
bread). This means that it may be article attacking Chancellor
to nourishment. misleading to judge the impact of Otto von Bismarck’s
Ernst Engel increasing income on food as a agricultural protectionism
group. A further complication is and was promptly “retired”
that a product is not always normal on health grounds. Engel was
or inferior—this may change at part of the German historical
different levels of income. Given school of economics. A prolific
extra income, very poor people writer, he believed in reforming
might buy more bread, those on policy to improve the lives of
high incomes might buy more the working classes. Perhaps
caviar, but the super-rich might his greatest legacy was his
choose to give up caviar and dine influence in the creation of
on edible gold flakes instead. ■ institutions for statistical
analysis in many European
countries. Engel died near
Dresden in 1896, aged 76.

Key works

1857 Production and
Consumption in Saxony
1883 The Worth of People
1895 The Cost of Living for
Belgian Workers

126 IN CONTEXT

COMPANIES FOCUS
ARE PRICE Markets and firms
TAKERS NOT
PRICE MAKERS KEY THINKER
Alfred Marshall (1842–1924)
THE COMPETITIVE MARKET
BEFORE
1844 Jules Dupuit, a French
engineer, originates the idea
of consumer surplus—a
measurement of welfare that
can be used to assess the
impact of competition.

1861 John Elliott Cairnes
clarifies the logic of
J. S. Mill’s and David Ricardo’s
theories of competition.

AFTER
1921 Frank Knight develops
the notion of perfect
competition.

1948 Friedrich Hayek’s
Individualism and Economic
Order attacks Marshall’s view
of perfect competition.

I n the late 18th century Adam
Smith (p.61) wrote about the
impact of competition on
firms’ abilities to set prices and
make profits above a “natural” level.
However, there was no formal
analysis of the situation until
British economist Alfred Marshall
(p.110) published Economic
Principles in 1890. The ideas in
Marshall’s model remain a key part
of mainstream economic theory,
although the theory has been
criticized as not representing the
true nature of competition.

Perfect competition
The model that Marshall developed
to explain why firms were unable to
set their own prices has become
known as “perfect competition.”

INDUSTRIAL AND ECONOMIC REVOLUTIONS 127

See also: Monopolies 92–97 ■ Supply and demand 108–13 ■ Economic liberalism 172–77 ■ Price discrimination 180–81 ■
Markets and social outcomes 210–13

In competitive industries small
firms make identical products, and sellers

and buyers alike know the
market price.

The industry price Any firm that attempts A perfect market is a
is determined by the to sell at a price higher district… in which there are
actions of all consumers than the market price many buyers and many sellers
all so keenly on the alert and
and all producers. will sell nothing. so well acquainted with one
another’s affairs that the price

of a commodity is always
practically the same for the

whole of the district.
Alfred Marshall

Companies are Firms must accept are indifferent about which firms
price takers the market price. they buy from. Third, anyone can
start buying and selling foreign
not price makers. acquire the factors of production currency without any legal, social,
they need to produce goods with or technological barriers being
In fact, Marshall himself preferred perfect ease. placed in their way—entry to the
the terms “free competition” and market is easy.
“perfect markets.” Competition in action
The market for foreign currency In a perfect market there is
The model is based on a set meets the conditions of perfect perfect information—all the
of assumptions, derived from the competition, and it is a useful participants know exactly what the
ideas of the classical economists, example for exploring its operations. “going price” is. Those buying and
about conditions in the market and Globally, there are so many firms selling foreign exchange know how
the behavior of firms. selling foreign currency that they much is being paid for a currency
each make up a tiny fraction of the at all times. In addition each firm
The first assumption is that market for euros, for example. They knows everything about the other
there is such a large number of sell to millions of buyers who all firm’s costs of production. This
firms selling the product to such need to buy currency, and each transparency implies that no
a large number of customers that buyer (a single tourist, for example) consumer can be fooled into paying
each of the firms and customers also makes up an insignificant part a higher price, and that firms know
individually represents a negligible of the market. the best and cheapest way to
part of the market. supply the product. Finally, self-
Second, the euro or dollar that interested firms aim to maximize
The second assumption is the tourist buys from each company profits. Workers will look for the
that every firm is trying to sell an is exactly the same, so the buyers highest-paid work, and capitalist
identical product. Third, the model investors will look for markets with
assumes that all the firms are free the highest profits. ❯❯
to enter or leave the industry at
will, and they are able to move or

128 THE COMPETITIVE MARKET

The assumptions of Marshall’s per ton—which is determined by

model create certain consequences the industry. At this industry price
for firms in perfectly competitive (shown as a dotted line in the
industries. One of the most graph), each farm can sell as much
as it likes, but it will sell nothing at
COMPANIESimportant of these is that firms
ARE PRICEhave no power over the price thatany price higher than this (because Laborers will seek those
buyers can go elsewhere). Farms employments, and capitalists
they can charge. This is because can choose to sell at a lower price those modes of investing their
there are so many firms selling an than other farms if they desire, but capital, in which… wages and
identical product that if any one firm
TAKERS NOTnothing. This is virtually guaranteed extra demand, because in perfect profits are highest.
attempts to sell at a price higher this would be of no advantage to John Elliott Cairnes

than its competitors, it will sell them—a lower price will not attract Irish economist (1824–75)

because the consumer has perfect competition each farm is a tiny part revenue minus cost—in this case,
$600,000. This is an example of
knowledge about the prices being what classical economists such as
asked by all firms. In this way the David Ricardo (p.84) describe as
“the market price moving away from
PRICE MAKERSmarket price is determined by the the natural price.” However, in a
of the total world supply (in wheat, perfectly competitive market these
this is around 700 million tons). high profits cannot be sustained in
By lowering the price, the farm the long term.

