The Economics Book

ON

50 INTRODUCTION

Anne-Robert- Richard Arkwright opens Adam Smith’s classic The American
Jacques Turgot a mechanized cotton work, An Inquiry Declaration of
argues for the mill in England and later into the Nature Independence
exemption of trade introduces machinery and Causes of the
Wealth of Nations, is adopted
and industry that sets the pace is published. by Congress.
from taxation. for industrialization.

1766 1771 1776 1776
1776 1780S
1770S 1774

David Hume Turgot is appointed The first of James Watt’s Smith’s proposals on
denounces trade finance minister in steam engines are liberalizing trade
protectionism, arguing France and attempts to put into operation in
that countries should not reform the tax system are adopted by
strive to export more British factories, marking British Prime
than they import. by taxing the true beginning of the Minister William
wealthy landowners. Industrial Revolution. Pitt the Younger.

T oward the end of the 18th had begun to industrialize on to his thesis was the concept of
century much of the world an unprecedented scale. A fresh “rational economic man.” Smith
was undergoing enormous approach was needed to describe argued that individuals made
political change. The so-called and meet the demands of this economic decisions on the basis
Age of Reason produced scientists rapidly emerging economic of reason and in their own self-
whose discoveries were leading new world. interest, not for the good of society.
to new technologies that would When they were allowed to act in
transform the way goods were Rational economic man this way in a free society with
produced. At the same time The economist who rose most competitive markets, an “invisible
political philosophers had inspired successfully to this new challenge hand” guided the economy for the
revolutions in France and North was a Scotsman, Adam Smith benefit of all. This was the first
America that would have a (p.61). His background in the detailed description of a free
profound effect on the social philosophy of British Enlightenment market economy, which Smith
structures of both the Old and thinkers, such as John Locke and advocated as the means of
the New Worlds. In the field of David Hume (p.47), led him to ensuring prosperity and freedom.
economics a new scientific approach the subject initially as It is generally regarded as a
approach was overturning the one of moral philosophy. However, milestone in the development
old mercantilist view of an economy in his famous book of 1776, The of economics as a discipline. The
driven by protected trade and Wealth of Nations, he presented approach to economics that Smith
reliant on exports as a means of a comprehensive analysis of the helped to establish is often referred
preserving its wealth. By the end market economy and how it to as “classical” economics. His
of the Napoleonic wars in 1815, contributed to the economic analysis of a competitive market
Europe, and Britain in particular, welfare of the people. Central economy was essentially a

THE AGE OF REASON 51

The storming Edmund Burke Jean-Baptiste Say Jean Charles Léonard de
of the Bastille criticizes state proposes Say’s law Sismondi describes
prison in Paris involvement in the of markets: there
sparks off the regulation of wages can never be a deficiency business cycles and the
French Revolution. of demand or a glut of difference between
and prices. goods in the economy.
long-term growth and
short-term ups and downs.

1789 1795 1803 1819
1791 1798 1817 1819

Jeremy Bentham Thomas Malthus David Ricardo lays The US suffers its
sets out his theory of warns of the danger of the foundations for first major financial
utilitarianism; its goal population outstripping 19th-century classical crisis, which follows
economics, advocating
is “the greatest resources, and the free trade and the a period of
happiness of the suffering that this specialization of labor. sustained growth.
greatest number.”
will bring.

description of what we now know economy of an industrialized gloomy predictions of the suffering
as capitalism. However, The Wealth society. In particular Smith that would ensue from a population
of Nations was far more than a addressed the place of government growing faster than resources
description of the economy as in a capitalist society, arguing for could feed it. Many of Smith’s ideas
a whole, or “macroeconomics.” a limited role for the state. were also taken up by the French
It also examined issues such as physiocrat school, most notably
the division of labor and its Ending protectionism Anne-Robert-Jacques Turgot (p.65)
contribution to growth, and what British political economist and François Quesnay (p.45), who
factors were involved in giving David Ricardo (p.84) was one of argued for a fair system of taxation,
value to goods. The publication the most influential of Smith’s and Jean-Baptiste Say (p.75), who
of Smith’s work coincided with the followers. A staunch advocate of first described the relationship
start of the Industrial Revolution free trade, Ricardo put the final nail between supply and demand in
in Britain, a period of rapidly in the coffin of protectionism when a market economy.
accelerating economic growth and he showed how all countries, even
prosperity aided by dynamic new those that were less productive, Not everyone agreed with
technology and innovation. Smith’s could benefit from free trade. He Smith’s analysis, of course, and
ideas found a willing audience, also cast a critical eye over the in the 19th century there was soon
eager to understand how the ways that government spending to be a strong reaction against the
economy worked and how best to and borrowing affected the notion of a completely free market
take advantage of it. His work was economy. Another of Smith’s capitalist economy, but the
hugely influential, raising many of followers was Thomas Malthus classical economists of the early
the questions that needed to be (p.69), a British clergyman and industrial period raised questions
addressed in managing the scholar famous today for his that remain at the center of
economics today. ■

52

MAN IS A COLD,
RATIONAL
CALCULATOR

ECONOMIC MAN

IN CONTEXT As individuals we are M ost economic models
self-interested. are underpinned by the
FOCUS assumption that humans
Decision making We aim to improve are essentially rational, self-
our personal well-being by interested beings. This is Homo
KEY THINKER consuming goods and services Economicus, or “economic man.”
Adam Smith (1723–90) The idea—which applies equally
and achieving goals. to men and women—assumes that
BEFORE every individual makes decisions
C.350 BCE Greek philosopher We make decisions by designed to maximize their personal
Aristotle claims that innate collecting information and well-being, based on a level-headed
self-interest is the primary calculating which actions will evaluation of all the facts. They
economic motivator. choose the option that offers the
help us achieve our aims greatest utility (satisfaction) with
1750s French economist without being too costly. the least effort. This idea was
François Quesnay claims that first expounded by Adam Smith
self-interest is the motivation Man is a cold, (p.61) in his 1776 work, The
behind all economic activity. rational calculator. Wealth of Nations.

AFTER Smith’s central belief was that
1957 US economist Herbert human economic interaction is
Simon argues that people are governed mainly by self-interest.
not able to acquire and digest He argued that “it is not from the
all available information about benevolence of the butcher, the
every topic, so their rationality brewer, or the baker that we can
is “bounded” (limited). expect our dinner, but from their
regard to their own interest.” In
1992 US economist Gary making rational decisions suppliers
Becker receives the Nobel seek to maximize their own profit;
Prize for his work on rational the fact that this supplies us with
choice in the fields of our dinner matters little to them.
discrimination, crime,
and human capital. Smith’s ideas were developed
in the 19th century by the British
philosopher John Stuart Mill (p.95).
Mill believed people were beings

THE AGE OF REASON 53

See also: Free market economics 54–61 ■ Economic bubbles 98–99 ■ Economics and tradition 166–67 ■
Markets and social outcomes 210–13 ■ Rational expectations 244–47 ■ Behavioral economics 266–69

who desire to possess wealth, by itself, and some goals may appear Monks who lead a life of fasting and
which he meant not just money, but to be quite irrational to most prayer, denying worldly goods in the
a wealth of all things good. He saw people. For example, while to expectation of an afterlife, act rationally
individuals as motivated by the will most of us it may seem a dangerous within their beliefs, regardless of what
to achieve the greatest well-being decision to inject the human body others may think of their goal.
possible, while at the same time with unverified performance-
expending the least possible effort enhancing drugs, for numerous economists have begun to explore
to achieve these goals. athletes—in the context of the ways in which humans act
the desire to be the best—the differently from Homo Economicus
Costs and benefits decision may be a rational one. when making choices. The idea
Today, the idea of Homo of “economic man” may not be
Economicus is referred to as Some people have questioned entirely accurate for explaining
rational choice theory. This says whether the idea of Homo individual behavior, but many
that people make all kinds of Economicus is realistic. They economists argue that it remains
economic and social decisions argue that it does not allow for the useful in analyzing the actions of
based on costs and benefits. For fact that we cannot weigh every profit-maximizing firms. ■
example a criminal thinking of relevant factor in a decision—the
robbing a bank will weigh the world is too complex to collect and
benefits (increased wealth, greater evaluate all the relevant facts
respect from other criminals) against needed to calculate costs and
the costs (the chances of getting benefits for every action. In
caught and the effort involved in practice we often make quick
planning the heist) before deciding decisions based on past experience,
whether to commit the crime. habit, and rules of thumb.

Economists consider actions The theory also falters when
to be rational when they are taken there are conflicting long- and
as a result of a sober calculation of short-term goals. For instance
costs and benefits in relation to someone might buy an unhealthy
reaching a goal. Economics may burger to stave off immediate
have little to say about the goal hunger, despite knowing that this
is an unhealthy choice. Behavioral

Family economics

Parents’ investments in children, US economist Gary Becker (1930– ) believes that investment in
especially through education, are an was one of the first to apply a child is motivated by the fact
important source of an economy’s economics to areas usually that it often produces a better
capital stock, according to Becker. thought of as sociology. He argues rate of return than traditional
that decisions relating to family retirement savings. However,
life are made by weighing costs children cannot be legally forced
and benefits. For example he to take care of their parents,
views marriage as a market and so they are brought up with a
has analyzed how economic sense of guilt, obligation, duty,
characteristics influence the and love, which effectively
matching of partners. Becker also commits them to helping their
concluded that family members parents. For this reason it can be
will help each other, not out of argued that the welfare state
love, but out of self-interest in the damages families by reducing
hope of a financial reward. He their need for interdependence.

THE INVISIBLE

HAND OF

THE MARKET BRINGS

ORDER

FREE MARKET ECONOMICS



56 FREE MARKET ECONOMICS

IN CONTEXT A ccording to the Scottish Mandeville’s Fable of the Bees
thinker Adam Smith, the explored the idea that when people
FOCUS West had embarked on act out of self-interest, they benefit the
Markets and firms a great revolution before the 18th whole of society, like the self-interested
century, with nations changing behavior of bees benefits the hive.
KEY THINKER from agrarian, or agricultural,
Adam Smith (1723–90) societies to commercial ones. answer. Man, in his freedom, rivalry,
During the Middle Ages towns had and desire for gain, is “led by an
BEFORE developed, and they were slowly invisible hand to promote an end,
1714 Dutch writer Bernard joined up by roads. People brought which was no part of his intention”
Mandeville illustrates the goods and fresh produce to the —he inadvertently acts on behalf of
unintended consequences that towns, and the markets—with the wider interest of society.
can arise from self-interest. their buying and selling—became
a part of life. Scientific innovation Laissez-faire economics
1755–56 Irish banker Richard produced reliable, agreed-upon The idea of “spontaneous order”
Cantillon describes a version of units of measurement, along with was not new. It was proposed in
“spontaneous order.” new ways of doing things, and 1714 by the Dutch writer Bernard
centralized nation-states formed Mandeville in his poem The Fable
AFTER from the mix of principalities that of the Bees. This told the story
1874 Léon Walras shows how had dotted Europe. People enjoyed of a beehive that was thriving
supply and demand lead to a a new freedom and had begun to on the “vices” (self-interested
general equilibrium. exchange goods for their own behavior) of its bees. When the
personal gain, not merely for that of bees became virtuous (no longer
1945 Austrian economist their overlord. acting in their own self-interest
Friedrich Hayek argues that but trying to act for the good of
market economies produce Smith asked how the actions the hive), the beehive collapsed.
an efficient order. of free individuals could result in Smith’s notion of self-interest was
an ordered, stable market—where
1950s Kenneth Arrow and people could make, buy, and sell
Gérard Debreu identify what they wanted without enormous
conditions under which free waste or want. How was this possible
markets lead to socially without some kind of guiding hand?
optimal outcomes. In his great work of 1776, The
Wealth of Nations, he provided the

Covent Garden Market in London
is pictured here in 1774. Smith thought
markets were key to making society fair.
With the freedom to buy and sell, people
could enjoy “natural liberty.”

THE AGE OF REASON 57

See also: Economic man 52–53 ■ The division of labor 66–67 ■ Economic equilibrium 118–23 ■ The competitive market
126–29 ■ Creative destruction 148–49 ■ Economic liberalism 172–77 ■ Markets and social outcomes 210–13

not a vicious one. He saw humans Every individual acts out This might lead to a
as having an inclination to “truck of self-interest. chaotic mix of products
and barter” (bargain and exchange)
and to better themselves. Humans, and prices, but…
in his view, were social creatures
who act with moral restraint, using … other self-interested people provide competition—
“fair play” in competition. they take advantage of each other’s greed.

Smith believed that If one seller charges If one employer pays wages
governments should not interfere too much… that are too low…
with commerce, a view that was
also held by other Scottish thinkers … another will undercut … another will
around him, including the his price, and the first seller’s take his employees,
philosopher David Hume (p.47). and his firm will fail.
An earlier French writer, Pierre de products will fail to sell.
Boisguilbert, used the phrase laisse
faire la nature (“leave nature alone”), Businesses fail unless they pay market
by which he meant “leave business wages and make products the market demands
alone.” The term “laissez-faire” is
used in economics to advocate at the price people are willing to pay.
minimal government. In Smith’s
view government did have an The invisible hand of the
important role, supplying defense, market brings order.
justice, and certain “public goods”
(pp.46–47) that private markets goods that people want. If demand Society, the Austrian economist
were unlikely to provide, such for a product exceeds its supply, Friedrich Hayek (p.177) showed
as roads. consumers compete with each how prices respond to individuals’
other to drive the price up. This localized knowledge and desires,
Smith’s vision was essentially creates a profit opportunity for leading to changes in the amounts
optimistic. The English philosopher producers, who compete with each demanded and supplied in the
Thomas Hobbes had earlier argued other to supply more of the product. market. A central planner, Hayek
that without strong authority, said, could not hope to gather up
human life would be “nasty, This argument has stood the so much dispersed information. It is
brutish, and short.” British test of time. In an essay in 1945, widely believed that communism ❯❯
economist Thomas Malthus (p.69) titled The Use of Knowledge in
looked at the market and predicted
mass starvation as a direct result of
increased wealth. After Smith,
Karl Marx (p.105) would predict
that the market leads to revolution.
Smith, however, saw society as
perfectly functional, and the entire
economy as a successful system,
an imaginary machine that worked.
He mentioned the “invisible hand”
only once in his five volume work,
but its presence is often felt. Smith
described how his system of
“perfect liberty” could have positive
outcomes. First, it provides the