collective interaction of all the firms would merely lower its profits. The Short-term profits
TanHdEconCsOumMePrs,EaTndITeaIcVhEfirMm AhaRsKETfarm has only to decide what output Classical economists such as Smith
to accept that one particular price is it needs to produce to maximize and Ricardo were well aware of the
consequences—in competitive
the price at which they can sell the profits. In the case demonstrated by markets—of a price being well
above that required to cover costs.
product. They have to “take” the the graph, it is 3,000 tons, which The high level of profits would act
as an incentive for new firms to
price, not make it. the farmer knows can be sold for enter the industry. The lack of
barriers to entry in a perfect market
$350 per ton. allows any firm to enter the market
easily. In our example it is easy to
Competitive selling In this example, the farm is imagine farmers switching out of
barley production and into wheat
The standard representation of selling wheat for much more than production if wheat is more
profitable to produce. The impact
Marshall’s perfectly competitive the cost of producing it. By selling of the new entrants would be to
increase total supply, and through
industry (see below) demonstrates 3,000 tons at $350 per ton, the competitive pressure drive the
price downward, so that in a short
this idea. For instance, at any farm’s revenue is $1.05 million; its time firms would only be able to
make a “normal” level of profit.
moment in time there will be a costs, however, are $450,000 ($150 This would be when the price just

world price of wheat—such as $350 × 3,000 tons). The farm’s profit is

Price is In the perfectly competitive industry price
determined in remains the same regardless of any individual firm’s
the industry level of output. A firm will expand production until it
reaches a level beyond which any further production
350 would cost more than the goods’ selling price.

PRICE ($) Average cost
per ton for
firm to supply
product

PROFIT

150 Cost per ton initially Point at which
Cost of decreases with increased production
production economies of scale would decrease profits

0 1,500 3,000
0

OUTPUT OF FIRM (TONS)

INDUSTRIAL AND ECONOMIC REVOLUTIONS 129

covered the costs of production— any—real industries that come Traders determine prices of
the excess profits (shown on the close to the assumptions required commodities such as wheat through
graph in blue) would vanish. for the model to be useful. In fact, competing with each other. In
both currency markets and competitive markets no single trader
When the assumptions that agriculture are unlikely to be good has the power to influence the price.
underlie perfect competition are examples of the theory of perfect
violated, firms can make large competition because of the introducing new technologies to
profits in the long run. For instance, existence of large firms that can reduce their costs and consistently
if there are any barriers to entering influence price, and because raise profits.
an industry—such as technological governments can and do
or legal barriers—excess profits do manipulate these markets. The Attacks on perfect competition
not get competed away. The most defenders of perfect competition around this point continued through
extreme form of this is that of a argue that the model represents a the 20th century. The Austrian-born
monopoly. To maximize profits, a theoretical, ideal form of market British economist Friedrich Hayek
monopolist charges a higher price structure that is useful for (p.177) argued that competition
and produces less than would be understanding how firms behave, is a dynamic discovery process
the case in a perfectly competitive even if there are no industries that in which entrepreneurs seek new
market. This is why economists actually meet its requirements. profit opportunities in a world of
believe that perfectly competitive constant change—it is not simply
markets are more socially beneficial A more fundamental criticism the sterile copying of prices
than monopolized ones. Under is that perfect competition as suggested by Marshall’s model. ■
conditions of lower output produced described by Marshall has lost its
by a monopoly, consumers could real meaning; in fact, there is no
gain from extra units of production. “competition” in the model. Firms are
But in perfectly competitive seen as making identical products,
markets, these extra units are responding passively to prices, and
produced as more firms enter the accepting that they will end up
market—prices drop as high profits making normal profits. This is a long
are competed away. way from the situation suggested by
Smith, where firms desperately try
Impossibility of perfection to make different, higher-quality
There are a number of controversies products than their competitors,
around Marshall’s model of perfect which they seek to sell at higher
competition. First, there are few—if prices, while also intermittently

Marshall on risk, uncertainty, and profit

In 1921, US economist Frank equilibrium; entrepreneurs do
Knight (p.163) published Risk, not earn profits as a reward for
Uncertainty, and Profit, which taking predictable risks. On the
analyzed the effects of uncertainty other hand real uncertainty is
on Marshall’s model of perfect immeasurable—it comes
competition. Knight defined risk principally from not being able
as a measurable uncertainty, such to see into the future. For
as the chance of a champagne Knight, entrepreneurs accept
bottle exploding. The proportion the responsibility of working
of bottles that burst is practically with an uncertain future and
constant, and the producer can take decisions on this basis. The
therefore add it to costs or insure amount that entrepreneurs will
against it. For this reason risk earn is unknown because the
does not disrupt the competitive future is unknown.

130

MAKE ONE PERSON
BETTER OFF WITHOUT
HURTING THE OTHERS

EFFICIENCY AND FAIRNESS

IN CONTEXT I n the 19th century a group of dominate modern economics. His
British philosophers known as argument is based on a ranking
FOCUS the utilitarians introduced the of relative happiness known as
Welfare economics idea that the happiness of individuals “ordinal utility,” rather than an
can be measured and added up, absolute measurement of happiness
KEY THINKER or aggregated. Italian economist (“cardinal utility”).
Vilfredo Pareto (1848–1923) Vilfredo Pareto disagreed. In his
Manual of Political Economy, he Pareto said that individuals
BEFORE introduced a weaker definition of know their own preferences and
1776 Adam Smith’s The social welfare that has come to will do what suits them best. If
Wealth of Nations relates everyone follows their own tastes,
self-interest to social welfare.
A government wants … but individual welfare
1871 British economist to improve the welfare is unmeasurable in absolute
William Jevons says that value
depends entirely on utility. of its people… (not relative) terms.

1874 French economist Léon A reasonable aim … where each individual
Walras uses equations to would be to reach a state trades to improve their
determine the overall of Pareto efficiency… own welfare…
equilibrium of an economy.
… until they reach a
AFTER compromise, or equilibrium, where
1930–50 John Hicks, Paul you can’t make one person better off
Samuelson, and others use
Pareto optimality as the basis without hurting the others.
of modern welfare economics.

1954 US economist Kenneth
Arrow and French economist
Gérard Debreu use
mathematics to show a
connection between free
markets and Pareto optimality.

INDUSTRIAL AND ECONOMIC REVOLUTIONS 131

See also: Free market economics 54–61 ■ Economic equilibrium 118–23 ■
Markets and social outcomes 210–13

constrained as they are by the inefficient: a transfer of chicken Vilfredo Pareto
obstacles they face, society will from John to Jane would help Jane
soon reach a point where no one without hurting John. Often Born in France in 1848,
can be made better off without preferences aren’t so clear cut: both Vilfredo Pareto was the son
hurting someone else. This state might like chicken and rice but to of an Italian marquis and a
is known as Pareto optimality, or different degrees. In that case Jane French mother. The family
Pareto efficiency. and John can exchange just small moved to Italy when he was
amounts of chicken and rice until four, and Pareto was schooled
Pareto efficiency an optimal allocation emerges. in Florence, then in Turin,
Suppose a couple named Jane and where he acquired a PhD in
John both like rice. If we have a We can all agree engineering. While working
sack of rice, any division of it Using Pareto efficiency reduces the as a civil engineer, he became
between them—even one where need to judge between conflicting interested in economics and
one person gets all the rice—would interests. Avoiding such judgments free trade. In 1893, he was
be optimal, because only taking is the hallmark of positive economics recommended by his friend,
rice away from a person is said to (describing how things are), as the Italian economist Maffeo
hurt them. In this way Pareto opposed to normative economics Pantaleoni, to succeed Léon
efficiency is different from fairness. (prescribing how they should be). Walras (p.120) to the chair of
Pareto argued that free markets are political economy at the
In most situations there are efficient in his sense of the term. University of Lausanne in
many goods and tastes. For instance, This formalized Adam Smith’s idea Switzerland. He took up the
if John likes rice but not chicken, that self-interest and free market post at the age of 45, and it
and Jane likes chicken but not competition operate for the was there that he made his
rice, an allocation in which John common good (pp.54–61). ■ major contributions to the
had everything would be Pareto field, including his theories on
income distribution.
QUANTITY OF FLOWERS Pareto efficiency can be used to
determine efficient production. If two Pareto continued to teach
people own a garden, and one prefers until 1911. His works were
flowers while the other prefers vegetables, prolific, covering sociology,
the garden can be planted with flowers, philosophy, and mathematics
vegetables, or a combination of both. as well economics. He died in
Any point on the Pareto frontier, such Geneva in 1923.
as B or C, is Pareto efficient. Any point
under the line, such as A, is inefficient. Key works
B
1897 Course of Political
A The Pareto frontier Economy
1906 Manual of Political
C Economy
1911 Mathematical Economics
0
0
QUANTITY OF VEGETABLES

132

THE BIGGER THE
FACTORY, THE LOWER
THE COST

ECONOMIES OF SCALE

IN CONTEXT F rom the beginning of the this effect in Principles of
Industrial Revolution, when Economics. He pointed out that
FOCUS manufacturing shifted from when firms increase their output,
Markets and firms small-scale outfits to large factories, all they can do in the short run is
it became apparent that bigger alter the number of workers to
KEY THINKER firms could produce at a lower cost. increase production—nothing else.
Alfred Marshall (1842–1924) As a firm grows and produces more, As extra workers add less to output
it uses more machinery, labor, and than the workers before them, costs
BEFORE raw materials, so a bigger factory per unit rise. Yet in the long run,
1776 Adam Smith explains has higher total costs. But it can if a firm is able to double the size
how large firms can lower unit also produce more for a lower unit of its factory, workforce, and
costs through labor division. cost. This fall in average costs is machines, it will be able to take
known as economies of scale. advantage of the specialization of
1848 John Stuart Mill labor, and costs will fall.
suggests that only large firms In 1890, British economist
can adapt successfully to Alfred Marshall (p.110) explored In the 1960s another British
certain business changes, economist, Alfred Chandler (1918–
and that this can lead to the 2007), showed how the growth of
creation of natural monopolies. large corporations caused a new
Industrial Revolution at the start of
AFTER the 20th century. Large enterprises
1949 South African economist came to dominate industries,
Petrus Johannes Verdoorn producing more goods at lower cost
shows that increasing growth and driving competitors out of
creates increasing productivity business. These large firms often
through economies of scale. enjoyed a “natural monopoly.” ■

1977 Alfred Chandler Alfred Chandler described the
publishes The Visible Hand: development of large US corporations,
the Managerial Revolution such as those in the auto industry, into
in American Business, vast production-line industries.
which describes the rise
of giant corporations and See also: Diminishing returns 62 ■ The division of labor 66–67 ■
mass production. Monopolies 92–97 ■ The competitive market 126–29

INDUSTRIAL AND ECONOMIC REVOLUTIONS 133

THE COST OF GOING
TO THE MOVIES IS
THE FUN YOU’D HAVE
HAD AT THE ICE RINK

OPPORTUNITY COST

IN CONTEXT E conomists at the end of the Economics brings
1800s were still wrestling into view that conflict
FOCUS with what determined the of choice which is one of the
Theories of value value of a product. By 1914, permanent characteristics
Austrian economist Friedrich von of human existence.
KEY THINKER Weiser was convinced that the
Friedrich von Wieser value of something was determined Lionel Robbins
(1851–1926) by what had to be given up in order
to get it. In a world where people one course of action, opportunity
BEFORE have infinite wants and yet have cost means more. You can’t watch
1817 David Ricardo argues only a fixed amount of resources to a movie and ice skate at the same
that the value of a commodity meet those wants, he argued that time. Sometimes there is what can
is determined by the amount scarcity would create the need for be called an opportunity cost even
of labor hours used to choices. He called this concept if there is no monetary cost. Weiser
produce it. “opportunity cost” in Foundations thought that ultimately the price of
of Social Economy (1914). In 1935, a product was determined by how
AFTER US economist Lionel Robbins much it was desired, and this is
1920 Alfred Marshall argues argued that a tragedy of human life measured by what people were
in Principles of Economics that is that the consequence of choosing willing to give up to get it, rather
both supply and demand have to do one thing is that something than how much it cost to produce. ■
a role in determining price. else has to be given up.