58 FREE MARKET ECONOMICS

collapsed in Eastern Europe because In that case, opportunities for gain Consumption is the
central planning failed to deliver the will arise, and prices will increase, sole end and purpose
goods that people wanted. Some but only until competition brings
criticisms of Smith’s first point have new firms into the market and of all production.
been raised, such as the fact that prices fall back to their natural Adam Smith
the market might only provide the level. If one industry begins to
goods that are wanted by the rich; suffer a slump in demand, prices about competition, although
it ignores the desires of the poor. It will drop and wages will fall, but dissenters, such as Austrian-
also responds to harmful desires— as a different industry rises, it will American economist Joseph
the market can feed drug addiction offer higher wages to attract Schumpeter (p.149), would later
and promote obesity. workers. In the long run, Smith say that innovation can also lower
says, “market” and “natural” rates prices, even where there appears to
Fair prices will be the same: modern be little competition. As inventors
Second, Smith said that the market economists call this equilibrium. come forward to provide higher
system generates prices that are quality products at lower prices,
“fair.” He believed that all goods Competition is essential if they blow away existing firms in
have a natural price that reflects prices are to be fair. Smith attacked a storm of creative destruction.
only the efforts that went into the monopolies occurring under the
making them. The land used in mercantilist system, which Fair incomes
making a product should earn its demanded that governments Smith also argued that market
natural rent. The capital used in its should control foreign trade. When economies provide incomes that
manufacture should earn its natural there is only one supplier of a are fair and can be spent on goods
profit. The labor used should earn good, the firm that supplies it can in a sustainable “circular flow,”
its natural wage. Market prices and permanently hold the price above
rates of return can differ from their its natural level. Smith said that
natural levels for periods of time, as if there are 20 grocers selling a
might happen in times of scarcity. product, the market is more
competitive than if there are just
Smith described the ways in which two. With effective competition
labor, landowners, and capital (here and low barriers to entry into a
invested in the horses and plow) work market—which Smith also said
together to keep the economic system was essential—prices tend to be
moving and growing. lower. Much of this underlies
mainstream economists’ views

THE AGE OF REASON 59

in which money paid in wages Demand in a market can change for many reasons. As it does so,
circulates back into the economy the market responds by altering supply. This happens spontaneously—
when the worker pays for goods, there is no need for a guiding hand or plan in a market that encourages
only to be paid back out in wages competition among self-interested people.
to repeat the process. Capital
invested in production facilities helps During a rainy summer…
to increase labor productivity,
which means that employers can … demand … demand for
afford to pay higher wages. And if for umbrellas sunglasses
employers can afford to pay more, drops.
they will because they have to soars.
compete with each other for workers. As prices
As prices drop, so do
Turning to capital, Smith rise, so do profits.
said that the amount of profit that
capital can expect to earn through profits.
investments is roughly equal to
the rate of interest. This is because Umbrella firms Self-interested
employers compete with each other employ more employers let
to borrow funds to invest in profitable people and go of staff.
opportunities. Over time the rate enjoy profits
of profit in any particular field until other Staff go to work
falls as capital accumulates and in the booming
opportunities for profit are exhausted. firms enter the umbrella business.
Rents gradually rise as incomes market, forcing
rise and more land is used. prices back to a
“natural level.”
Smith’s realization of the
interdependence of land, labor, and labor (pp.66–67). Economists It is not from the
capital was a real breakthrough. He call this “Smithian growth.” As benevolence of the butcher,
noted that workers and landowners more products are produced and
tend to consume their incomes, consumed, the economy grows, the brewer, or the baker
while employers are more frugal, and markets also grow. As markets that we expect our dinner,
investing their savings in capital grow, there are more opportunities
stock. He saw that wage rates vary, for specialization of work. but from their regard
depending on different levels of to their self-interest.
“skill, dexterity, and judgment,” The second engine of growth is
and that there are two forms of the accumulation of capital, driven Adam Smith
labor: productive (engaged in by saving and the opportunity for
agriculture or manufacturing) and profit. Smith said that growth can
what he called “unproductive” be reduced by commercial failures,
(supplying services needed to back a lack of resources required to
up the main work). The highly maintain the fixed capital stock,
unequal outcomes of today’s an inadequate money system
market system are a long way (there is more growth with paper
from what Smith envisioned. money than with gold), and a ❯❯

Economic growth
Smith claimed that the invisible
hand itself stimulates economic
growth. The source of growth is
twofold. One is the efficiencies
gained through the division of

60 FREE MARKET ECONOMICS

high proportion of unproductive There is no art which invisible hand would be socially
workers. He claimed that capital is one government sooner beneficial. Kenneth Arrow and
more productive in agriculture than learns of another than Gérard Debreu (pp.208–11) showed
in manufacturing, which is higher that of draining money how free markets do this, but they
than in trade or transport. also showed that the conditions
Ultimately, the economy will grow from the pockets needed were stringent and did not
until it reaches a wealthy, stationary of the people. bear much relation to reality.
state. In this, Smith underestimated Adam Smith
the role of technology and This was not the end of the
innovation—the Schumpeterian their returns. Later, free market story. After World War II the idea
growth described earlier (p.58). theory took a different, of laissez-faire was in hibernation.
“neoclassical” form with general However, from the 1970s, Keynesian
Classical legacy equilibrium theory, which sought policies, which advocated state
Smith’s system was comprehensive. to show how a whole economy’s intervention in economies, seemed
It considered small (microeconomic) prices could reach a state of stable to break down, and laissez-faire
details and the large (macroeconomic) equilibrium. Using mathematics, enjoyed a strong resurgence. The
picture. It looked at situations in economists such as Léon Walras seeds of this flowering can be
both the short and long run, and its (p.120) and Vilfredo Pareto (p.133) found in works on the market
analysis was both static (the state reframed Smith’s claim that the economy by Milton Friedman
of trade) and dynamic (the economy (p.199) and the Austrian School,
in motion). It looked in detail at the notably Friedrich Hayek (p.177),
class known as workers, who were skeptical about the good
distinguishing entrepreneurs such that interfering governments can
as farmers and factory owners from do and argued that social progress
suppliers of labor. In essence it would be attained through
established the parameters for unfettered markets. Keynesians,
“classical” economics, which too, recognized the power of
focuses on the factors of production markets—but for them markets
—capital, labor, and land—and needed to be nudged to work best.

The free market approach
enjoyed an important boost from
theories in the 1960s and 70s based
on the role of rationality and rational
expectations (pp.244–47). Public
choice theory, for example, depicts
government as a group of self-
seeking individuals who maximize
their own interests and extract
money without regard to the social
good (“rent-seeking”). New classical
macroeconomics uses Smith’s
assumption that markets always
sort themselves out and adds the
point that people can see the future
implications of any government
actions and understand the

Localized markets such as this
one in Kerala, India, exhibit all the
hallmarks of Smith’s free market and
demonstrate the natural way in which
supply and price adjust to demand.

THE AGE OF REASON 61

workings of the economic system, Smith didn’t foresee the kinds of Adam Smith
so state intervention will not work. inequalities that can arise from free
Even so, most economists today markets in their present form. In stock The founder of modern
believe that the market can fail. exchanges and money markets notions economics, Adam Smith was
They focus on disparities in of “fairness” become almost irrelevant. born in Kirkcaldy, Scotland,
information, held by various in 1723, six months after his
participants in a market. George rationality (pp.266–69), and see father’s death. A reclusive,
Akerlof referred to this in his The the non-rationality of humans as absentminded scholar, he
Market for Lemons (pp.274–75). a reason for markets to fail. went to Glasgow University at
Behavioral economists have the age of 14, then studied at
questioned the whole notion of The issue of laissez-faire Oxford University for six years
economics divides economists before returning to Scotland
Human society, when along political lines. Those on the to take up a professorship in
we contemplate it in a political Right embrace laissez- logic at Glasgow University.
certain abstract and faire; those from the Left align In 1750, he met and became
themselves with Keynesian close friends with the
philosophical light, intervention. This remains a philosopher David Hume.
appears like a great, central debate in economics today.
an immense machine. In 1764, Smith resigned
The financial crisis of 2007–08 his post at Glasgow to travel
Adam Smith has added fuel to this dispute. The to France as tutor to the Duke
free marketeers felt vindicated in of Buccleuch, a Scottish
their theories about the business aristocrat. In France, he
cycle, while Keynesians pointed met the physiocrat group of
to market failure. US economist economists (pp.40–45) and the
Nouriel Roubini (1959– ), who philosopher Voltaire, and he
predicted the crash, was speaking began writing The Wealth of
of those who had distorted Smith’s Nations. He devoted 10 years
ideas when he said that “decades to the book before accepting a
of free market fundamentalism laid position as Commissioner of
the foundation for the meltdown.” ■ Customs. He died in 1790.

Key works

1759 The Theory of Moral
Sentiments
1762 Lectures on
Jurisprudence
1776 An Inquiry into
the Nature and Causes
of the Wealth of Nations

62

THE LAST WORKER
ADDS LESS TO
OUTPUT THAN
THE FIRST

DIMINISHING RETURNS

IN CONTEXT F renchman Anne-Robert- Péravy, had said that for each extra
Jacques Turgot (p.65) was worker on the land, the amount of
FOCUS one of a small group of additional output is constant; in
Markets and firms thinkers known as the physiocrats, other words each extra worker adds
who believed that national wealth the same to production as the last.
KEY THINKER was created from agriculture. But in 1767, Turgot pointed out that
Anne-Robert-Jacques unprepared soil produces very little
Turgot (1727–81) Turgot’s twin interests in tax and when sowed. If the soil is plowed
the output of land led him to develop once, output increases; plowed
BEFORE a theory that explains how the twice, it might quadruple. Eventually,
1759 French economist output of each extra worker changes however, the extra work begins to
François Quesnay publishes as successive workers are added to increase output less and less, until
Economic Table—a model that the production process. A fellow additional workers add nothing
demonstrates the physiocrats’ physiocrat, Guerneau de Saint- further to production, because the
economic theories. fertility of the soil is exhausted.

1760s French physiocrat The earth’s fertility The role of technology
Guerneau de Saint-Péravy’s resembles a spring that is Turgot’s idea is that adding more of
essay on the principles of being pressed downward… a variable factor (workers) to a fixed
taxation argues that the ratio the effect of additional weights factor (land) will lead to the last
of outputs to inputs is fixed. will gradually diminish. worker adding less to output than
the first. This has become known
AFTER A R J Turgot as “diminishing marginal returns,”
1871 Austrian Carl Menger and it is one of the most important
argues in Principles of pillars of modern economic theory.
Economics that price is It explains not only why it costs
determined at the margin. more to produce more, but also why
countries struggle to get richer if
1956 In A Contribution to the their population expands without
Theory of Economic Growth, improvements in technology. ■
US economist Robert Solow
applies the idea of diminishing See also: The circular flow of the economy 40–45 ■ Demographics and
marginal returns to the growth economics 68–69 ■ Economic growth theories 224–25
prospects of countries.

THE AGE OF REASON 63

WHY DO DIAMONDS
COST MORE THAN
WATER?

THE PARADOX OF VALUE

IN CONTEXT I n 1769, Anne-Robert-Jacques from important—feeding himself—
Turgot (p.65) noted that to trivial—feeding birds. If he loses
FOCUS despite its necessity, water a bag of wheat, he will merely stop
Theories of value is not seen as a precious thing feeding the birds. Even though the
in a well-watered country. Seven farmer needs wheat to feed himself,
KEY THINKER years later Adam Smith (p.61) the price he is willing to pay to
Adam Smith (1723–90) took this idea further, noting that replace the fifth bag of wheat is low,
although nothing is more useful because it only generates a small
BEFORE than water, hardly anything can amount of pleasure (feeding birds).
1691 English philosopher be exchanged for it. Although a
John Locke connects a diamond has very little value in Water is abundant, but diamonds
commodity’s value to its utility terms of use, “a very great quantity are scarce. One extra diamond has
(the satisfaction it affords). of other goods may frequently be a high marginal utility and so
had in exchange for it.” In other commands a much higher price
1737 Swiss mathematician words, there is an apparent than an extra cup of water. ■
Daniel Bernoulli poses the contradiction between the prices
“St Petersburg Paradox,” of certain commodities and their
examining how players can importance to people.
evaluate options involving
chance. The paradox is Marginal utility Diamonds are worth more than
resolved by applying the This paradox can be explained water because each one is extremely
concept of marginal utility. with the help of a concept known valuable no matter how many you have,
as marginal utility: the amount of while water becomes less valuable, per
AFTER pleasure gained from the last unit unit, as quantities increase.
1889 Austrian economist of the commodity consumed. In
Eugen von Böhm-Bawerk 1889, the Austrian economist
develops the subjective Eugen von Böhm-Bawerk explained
theory of value (the value it through the example of a farmer
of an object depends on a with five bags of wheat. The
person’s needs rather than farmer’s use of the wheat ranges
the object itself), using the
idea of marginal utilities. See also: The labor theory of value 106–07 ■ Utility and satisfaction 114–15 ■
Opportunity cost 133

64

MAKE TAXES
FAIR AND
EFFICIENT

THE TAX BURDEN

IN CONTEXT W ho bears the burden of from prices and profits to amounts
tax? The key question of goods consumed and incomes
FOCUS of “tax incidence” received. Changes in these can
Economic policy intrigued the gifted economist ripple through the economy in
Anne-Robert-Jacques Turgot, who surprising ways. The “burden” of
KEY THINKER was the French Minister of Finance a tax—which is taken to mean a
Anne-Robert-Jacques from 1774–76. The question is not decrease in happiness, welfare, or
Turgot (1727–81) as simple as “who should pay tax?” money—can be shifted from one
because taxes affect many things, person or group to another. If you
BEFORE
1689–1763 Expensive wars, They must fall Taxes They must be
together with an inefficient mainly on those should… collected
tax system that exempted effectively.
landowners and unions, lays able to pay
the ground for French financial the most.
crisis and the Revolution.
They must fall … be … be They must
AFTER equally fair. efficient. maximize
1817 In his Principles of welfare while
Political Economy and upon similar raising sufficient
Taxation, British economist people.
David Ricardo argues that revenue.
taxes should fall on luxuries.
They must fall Make taxes They must
1927 British mathematician on those fair and distort markets
Frank Ramsay emphasizes the efficient.
importance of price elasticity. most likely as little as
to benefit. possible.
1976 Economists Anthony
Atkinson and Joseph Stiglitz
suggest uniform commodity
taxes are optimal in The
Design of Tax Structure.

THE AGE OF REASON 65

See also: The circular flow of the economy 40–45 ■ Efficiency and fairness 130–31 ■ External costs 137 ■ The theory of
the second best 220–21 ■ Taxation and economic incentives 270–71

are planning a vacation and a new produce nothing, Turgot argued Aristocrats at Versailles were
fuel tax puts the airfare above the that the landowners should be targeted by Turgot’s tax reforms of
level you are prepared to pay, the taxed on the rent they charged. 1776. He suggested they should no
tax has made you unhappy. The longer be exempt from tax, so they
new fuel tax has reduced your Later economists refined the arranged his dismissal from office.
welfare, but not necessarily the principles of fairness and efficiency
airline company’s profits. that go into an optimal tax system. goods (for sale to final users);
Fairness includes the idea that those income taxes should be linked to
Who should pay taxes? most able to pay should pay the ability rather than income; and
Turgot argued that taxes interfere most; that similar people should face taxes on company profits and
with the free market and should be similar taxes; and that those who income from capital should be
simplified. Powerful groups should benefit from government spending, minimal. “Market failure” analysis,
not be exempt from taxation, and such as users of a new bridge, on the other hand, suggests that
the details of its implementation should contribute to it. Efficiency taxes on undesirables such as
matter. His recommendation was means both effectiveness in pollution increase people’s welfare.
for a single tax on a country’s net collection and maximizing society’s
product—the value of its total goods welfare while raising the required In general, tax policies have
and services minus depreciation. revenue. Economists argue that moved in the directions shown
efficiency means disturbing the by such theories while paying
His thinking was influenced by market as little as possible, attention to revenue and political
an early school of economists particularly to avoid blunting acceptability. ■
known as the physiocrats, who incentives for work and investment.
believed that only agriculture
(land) produces a surplus. Other Perfect tax design
industries do not produce a surplus The last few decades have seen
and so cannot afford to pay tax— huge strides in the sophistication
they will always try to pass it on by of tax design, integrating both
increasing prices and charges until fairness and efficiency. “Perfect
finally it reaches the landowners. markets” theory, for example,
As farmers pay much of their suggests commodity taxes should
surplus in rent to landowners, who be uniform and apply only to “final”