1949 Ludwig von Mises True cost
explains in Human Action This means that the cost of going
how prices convey important to the movies, for example, is not
information in markets. really the cost of admission to the
cinema but also the enjoyment you
1960 Italian economist give up from your next best choice
Piero Sraffa questions the of activity. So although there is a
opportunity cost measure monetary consequence of choosing
of value in Production of
Commodities by Means See also: Economic man 52–53 ■ The labor theory of value 106–07 ■
of Commodities. Utility and satisfaction 114–15

134

WORKERS MUST
IMPROVE THEIR
LOT TOGETHER

COLLECTIVE BARGAINING

IN CONTEXT Workers depend on There are many workers and
employers for few employers, so employers
FOCUS hold the balance of power.
Society and the economy their livelihood.

KEY THINKER So employers dictate the An individual worker has
Beatrice Webb (1858–1943) terms to workers. little power, because he
or she is easily replaced.
BEFORE
1793 Friendly societies, an But by acting together, Workers must
early kind of union, are given workers shift the improve their
legal recognition in the UK. balance of power. lot together.

1834 Workers in the US T he term “collective their books brought about change
and Europe begin to unite in bargaining” was coined at government level. In 1894, they
national organizations. by British socialist reformer published History of Trade
Beatrice Webb in 1891 to describe Unionism, documenting the rise
1870s Union power in France the process by which workers of the unions during the Industrial
and Germany becomes firmly organize into unions, which Revolution in Britain, when large
allied to socialist movements. negotiate pay and conditions with numbers of workers were thrown
employers on the workers’ behalf. together in the new factories.
AFTER Webb and her husband, Sidney, Conditions were harsh, job security
1920s and 30s Trade unions campaigned against poverty, and almost non-existent, and wages
fight for workers’ rights during
the Great Depression.

1955 US unions unite under a
single umbrella: the AFL–CIO.

1980s Union membership and
collective bargaining begins to
decline in the face of privatized
public services and measures
by right-wing governments to
curb union power.

INDUSTRIAL AND ECONOMIC REVOLUTIONS 135

See also: Marxist economics 100–05 ■ The labor theory of value 106–07 ■ Depressions and unemployment 154–61 ■
The social market economy 222–23 ■ Sticky wages 303

If a group of workmen led to a new law, limiting union Public sector workers demonstrate
concert together, and send rights to meetings for collective in Madrid, Spain, in 2010 to protest
representatives to conduct the bargaining purposes. against job cuts. Today, trade unions
bargaining on behalf of the are stronger in the public sector than
whole body, the position is As union membership in Europe the private sector in most countries.
increased throughout the 19th
at once changed. century, a struggle developed of jobs and depresses wages in
Beatrice Webb between those who saw unions as industries that are not unionized.
Sidney Webb following in the tradition of crafts Perhaps for this reason or more
guilds, negotiating for better political ones, governments have
often close to the breadline. The working conditions for their often sought to curtail union power
Combination Acts of 1799 and 1800 members, and those who saw by outlawing sympathetic strikes.
outlawed trade unions, and any unions as the vanguard of a
worker who combined with another revolution, fighting for a better The globalization of production
to gain a wage increase or a world for all working people. has also isolated groups of workers
decrease in hours was sentenced to within countries. The terms under
three months in jail. After the acts A continuing struggle which people work on a global
were repealed in 1824, trade unions Collective bargaining was widely product are often locally determined
formed rapidly, especially in the adopted because it works for between workers and the company,
textile industry. A series of strikes employers as well as workers. rather than set industrywide across
It dramatically simplifies the the whole country. ■
process of agreeing to conditions
because one agreement can
often be applied industrywide.

However, since the 1980s trade
unions and the power of collective
bargaining have shrunk
dramatically. US economist Milton
Friedman (p.199) has argued that
unionization gives higher wages
for union members at the expense

Beatrice Webb Born in Gloucestershire, UK, in newspaper The New Statesman.
1858, Beatrice Webb was the child The Webbs helped to shape the
of a radical member of parliament. trade union movement. They
She grew up with a keen interest created a blueprint for the UK’s
in social questions and became National Health Service and
fascinated in the structural welfare systems around the
problems underlying poverty. In world. Beatrice Webb died
1891, she met her lifelong partner, in 1943.
Sidney Webb, and the pair became
central to the British Labour Key works
movement. They formulated the
idea of “the national minimum”— 1894 History of Trade Unionism
a minimum level of wages and (with Sidney Webb)
quality of life below which a 1919 The Wages of Men and
worker could not be allowed to Women
fall. They also founded the London 1923 The Decay of Capitalist
School of Economics and the Civilization