Anne-Robert-Jacques Born in Paris, France, in 1727, labor to build roads by
Turgot Turgot was destined for the instituting a road-building tax
priesthood until an inheritance instead. Louis XVI did not
in 1751 allowed him to pursue a approve and dismissed Turgot
career in administration. By the from office. His reforms—which
late 1760s, he had become friendly some felt might have averted
with the physiocrats, and later the French Revolution of 1789—
met Adam Smith. From 1761 to were overturned. He died aged
1774, he was the Intendant of 54 in 1781.
Limoges, a regional administrator.
On the accession of Louis XVI in Key works
1774, Turgot became Minister of
Finance and set about making 1763 Taxation in General
reforms that encouraged free 1766 Reflections on the
trade. In 1776, he abolished the Production and Distribution
guilds and ended a government of Wealth
policy that used unpaid, forced 1776 The Six Edicts

66

DIVIDE UP PIN
PRODUCTION, AND
YOU GET MORE PINS

THE DIVISION OF LABOR

IN CONTEXT When workers concentrate
on one task…
FOCUS
Markets and firms … repetition increases … no time is
skill and speed. wasted through switching
KEY THINKER
Adam Smith (1723–90) between tasks.

BEFORE This increases production
380 BCE In The Republic, and reduces cost.
the Greek philosopher Plato
explains how a city emerges, Divide up pin production,
then grows by exploiting the and you get more pins.
gains made by dividing labor.
W henever people work in sequence required to make
1705 Dutch philosopher a group, they invariably something, and when several
Bernard Mandeville coins the start by deciding who is people each do just one task each.
term “division of labor” in his going to do what. It was the great Writing in 1776, Smith noted that
The Fable of the Bees. Adam Smith (p.61) who turned if one man set about making a pin,
this division of labor into a going through the many steps
AFTER central economic idea. At the very involved, he might make “perhaps
1867 Karl Marx argues that start of his influential book The not one pin in a day.” But by
division of labor alienates Wealth of Nations, Smith explains dividing the process among several
workers and is a necessary the differences between production men, with each specializing in a
evil that will eventually be when one person carries out the full single step, many pins could be
superseded.

1922 Austrian economist
Ludwig von Mises argues
that division of labor is not
alienating but brings huge
benefits, including greater
leisure time.

See also: Comparative advantage 80–85 ■ Economies of scale 132 ■ THE AGE OF REASON 67
The emergence of modern economies 178–79
All-American jobs?
What was groundbreaking about
Smith’s idea was that he put When people working in
division of labor at the heart of industry worry about the
the economic system, insisting that strength of their home
it is the engine that drives growth. economy and rates of
The more specialized the workers employment, they sometimes
and businesses, the greater the urge consumers to buy home-
market growth and the higher produced goods. However, it
the returns on investments. can be hard to know what is
home-produced since division
In a busy stockroom, labor may be A necessary evil of labor has now become
divided between porters, inventory Karl Marx (p.105) saw the power global in scope. For example,
clerks, a manager, accountants, of this idea but believed that the Apple is a US company, so
distribution specialists, IT workers, division of labor was a temporary, consumers might suppose that
and truck drivers. necessary evil. Specialization by buying an iPhone they are
alienates, condemning workers contributing to US jobs. In fact,
made in a day. Smith concluded to the dispiriting condition of a of all the processes involved in
that the division of labor causes machine performing repetitive making an iPhone, only the
“in every art, a proportionable tasks. He distinguished between product and software design
increase of the productive powers the technical division of labor, and marketing occur primarily
of labor.” such as each specialized task in in the US.
house building, and social division,
The engine of growth which is enforced by hierarchies Each iPhone is assembled
Smith was not the first to of power and status. by workers in China, using
appreciate the value of the division parts—such as the case,
of labor. About 2,200 years earlier Labor division is the norm screen, and processor—made
Plato had argued that a state needs within most companies today. by workers in South Korea,
specialists, such as farmers and Many large corporations now Japan, Germany, and six
builders, to supply its needs. The outsource tasks formerly carried other countries. In addition,
Islamic philosopher Al-Ghazali out by their own staff to cheaper each of these parts has been
(1058–1111) noted that if we take overseas workers, giving the assembled by a range of
into account every step involved division of labor a new, specialists around the world.
in making bread, from clearing the international dimension. ■ The iPhone is a truly global
weeds in the fields to harvesting product, made by perhaps
the wheat, we would find that the Every expansion of the tens of thousands of people.
loaf takes its final form with the personal division of labor
help of over a thousand workers. Assembly-line workers in
brings advantages China build computer processors
Many early thinkers linked to all who take part in it. with components made in up to
division of labor to the growth of nine different countries.
cities and markets. Some thought Ludwig von Mises
that the division of labor caused the
growth, while others proposed that
the growing cities allowed the
division of labor.

68

POPULATION
GROWTH KEEPS
US POOR

DEMOGRAPHICS AND ECONOMICS

IN CONTEXT D uring the 18th century output is added. The result is
enlightened thinkers an ever-widening imbalance
FOCUS began to consider the between the number of people
Growth and development possibility of improving society’s lot and the supply of food.
through wise social and economic
KEY THINKER reforms. The British economist However, there is a
Thomas Malthus (1766–1834) Thomas Malthus was a pessimistic counteracting force. Malthus
voice in this optimistic era, saw that malnutrition and disease
BEFORE claiming that the growth of caused by a more limited food
17th century Mercantilist populations dooms societies to supply would lead to increased
thought argues that a large poverty. Malthus argued that the mortality and stop the imbalance
populace benefits the economy. human sex drive causes faster and from getting out of control. Less
faster expansion of the populace. food to go around would also mean
1785 French philosopher Food production would not keep up fewer children could be supported,
Marquis de Condorcet because of the law of diminishing and the birth rate would fall. This
argues for social reform returns: as more people work on a would lessen the pressure on land,
to raise living standards. fixed amount of land, less and less restoring living standards.

1793 English philosopher Survivors of an earthquake in The Malthusian trap
William Godwin advocates Pakistan receive food handouts. As well as preventing total
the redistribution of national Malthus opposed any such relief— starvation, changes in birth and
resources to help the poor. to assist the destitute would only death rates stop the population
encourage them to have more children. from benefiting from higher living
AFTER standards for very long. Suppose
1870s Karl Marx attacks that the economy has a windfall
Malthus’s ideas, characterizing through the discovery of land. Extra
him as a reactionary defender land gives a one-time boost to food
of the status quo. production and provides more
food per person. People become
1968 US ecologist Garrett healthier and the death rate falls.
Hardin warns of the dangers of Higher living standards allow for
overpopulation in his essay more children. Together, these
The Tragedy of the Commons. forces add to population growth.
Food production cannot keep up,
and the economy reverts to the

THE AGE OF REASON 69

See also: Agriculture in the economy 39 ■ Diminishing returns 62 ■ The
emergence of modern economies 178–79 ■ Economic growth theories 224–25

The human sex Growth in the
drive causes the food supply is unable
population to grow.
to keep up.