136

PEOPLE
CONSUME TO
BE NOTICED

CONSPICUOUS CONSUMPTION

IN CONTEXT T he US economist Thorstein devastating critique, The Theory of
Veblen was the first to note the Leisure Classes, which argued
FOCUS that economic behavior is that the defining qualities of New
Society and the economy driven by psychological factors, York high-society were like those of
such as fear and status-seeking, primitive tribal chieftains—a surfeit
KEY THINKER as much as by rational self-interest. of leisure and money. The rich did
Thorstein Veblen Having grown up in a Norwegian not buy things because they
(1857–1929) farming community in Minnesota, needed them but to display their
Veblen was an outsider who wealth and status. Veblen was
BEFORE observed the extremely rich and the first to describe this as
1848 British philosopher self-satisfied Americans of the “conspicuous consumption.”
John Stuart Mill’s theory of 1890s. In 1899, he published his
political economy assumes Consumption trap
that utility (satisfaction) lies US oil tycoon John D. Rockefeller Today, “Veblen goods” (p.117) are
at the heart of economics. (left), pictured here with his son, was luxury items such as Porsche cars
the first person to be worth more than and Rolex watches. A person’s
1890 British economist $1 billion. Rockefeller was part of the satisfaction increases the more
Alfred Marshall moves the New York society Veblen criticized. of them they have and the less of
focus of economics away from them that other people have. Veblen
markets and towards the believed that rich societies can
study of behavior. suffer from a “relative consumption
trap” in which production is
AFTER squandered on these types of
1940 Hungarian economist goods. As more people consume
Karl Polanyi argues that them, there may be no gains in
economic behavior is rooted overall well-being. Some
in society and culture. economists have argued that
wasteful consumption, fueled by
2010 US economist Nathan credit card usage, contributed to
Pettit says that “conspicuous the global financial crisis of 2008. ■
consumption” and the
resulting debt played a key See also: Economic man 52–53 ■ Spending paradoxes 116–17 ■ Economics and
role in crippling global tradition 166–67 ■ Behavioral economics 266–69
financial markets in 2008.

INDUSTRIAL AND ECONOMIC REVOLUTIONS 137

MAKE THE
POLLUTER PAY

EXTERNAL COSTS

IN CONTEXT I f a supermarket threw old Governments now use this idea in
boxes into a nearby garden to policies such as carbon taxes to
FOCUS save money on waste disposal, reduce carbon emissions. As well
Economic policy they would clearly be responsible as being economically efficient,
for clearing it up. However, when many believe that it is morally right
KEY THINKER the damage is less obvious but has to make the polluter pay, and shift
Arthur Pigou (1877–1959) a cost to society—such as air the responsibility for the problem
pollution from a factory—can the to business. However, imposing
BEFORE market system devise a solution? a Pigouvian tax is not simple. As
16th century London Pigou himself pointed out, correctly
households are forced to pay Taxing polluters estimating the true cost of pollution
for sewage cesspits in their In the 1950s economists began to is not a trivial matter. ■
own houses, rather than throw refer to such costs as externalities
sewage into the streets. because these costs aren’t reflected In general, industrialists
in market prices and affect third are interested, not in
AFTER parties. This is a market failure:
1952 British economist because the factory doesn’t have to the social, but only in the
James Meade tells a fable face the true social costs of its private, net product
of beekeepers who received actions, it will create too much of their operations.
no benefit from their bees pollution relative to what would be Arthur Pigou
pollinating nearby orchards, so socially efficient. British economist
stopped raising enough bees. Arthur Pigou argued that the way
to deal with this was to tax the
1959 British economist Ronald polluter. This “Pigouvian tax,” as
Coase argues that the way to it came to be called, was intended
cope with external costs is to to ensure that the full costs
focus on property rights so of pollution were factored into the
that pollution is owned and polluter’s decisions so a business
its costs negotiated. would only pollute if buyers were
prepared to pay for the damage.
1973 James Cheung shows
the fable of the bees to be See also: The tax burden 64–65 ■ Markets and social outcomes 210–13 ■
false since apple-growers The theory of the second best 220–21 ■ Economics and the environment 306–09
and beekeepers do negotiate.

138

PROTESTANTISM
HASMADE US
RICH

RELIGION AND THE ECONOMY

IN CONTEXT The Reformation Calvinist Protestantism
made northern Europe claimed only the elect are
FOCUS predestined for salvation.
Society and the economy Protestant.

KEY THINKER Protestants work harder, Hard work and
Max Weber (1864–1920) believing it demonstrates frugality are outward

BEFORE personal salvation. manifestations
1517 Martin Luther publishes of the elect.
The Ninety-Five Theses,
starting the religious conflict They refuse luxuries … growing the economy
that leads to the Reformation. and reinvest their profits and the wealth
of the nation.
1688 The Glorious Revolution into further business…
ends any chance of Catholicism
returning to Britain and paves Protestantism has
the way for the world’s first made us rich.
Industrial Revolution.
T he German sociologist Max the US had fared better than the
AFTER Weber was interested in Catholic societies of South America
1993 Swedish social scientist the contrasting levels of and the Mediterranean because of
Kurt Samuelsson argues that economic success in various Protestant beliefs in predestination,
Puritan leaders did not truly countries during the 16th to 19th vocation, and the work ethic.
endorse capitalistic behavior. centuries. In The Protestant Ethic
and the Spirit of Capitalism, he For Catholics divine reckoning
2009 Harvard economist argued that northern Europe and is a future event: one must live a
Davide Cantoni publishes decent life and perform good deeds
The Case of Protestantism
in 16th Century Germany, in
which he claims to find “no
effects of Protestantism on
economic growth.”

INDUSTRIAL AND ECONOMIC REVOLUTIONS 139

See also: Economic man 52–53 ■ Economics and tradition 166–67 ■ Institutions in economics 206–07 ■
Market information and incentives 208–09 ■ Social capital 280

they were already destined for God helps those who
heaven. The Bible encourages hard help themselves.
work and frugality, so Protestants Max Weber
aimed to embody these qualities
and demonstrate that they were
among the saved, while everyone
else faced damnation. Forbidden to
buy luxuries, they reinvested their
profits back into their business.