The population As there is not enough Thomas Malthus
decreases, and the food for all, some people
Thomas Robert Malthus was
food supply is die from hunger. born in Surrey, England, in
adequate again. 1766, and was given a liberal
education by his father, a
Population growth “Poor relief” (welfare country squire. His godfathers
keeps us poor. benefits) would bring were the philosophers David
health to the poor, but Hume and Jean-Jacques
encourage them to have Rousseau. He was born with
a cleft palate and suffered
more children. from a speech defect.

original, lower level of living allowed more food to be produced At Cambridge University
standards. This is called the from the same amount of land and Malthus was tutored by a
Malthusian trap: higher living labor. New machines and factories religious dissenter, William
standards are always choked off allowed more goods to be produced Frend, before being ordained
by population growth. So whatever per worker. Technological progress into the Church of England in
happens, the economy always meant that growing populations 1788. Like his teacher he
reverts to the level of food output enjoyed ever-higher living never shied away from
that is just enough to support a standards. By 2000, Britain controversy. In 1798, he
stable population. had more than three times the published his Essay on the
population of Malthus’s time, Principle of Population,
Malthus’s vision was one of with incomes 10 times higher. the work that would bring
economic stagnation, with the him notoriety. In 1805, the
population eking out a living and Over time, technology has new East India College
its growth being checked by overcome the constraints of land appointed him Professor of
hunger and disease. However, his and demographics. Malthus did Political Economy, a subject
model—an economy of farmers not foresee this. Today, his ideas not yet taught at universities,
toiling with simple tools on a fixed are echoed in fears that population which perhaps makes him the
amount of land—was already out of levels are pushing against the first academic economist.
step with the times by the turn of capacity of the Earth in ways that Malthus died of heart disease
the 18th century. New techniques new technology cannot offset. ■ in 1834, aged 68.

Key works

1798 An Essay on the Principle
of Population
1815 The Nature of Rent
1820 Principles of Political
Economy

70 IN CONTEXT

MEETINGS OF FOCUS
MERCHANTS END Markets and firms
IN CONSPIRACIES
TO RAISE PRICES KEY THINKER
Adam Smith (1723–90)
CARTELS AND COLLUSION
BEFORE
1290s Wenceslas II, Duke
of Bohemia, introduces laws
to prevent metal ore traders
from colluding to raise prices.

1590s Traders from the
Netherlands collaborate in a
cartel with a monopoly of the
spice trade in the East Indies.

AFTER
1838 French economist
Augustin Cournot describes
competition in oligopolies.

1864 US economist George
Stigler publishes A Theory
of Oligopoly, examining the
problems of maintaining
successful cartels.

1890 The first antitrust law
is passed in the US.

C ompetition is key to the
efficient working of free
markets. The presence
of several producers in a market
drives production and keeps prices
down as each competes to attract
customers. If there is only a single
supplier—a monopoly—it can
choose to restrict its output and
charge higher prices.

Between these two extremes
sits the oligopoly, where a few
suppliers—sometimes only two or
three—dominate the market for a
particular product. Competition
between producers in an oligopoly
would clearly be in the interests
of the consumer, but there is an
alternative for the producers that

THE AGE OF REASON 71

See also: Effects of limited competition 90–91 ■ Monopolies 92–97 ■ The competitive market 126–29 ■ Markets and social
outcomes 210–13 ■ Game theory 234–41

Where a market has only … they may decide to
a few suppliers… collude, forming a cartel.

The market is Cartel members can British Airways was fined $546
transformed into a set prices high and million for collusion in 2011, after
virtual monopoly and production low, and enjoy Virgin Atlantic admitted that the
competition disappears. two companies had met six times
increased profits. to discuss proposed price rises.

Meetings of merchants despite being a notable feature of
end in conspiracies the German and US economies
to raise prices. in the 1920s and 1930s.

may be more beneficial to their meet together, even for merriment In the 20th century the US and
profit levels: cooperation. If they and diversion, but the conversation the European Union (EU) used
choose this route and can agree ends in a conspiracy against the legislation to discourage collusion.
not to undercut one another, they public, or in some contrivance to However, cartels among producers
can act collectively like a monopoly raise prices.” remain a feature of market
and dictate the terms of the market economies. Collaborations might be
to their own benefit. Collaborations between a simple agreement between two
producers have existed for as firms, such as when Unilever and
Forming cartels long as there have been markets, Procter & Gamble colluded to fix
This sort of cooperation between and businesses in many areas the price of laundry detergent in
firms is known by economists of commerce have formed Europe in 2011, or they can take
as “collusion.” The price fixing associations to their mutual benefit. the form of an international trade
that results makes markets less In the US in the 19th century association, such as the
efficient. Scottish economist Adam these restrictive or monopolistic International Air Transport
Smith (p.61) recognized the practices were known as “trusts,” Association (IATA). The IATA’s
importance of self-interest in free but the word “cartel” is now used original function was to set prices
markets but was suspicious enough to describe such collaborations, for fares, which led to accusations
of the motives of suppliers to warn: which operate on a national or of collusion, but it still exists as a
“People of the same trade seldom international level. The word has representative organization for the
gained a negative connotation airline industry. Cartels can even
be formed through cooperation
between governments of countries
producing a particular commodity,
as happened in the case of
the Organization of Petroleum
Exporting Countries (OPEC), ❯❯

72 CARTELS AND COLLUSION

which was founded in 1960 to a version of the prisoner’s dilemma wealthy members see the chance
coordinate oil prices among (p.238), in which two prisoners can of gaining some extra profit
member countries. each choose either to remain silent and exceed their output quota,
or confess. If both remain silent or introducing an element of
Challenges for cartels both confess, they will receive light competitiveness and weakening
However, there are problems in sentences; but if only one confesses, the power of the cartel as a whole.
setting up and sustaining a cartel, he will receive immunity while his It only takes one cheat to undermine
which focus around prices and trust partner in crime will get a heavy the operation of a cartel, and the
between members. Participants in sentence. The best strategy for more members in the cartel, the
a cartel cannot simply fix prices. each of them is to remain silent (this greater the danger of the rules
They also have to agree on output incurs the shortest jail term), but the being broken.
quotas to maintain those prices and, temptation is to opt for immunity
of course, the share of the profits. and confess in the hope that the Enforcing agreements
The fewer the members of a cartel, other does not. The strategies that Very often, one of a cartel’s
the easier these negotiations are. apply here are equally applicable to members—the most powerful in
Cartels are more robust when cartels, where the rewards for all the terms of production—emerges as
there are a small number of firms players are greater if they collaborate an “enforcer.” When the efficacy of
accounting for most of the supply. than if they compete but are OPEC becomes threatened, for
greatest for any one player who instance, by a country such as
The second problem is ensuring breaks the agreement, while the Angola overproducing to increase
that members of a cartel abide by others suffer as a consequence. its profits, Saudi Arabia, the largest
the rules. Producers are attracted to member of the cartel, can take
collusion by the prospect of higher In practice, this is what tends to action to stop this. As the largest
prices, but this self-interest is also happen within a cartel, particularly producer with the lowest production
the weakness of the arrangement. when the quotas are unequally costs it can afford to increase
Individual members of a cartel divided. The 12 members of OPEC, production and lower prices to a
may be tempted to “cheat” by for example, meet regularly to agree level that will punish or may even
overproducing and undercutting on output and prices, but these are bankrupt the smaller countries,
their collaborators. In effect, this is seldom adhered to. The smaller, less while only lowering its own profits
in the short term. However, in many
Cartels can arrange price-fixing cases, the temptation to cheat and
by operating as a virtual monopoly. If the reluctance of the enforcer to
no one can offer the consumer a lower reduce its profits eventually lead
price, the one price offered can be much to the break-up of cartels.
higher than production costs, generating
high profits for the cartel.