The village blacksmith held an God-given vocations social inequalities and poverty,
important place in the community, Catholicism held that the only God- because material wealth was a sign
according to Max Weber, because he given vocation was priesthood, but of spiritual wealth.
dealt frequently with many people in Protestants thought that people
the course of his God-given vocation. could be called to any of the secular Weber’s argument can be
crafts and trades. The belief that challenged, however. The leading
in order to be saved. But Protestant they were serving God encouraged European power in the 16th and
teachings, especially those stemming them to work with religious fervor, 17th centuries, and the first global
from Calvinist Protestantism, claimed leading them to produce more superpower, was the thoroughly
that there was a pre-selected “elect” goods and make more money. Catholic Spanish Empire. Other
destined to be saved, who would live conflicting cases can also be found
a virtuous life as a consequence of Weber believed that the in the rise of Asian countries that
being part of the elect. Their actions Protestant faith led inevitably have never been Protestant, or even
in this physical life would not lead to to a capitalist economic society Christian. Japan is the third largest
their salvation, but merely show that because it gave believers the economy in the world, and China is
chance to view the pursuit of profit growing fast. ■
as evidence of devotion, rather than
of morally suspect motives such as
greed and ambition. The idea of
predestination also meant that
believers need not worry about

Max Weber Karl Emil Maximilian Weber was service in World War I he
one of the founding fathers of changed his political views
modern social science as well as and became a prominent critic of
an economist. He was born in the Kaiser. Weber commanded
1864 in Erfurt, Germany, and widespread respect in the
was brought up in a prosperous, political establishment and
cosmopolitan, and intellectual after the war helped write the
family. His father was an outgoing Weimar Republic’s constitution.
civil servant, while his mother He resumed teaching, but in
was a strict Calvinist Protestant. 1920 died of Spanish flu.

Weber studied law at the Key works
universities of Heidelberg and
Berlin, then held professorships 1904–05 The Protestant Ethic
in economics at various German and the Spirit of Capitalism
universities until his father’s death 1919 Politics as a Vocation
in 1897 left him too depressed to 1923 General Economic History
teach. After volunteering for

140

THE POOR
ARE UNLUCKY,
NOT BAD

THE POVERTY PROBLEM

IN CONTEXT Most sources of poverty are outside a person’s control.

FOCUS The poor In many countries This leads to
Society and the economy have no education must poor job
private be paid for, and prospects
KEY THINKERS property. the poor cannot
John Stuart Mill (1806–73) and bad health.
Amartya Sen (1933– ) afford it.

BEFORE The poor are unlucky, not bad.
1879 US economist Henry
George publishes Progress I n high-income countries deserving poor (the old, the young,
and Poverty, a huge bestseller governments often account for and the sick), the deserving
that called for a land tax to 30–50 percent of spending in unemployed (those willing to work
alleviate poverty. the economy. About half of this but unable to find employment), and
consists of “social transfers,” or the undeserving poor (beggars). The
1890s Charles Booth and welfare spending. In historical first two groups were given food
Seebohm Rowntree conduct terms such high social spending is and money donated by local people,
poverty surveys in the UK. a comparatively new development, but the third group were treated as
dating from the 1930s and 40s. criminals. With industrialization
AFTER the view of the poor changed, and
1958 US economist John Welfare spending has a long by the 18th century many people
Kenneth Galbraith draws history. In the 16th century thought that the poor had only
attention to poverty in his England’s Poor Law assumed there themselves to blame. British
book The Affluent Society. were three types of poor people: the

1973 Indian economist
Amartya Sen proposes a
new poverty index.

2012 The World Bank
defines extreme poverty
as an income of less than
$1 a day.

INDUSTRIAL AND ECONOMIC REVOLUTIONS 141

See also: Demographics and economics 68–69 ■ Development economics 188–93 ■ Development goals
Entitlement theory 256–57

economists David Ricardo (p.84) These unsanitary living conditions In September 2000, 189 world
and Thomas Malthus (p.69) asked of the poor in London, as depicted by leaders from the United
for the Poor Laws to be abolished, Gustave Doré in 1872, afflicted most of Nations signed eight
claiming handouts weakened the the cities of Europe. Adults, children, Millennium Development
incentive to work. and vermin fought for precious space. Goals to be met by 2015. The
goals are: end poverty and
This view became widely held, 21st-century poverty hunger, universal education,
but there was an alternative view After 1800, a great divergence of gender equality, child health,
given by British philosopher John wealth developed between Europe maternal health, combat
Stuart Mill (p.95) in 1848. Mill and North America, and the rest diseases (HIV/AIDS, TB, and
argued that economics is of the world. Poverty has been a malaria), environmental
concerned only with production— persistent problem in South Asia sustainability, and global
the distribution of wealth is and Sub-Saharan Africa. Economists partnership. One target was
society’s choice. In his work on have emphasized the role of health, to halve the number of people
politics he usually argued in favor education, and transportation, as in extreme poverty by 2015.
of limiting the role of government, well as direct support to the poor
but in this case he said the state in reducing poverty. According to the World
should step in to help those unable Bank, the percentage of
to help themselves and provide Indian economist Amartya Sen people in developing countries
citizens with the education they (p.257) argued that poverty is about who earn less than $1 a day
needed to earn a living. limitations in “capabilities and fell from 30.8 percent in 1990
functionings”—the things people to 14 percent in 2008, after
As the right to vote broadened can succeed in doing or being— adjustments were made for
in European countries during not the goods or services they have the different prices of goods
the 19th and 20th centuries, it access to. This idea is reflected in the different countries. This
was accompanied by greater in continuing questions about was largely thanks to progress
demands for social spending whether the poverty line is absolute in East Asia. However, $1 is a
and the redistribution of wealth. (meeting basic requirements) or desperate level. The average
Elaborate public health and relative (such as a percentage of “poverty line” used by
education systems developed the average income). ■ developing countries is $2
with those for welfare benefits. a day. In 2008, 2.5 billion
people in developing countries
(43 percent) had incomes
below this line.