We must not tolerate
oppressive government
or industrial oligarchy
in the form of monopolies

and cartels.
Henry A Wallace

US politician (1888–1965)

The difficulty in forming and Economists have their THE AGE OF REASON 73
maintaining cartels means that glories, but I do not
these “conspiracies” are less believe that antitrust Antitrust laws
common than Adam Smith law is one of them.
might have expected. In the George Stigler Cartels, like monopolies, are
1960s US economist George Stigler generally seen as harmful to
showed that the natural suspicion of into price-fixing of Atlantic flights, the efficiency of free markets
competitors acts against collusion confessed its collusion with British and a threat to overall
in a cartel, and that cartels are less Airways, who were heavily fined. economic well-being. Most
likely to occur as more firms enter governments have attempted
a market. As a result, even in Government approval to prevent this kind of collusion
industries where there are only a few Some libertarian economists, such by legislation in the form of
large producers, such as for video as Stigler, are skeptical of the need antitrust or competition laws.
games consoles and mobile phones, for such laws, given the instability The first such intervention
the preference is generally for of cartels. Governments are often was in the US in 1890, when
competition rather than cooperation. ambiguous about cartels, seeing the Sherman Act outlawed
some forms of cooperation as every contract or conspiracy
Nevertheless, the few cartels potentially desirable. For example, that restrained interstate or
that do exist pose enough of a while IATA’s price-setting policy foreign trade. This was
threat to the market for governments was considered collusion, OPEC followed by further antitrust
to feel the need to intervene. Public has sometimes been seen in a more laws including the Clayton Act
pressure from consumers opposed benign light as a trade bloc whose in 1914, which prohibited local
to price-fixing drove the move to policies lead to stability. The same price cutting to “freeze out”
“antitrust” legislation (see right) argument has been put forward in competition. Economists have
during the 20th century, outlawing defense of public cartels in certain tended to be skeptical about
cartels in most countries. Because industries, such as oil or steel, in antitrust legislation, which is,
of the difficulty of proving collusion, countries during times of depression. in any case, often difficult to
many of these laws offer immunity When regulated by governments, enforce. They point out that
to the first member of a cartel to cooperation between producers can cooperation does not always
confess—just as in the prisoner’s stabilize production and prices, lead to collusive practices,
dilemma—offering yet another protect the consumer and smaller such as price-fixing and
incentive to break up the cartel. producers, and make the industry bid-rigging, and many believe
This tactic was notably successful as a whole more competitive that much “trust-busting”
recently, when Virgin Atlantic internationally. Public cartels such legislation has been motivated
Airlines, worried by an investigation as these were common in both by political pressure rather
Europe and the US during the than economic analysis.
Mobile phone operators in the 1920s and 1930s, but mostly
Netherlands were investigated for disappeared after World War II. This 1906 cover of a political paper
suspected cartel practices in 2011, National cartels are still a feature lampoons US politician Nelson
including price-fixing mobile data of the Japanese economy. ■ Aldrich for building a “web” of tariffs
bundles for prepaid phones. to protect US goods from foreign
competition and raise local prices.

74

SUPPLY CREATES
ITS OWN DEMAND

GLUTS IN MARKETS

IN CONTEXT People produce commodities
and sell them to earn money.
FOCUS
The macroeconomy Nobody wants to hold on … people swap money for the
to money because it falls other products they want.
KEY THINKER
Jean-Baptiste Say in value, so…
(1767–1832)
Supply creates its
BEFORE own demand.
1820 British economist
Thomas Malthus argues that I n 1776, when Adam Smith Say claimed that as soon as a
underemployment and wrote The Wealth of Nations product is made, it creates a market
overproduction can occur. (pp.54–61), he noted that for other products “to the full extent
merchants around him commonly of its own value.” This means, for
AFTER felt there were two reasons why example, that the money a tailor
1936 John Maynard Keynes business failed: a scarcity of money receives when he makes and sells
states that supply does not or overproduction. He debunked the a shirt is then used to buy bread
create its own demand—it is first of these myths by explaining from the baker and beer from the
possible for a lack of demand the role of money in an economy, brewer. Say believed that people
to cause production to slow, but it was left to a later French had no desire to hoard money,
creating unemployment. economist, Jean-Baptiste Say, to and therefore the total value of
dismiss the second. His 1803 work, commodities supplied would equal
1950 Austrian economist A Treatise on Political Economy, the total value of goods demanded.
Ludwig von Mises argues is devoted to explaining the The common expression of what is
that Keynes’ denial is at the impossibility of overproduction. known as Say’s law has become
basis of Keynesian fallacies
about economics.

2010 Australian economist
Steven Kates defends Say’s
law and calls Keynesian
economics a “conceptual
disease.”

THE AGE OF REASON 75

See also: Free market economics 54–61 ■ Economic equilibrium 118–23 ■
Depressions and unemployment 154–61

“supply creates its own demand.” buying goods. They might, for Jean-Baptiste Say
In fact, Say never used this phrase; instance, want to save some
it was probably coined in 1921 by of their income. If these savings The son of a French Protestant
the US economist Fred Taylor in were not borrowed by others (such textile merchant, Jean-Baptiste
his Principles of Economics. as through a bank) and invested in Say was born in Lyons, France,
the economy (as capital for running in 1767. At the age of 18 he
The idea was important to Say a business, perhaps), the money moved to England, where he
because if supply creates an equal would no longer be circulating. spent two years apprenticed to
value of demand, there can never As people hold on to their money, a merchant before returning to
be overproduction, or “gluts,” in demand for goods eventually Paris to work at an insurance
the economy as a whole. Of course, becomes lower than the value company. He welcomed the
firms could mistake the level of of the goods produced. This French Revolution of 1789,
demand for a commodity and state of “negative demand” is both for its ending of the
overproduce, but as the Austrian- known as “demand deficiency,” religious persecution of the
born US economist Ludwig von and Keynes said it would lead protestant Hugenots, and for
Mises (p.147) later said, “the to pervasive unemployment. its removal of an essentially
bungling entrepreneur” would feudal economy, opening up
soon be driven from that market Given the dire state of the more prospects for commerce.
by losses, and the unemployed world economy during the Great
resources would be reallocated Depression of the early 1930s, In 1794, Say became editor
to more profitable areas of the Keynes’s argument seemed a of a political magazine in which
economy. In fact, it is impossible powerful one, especially when he promoted the ideas of Adam
to overproduce overall, because contrasted with a world based Smith. In 1799, he was invited
human wants are far greater than on Say’s law, which said that to join the French government,
our ability to produce commodities. unemployment would only occur in but Napoleon rejected some of
some industries for a short time. ■ his views, and Say’s work was
Say’s law has become a forum censored until 1814. During
for conflict between the classical this time he made a fortune by
and the Keynesian economists. The setting up a cotton factory. In
former, such as Say, believe that his later years he lectured on
production, or the supply side of economics in Paris. He died
the economy, is the most important after a series of strokes in
factor in growing an economy. 1832, aged 66.
Keynesians argue that growth
comes only with increased demand. Key works

Why keep money? Say believed that supply and demand 1803 A Treatise on Political
In his 1936 masterpiece The operate through a type of barter. We Economy
General Theory of Employment, swap the money we earn for goods we 1815 England and the English
John Maynard Keynes (p.161) want. In this image meat is bartered 1828 Complete Course of
attacked Say’s law, focusing on the for vegetables in an Incan marketplace. Practical Political Economy
role of money within the economy.
Say had suggested that all money
earned is spent on purchasing
other commodities. In other words
the economy works as if it were
based on a system of barter.
Keynes, however, suggested that
people might sometimes hold
money for reasons other than for

76

BORROW NOW,
TAX LATER

BORROWING AND DEBT

IN CONTEXT Should government spending
be financed by borrowing
FOCUS
Economic policy or taxation?