A man begs in Fortaleza, Brazil.
According to the United Nations,
today’s poor face “dehumanizing
conditions.” The UN is committed
to halving world poverty by 2015.

SOCIALISM

IS THE ABOLITION OF

RATIONAL

ECONOMY

CENTRAL PLANNING



144 CENTRAL PLANNING Modern production is
complex and varied.
IN CONTEXT
Only prices and profits
FOCUS can efficiently guide investment.
Economic systems
Under socialism the state
KEY THINKER owns the means of production.
Ludwig von Mises
(1881–1973) Without private ownership
and rivalry there is little
BEFORE information or incentive
1867 Karl Marx sees scientific for efficient production.
socialism as organized like
an immense factory. Socialism is the abolition of rational economy.

1908 Italian economist
Enrico Barone argues that
efficiency can be achieved
in a socialist state.

AFTER
1929 US economist Fred
Taylor says that mathematical
trial and error can achieve
equilibrium under socialism.

1934–35 Economists Lionel
Robbins and Friedrich Hayek
emphasize the practical
problems with socialism—
such as the scale of
computation required and
the absence of risk taking.

T he German philosopher mathematics to demonstrate how war’s defeated powers—Germany,
Karl Marx described free market competition produces Austria, and Hungary—saw
socialist economic efficient outcomes, he also socialist parties take power.
organization in his great work suggested that these could be
Capital in 1867 (pp.100–05). A achieved by a central planner under Free market economists seemed
socialist economy, he argued, socialism. His compatriot, the unable to offer theoretical counter-
required state ownership of the economist Enrico Barone, took this arguments to socialism. But then in
means of production (such as notion further in The Ministry of 1920, Austrian economist Ludwig
factories). Competition was Production in a Collectivist State von Mises raised a fundamental
wasteful. Marx proposed running (1908). Just a few years later, objection, claiming that planning
society as if it were one enormous Europe was engulfed by World under socialism was impossible.
factory and believed that capitalism War I, which many saw as a
would lead inevitably to revolution. catastrophic failure of the old order. Calculating with money
The Russian Revolution of 1917 Von Mises’ 1920 article Economic
Economists took Marx’s ideas provided an example of a socialist Calculation in the Socialist
seriously. When Italian economist takeover of the economy, and the Commonwealth carried a simple
Vilfredo Pareto (p.131) used challenge. He said that production

INDUSTRIAL AND ECONOMIC REVOLUTIONS 145

See also: Free market economics 54–61 ■ Marxist economics 100–05 ■ Economic liberalism 172–77 ■
Markets and social outcomes 210–13 ■ The social market economy 222–23 ■ Shortages in planned economies 232–33

in the modern economy is so longer exist—the state has to make Boris Kustodiev’s The Bolshevik
complex that the information them up. Von Mises said that this reflected the idealistic policies of the
provided by market prices—which was not as much of a problem for Russian Revolution. Within four years
is generated through the rivalry consumer goods. It is not difficult they had floundered and were replaced
of many producers focused on to decide, based on consumer by the New Economic Policy.
making profits—is essential to tastes, whether to devote land to
planning. We need prices and producing 1,000 gallons of wine or prices automatically reflect the
profits to establish where demand 500 gallons of oil. Nor is it a valuations of everyone involved in
lies and guide investment. His problem for simple production, as in trade. Second, market prices reflect
ideas started a debate between a family firm. One person can easily production techniques that are both
capitalism and socialism, called make a mental calculation as to technologically and economically
the “socialist calculation“ or whether to spend the day building feasible. Rivalry among producers
“systems debate.” a bench, making a pot, picking means only the most profitable
fruit, or building a wall. However, production techniques are selected.
Imagine planning a railway complex production requires formal
between two cities. Which route economic calculation. Without such Von Mises argued that genuine
should it take, and should it even be help, von Mises claimed, the human market prices rely on the existence
built at all? These decisions require mind “would simply stand of money, which must be used at all
a comparison of benefits and costs. perplexed before the problems stages—forbuying and selling the
The benefits are savings in the of management and location.” goods involved in production, and
transport expenses of many different for buying and selling them in
users. The costs include labor hours, Market prices consumption. Money is used in a
iron, coal, machinery, and so on. It is In addition to using money prices more limited way in the socialist
essential to use a common unit to as a common unit with which to system: for paying wages and
make this calculation: money, the evaluate projects, economic buying consumer goods. But money
value of which is based on market calculation under capitalism has is no longer needed at the state-
prices. Yet, under socialism, genuine two other advantages. First, market owned production end of the
money prices for these items no economy, just as it is not needed ❯❯

In the socialist
commonwealth, every
economic change becomes
an undertaking whose success
can be neither appraised in

advance nor
later retrospectively
determined. There is
only groping in the dark.
Ludwig von Mises

146 CENTRAL PLANNING

There is demand Planned economies lack basic market information about Everyone ends up
for different types of demand, so a central planning committee has to guess the with boots, even if
footwear in the economy type and level of demand for any item. Their ideas about some people wanted
—for example, some what people want or need are unlikely to be accurate. sneakers.
people want sneakers.

The central planning The committee tells
committee sees only a the factories to produce
demand for footwear— sensible, long-lasting
not for types of footwear. footwear—boots.

Demand Central planning Production Supply

for the internal workings of a Von Mises’s challenge sparked Socialism in action
factory. Von Mises considered several responses. Some economists For some of its life the Soviet Union
alternatives to money, such as claimed that a central planner could operated a form of market socialism.
Marx’s idea of valuing products equate supply and demand through At first it appeared to do well, but
by the number of hours of labor trial and error, similar to the process the economic system suffered from
that have gone into making them. that Léon Walras (p.120) had persistent problems. There were
But such a measure ignores the suggested for establishing periodic attempts at reform,
relative scarcity of different equilibrium in a market economy. shifting targets from output to
materials, the different qualities However, this mathematical sales, and trying to give more
of the labor, or the actual (as approach was really no different discretion to state firms. But state
opposed to labor) time that the from the arguments of Barone, and firms often hid resources from
production process takes. Only any discussion of mathematical central planners, met targets
market prices take all these equilibrium was considered through shortcuts that did not meet
factors into account. unrealistic by the Austrian School. customer needs, and neglected
tasks outside their plans. There
Changing prices Von Mises’s supporters, Lionel was considerable waste, and
Von Mises, and his followers in the Robbins and Friedrich Hayek (p.177), output fell well short of targets.
Austrian School of economists, did added that such computation was When the system collapsed, the
not believe that societies reach not practical. Moreover, the socialist Austrian School’s concerns about
equilibrium, where they “naturally” system could not replicate the risk incentives and information seemed
hover around a certain level, or taking in the face of uncertainty to have been justified by events.
state of balance. He argued that undertaken by entrepreneurs in the
economies are in constant market system. In 1936, economists Von Mises was equally critical of
disequilibrium; they are always Oskar Lange and Abba Lerner any form of government intervention
changing, and participants are proposed a system of “market in the market economy. He claimed
surrounded by uncertainty. socialism” whereby many separate that intervention produces adverse
Furthermore, a central planner firms are owned by the state and side effects that lead to further
cannot simply adopt the prices that seek to maximize profits, given intervention until, step-by-step,
previously prevailed under a market prices set by the state. Hayek, the society is led into full-blooded
system. If central planning relies on Austrian School’s new champion, socialism. In the market economy
prices from a different system, how led the response to market socialism firms make profits by serving
could socialism possibly supersede (pp.172–77), arguing that only the free consumers, and in his opinion—
the market economy? market could provide the necessary and that of the Austrian School—
incentives and information. there should be no restrictions

INDUSTRIAL AND ECONOMIC REVOLUTIONS 147

on such a worthwhile activity. standard, such as gold. The Ludwig von Mises
The Austrian School does not Austrian School are firm believers in
accept the concept of market laissez-faire (hands-off) government. The leader of the Austrian
failure, or at least sees it as trumped School, Ludwig von Mises was
by government failure. It believes In 1900, there were five leading the son of a railway engineer.
monopoly is caused by governments schools of economics. Marxism, the He was born in Lemberg,
rather than by private enterprise. German Historical School (which Austria–Hungary, in 1881 and
Externalities (outcomes that are not was also critical of the market studied at the University of
reflected in market prices) such as system), and three versions of the Vienna, where he regularly
pollution are taken into consideration mainstream free market approach: attended the seminars of the
by consumers or solved by voluntary the British School (led by Alfred economist Eugen von Böhm-
associations or the responses of Marshall), the Lausanne School Bawerk. From 1909–34, von
people whose property rights are (centered on general equilibrium Mises worked at the Vienna
affected by the externality. through mathematical equations), Chamber of Commerce,
and the Austrian School, led by serving as principal economic
For the Austrian School one of Carl Menger (p.335). The British adviser to the Austrian
the worst forms of government and Lausanne schools became government. At the same
intervention is interference in the mainstream economics, but time he also taught economic
money supply. They claim that when the Austrian School trod an theory at the university, where
governments inflate the supply of uncompromising path. Only recently, he attracted a dedicated
money (by printing more money, for following the 2008 financial crisis following but never became
example) it leads to interest rates and the retreat of socialism, has professor. In 1934, concerned
that are too low, which in turn result it begun to grow in popularity. ■ by Nazi influence in Austria,
in bad investments. The only thing he took a professorship at the
to do when a bubble bursts is to Socialist economies saw University of Geneva. In
accept the commercial failures and themselves as vast production lines, August, 1940, shortly after the
ensuing depression. They recommend assembling everything the economy German invasion of France, he
abolishing central banks and needed. During World War II this emigrated to New York and
basing money on a real commodity command style of production line taught economic theory at
worked relatively efficiently. New York University from
1948–67. He died in 1973.

Key works

1912 The Theory of Money
and Credit
1922 Socialism: An Economic
and Sociological Analysis
1949 Human Action: A
Treatise on Economics

148

CAPITALISM
DESTROYS THE
OLD AND CREATES
THE NEW

CREATIVE DESTRUCTION

IN CONTEXT To survive, capitalists The pursuit of
continually seek new profits new markets leads
FOCUS to innovations.
Economic systems through the pursuit of
new markets.
KEY THINKER
Joseph Schumpeter … existing sectors of industry As capital (money)
(1883–1950) are devastated. shifts to new markets

BEFORE and innovations…
1867 Karl Marx states that
capitalism moves forward Capitalism destroys
by crisis, repeatedly the old and creates
destroying a whole range
of productive forces. the new.

1913 German economist W hen a recession bites growth in a process originally
Werner Sombart argues that and companies and jobs described by Karl Marx (p.105)
destruction opens the way for start to disappear, there as “creative destruction.”
creation, just as a shortage of is often a demand for government
wood led to the use of coal. intervention to counteract these Schumpeter believed that
effects. The Austrian economist entrepreneurs are at the heart of
AFTER Joseph Schumpeter, writing in the capitalist progress. Where Adam
1995 US economist Clayton depths of the Great Depression in Smith (p.61) saw profit arising from
M. Christensen distinguishes the 1930s, disagreed. He insisted the earnings of capital, and Marx
between disruptive and that recessions are how capitalism from the exploitation of labor,
sustaining innovation. moves forward, weeding out the Schumpeter said that profit comes
inefficient and making way for new from innovation—which does not
2001 US economists Richard derive from capital or labor. He saw
Foster and Sarah Kaplan argue
that even the most exceptional
corporations cannot beat the
capital markets indefinitely.