KEY THINKER If the government If the government
David Ricardo (1772–1823) borrows now… increases tax now…

BEFORE … people will know that … people will have to
1799 Britain introduces they will pay more tax later pay more tax.
income tax during war with
revolutionary France. Public to repay the debt.
debt approaches 250 percent
of national income. It makes no difference whether
the government chooses to tax now
AFTER
1945 Following World War II, or “borrow now, tax later.”
government spending,
taxation, and borrowing rise in S hould government spending Political Economy and Taxation,
developed economies to meet be financed by borrowing or Ricardo argued that the method
new welfare commitments. taxation? This question was of financing should make no
first addressed in detail by British difference. Taxpayers ought to
1974 US economist Robert economist David Ricardo during realize that government borrowing
Barro revives the idea of Britain’s expensive Napoleonic today will lead to more taxation in
Ricardian equivalence, which wars against France (1803–15). the future. In either case they will
says that people spend in In his 1817 book Principles of be taxed, so they should set aside
the same way regardless of
whether their government
taxes or borrows.

2011 The European debt crisis
intensifies, sparking debate
about the limits of taxation
and public borrowing.

THE AGE OF REASON 77

See also: Economic man 52–53 ■ The tax burden 64–65 ■ The Keynesian multiplier 164–65 ■ Monetarist policy 196–201 ■
Saving to spend 204–05 ■ Rational expectations 244–47

savings that are equivalent to the One assumption is that people are economists to argue against
amount they would have been rational decision makers and have Keynesian policies—government
taxed today in order to meet that perfect foresight; they know that spending to increase demand and
eventuality. Ricardo suggested that spending now means taxes later. drive growth. They claim that if
people understand a government’s However, this is unlikely to be the people know that a government is
budget constraints and continue to case. Borrowing and lending must spending money to lift an economy
spend in the same way regardless of also take place at identical interest out of depression, their rational
its decision to tax or borrow because rates without transaction costs. expectations will ensure they
they know these will ultimately cost anticipate greater taxes in the
them the same. This idea became A further problem is that human future so they will not blindly
known as Ricardian equivalence. life is finite. If people are self- respond to the increased amount
interested, they are unlikely to care of money in the system now.
Imagine a family with a about taxes that will be imposed However, the practical evidence—
gambling father who resorts to after they die. Barro suggested, for or against—is inconclusive. ■
taking money from his sons. The however, that parents care about
father tells his sons that he will let their children and often leave
them keep their money this month bequests, partly so that their
because he has borrowed from his children can pay any tax liabilities
friend Alex. The happy-go-lucky that arise after the parents’ deaths.
younger son, Tom, spends his extra In this way individuals factor into
cash. The wise older son, James, their decision making the impact
realizes that next month, Alex’s loan of taxes that they expect to be
will have to be repaid with interest, imposed even after they die.
at which point his father will
probably ask him for money. James Government spending The Greek state was forced to borrow
hides away today’s extra cash, Ricardian equivalence, which large sums in 2011 to avoid bankruptcy.
knowing he will have to give it to is sometimes known as debt The civil unrest that followed made it
his father in a month. James has neutrality, is a hot topic today clear that there are limits to how much
recognized that his overall wealth because of the high spending, a government can borrow and tax.
hasn’t changed so he has no borrowing, and taxation of modern
reason to alter his spending today. governments. Ricardo’s insight
has been used by new classical
Ricardo was theorizing, and
did not suggest that Ricardian New classical macroeconomics
equivalence would ever be apparent
in the real world. He believed that US economists Robert Barro, through the mutual adjustment
ordinary citizens suffer from the Robert Lucas, and Thomas of supply (number of people
same fiscal illusion as Tom in our Sargent formed the school of seeking work) and demand
example, and will spend the money new classical macroeconomics (number of people needed).
on hand. However, some modern in the early 1970s. Its key Under this view everyone who
economists argue that citizens tenets are the assumption wants to work can, if they accept
suffer no such illusions. of rational expectations the “going wage.” Therefore,
(pp.244–47) and market all unemployment is voluntary.
The modern debate clearing—the idea that prices Rational expectations claims
The idea reemerged in an article by will spontaneously adjust to that people look to the future as
US economist Robert Barro (1944– ) a new position of equilibrium. well as the past when making
in 1974, and modern analysis has New classical theorists claim decisions so they cannot be
focused on examining the conditions that this applies in the labor fooled by a government when
under which people spend market: wage levels are set it chooses to borrow or tax.
regardless of taxation or borrowing.

78

THE ECONOMY
IS A YO-YO

BOOM AND BUST

IN CONTEXT B usiness cycles are the shift the occurrence of periodic
between strong economic economic crises, but it was the
FOCUS growth, described as a work of a later economist, the
The macroeconomy boom or expansion period, and Frenchman Charles Dunoyer
periods of economic decline or (1786–1862), who revealed their
KEY THINKER stagnation. They are often referred cyclical form. Sismondi challenged
Jean-Charles Sismondi to as cycles of boom and bust. The the “market knows best” orthodoxy
(1773–1842) Swiss historian Jean-Charles of Adam Smith (p.61), Jean-Baptiste
Sismondi was the first to identify Say (p.75), and David Ricardo (p.84).
BEFORE
1776 Adam Smith argues that In boom times This leads to
natural market forces create companies have excess supply.
an economic equilibrium. high profits. They
increase production
1803 Jean-Baptiste Say claims to satisfy demand
that the market will balance
supply and demand naturally. for goods.

1817 Welsh social reformer Eventually The Companies
Robert Owen identifies lower prices lead economy is cut prices to
overproduction and compete for
underconsumption as causes to an increase a yo-yo. customers…
of economic downturns. in demand and
… leading to
AFTER profits go lower profits,
1820s French economist back up. lay-offs, and
Charles Dunoyer identifies the economic
cyclical nature of the economy. depression.

1936 John Maynard Keynes
urges governments to spend
in order to avoid economic
fluctuations.

THE AGE OF REASON 79

See also: Free market economics 54–61 ■ The Keynesian multiplier 164–65 ■ Financial crises 296–301 ■ Housing and the
economic cycle 330–31

Skyscrapers are often built during overlooked short-term economic recover once prices become cheap
times of excessive optimism, a sure booms and busts or had attributed enough to stimulate demand and
sign that the economy is overheating. them to external events, such as credit becomes more available,
By the time they are finished, the war. Sismondi showed that short- starting the cycle all over again.
economy has often crashed. term economic movements are due
to the natural results of market An early crisis that confirmed
They believed that if the market forces—overproduction and these economic cycles was the Panic
is left to its own devices, an underconsumption—caused by of 1825. This stock-market crash was
economic equilibrium is quickly growing inequality during booms. one of the first documented crises
and easily achieved, leading to full caused solely by internal economic
employment. Sismondi thought a Fueling the boom events. It was precipitated by
sort of equilibrium would eventually As economies grow and businesses speculative investments in Poyais
be reached, but only after a do well, workers are able to demand —a fictional country invented by a
“frightful amount of suffering.” wage increases and buy more of the con man to attract investments—
goods they produce. This fuels the and the repercussions were felt in
Before Sismondi published his economy’s boom. As more and markets across the world.
New Principles of Political Economy more goods are sold, companies
in 1819, economists had either expand, hiring more workers to Sismondi argued against the
produce more goods. The new laissez-faire approach of Adam
workers then have money to buy Smith and claimed that government
goods, and the boom continues. intervention is necessary to
regulate the progress of wealth and
Competition means that all avoid these periodic crises.
companies will increase production
until supply outstrips demand, The discovery of these cycles
Sismondi argued. This forces enabled economists to analyze the
companies to cut prices in order to economy in a new way and to
attract customers, triggering falling devise strategies for trying to avoid
profits, falling wages, and lay-offs crashes and recessions. Keynes
among the workforce—in other built on Sismondi’s and Dunoyer’s
words an economic crash followed work to develop his own theories,
by a recession. Companies begin to which were to make up one of the
world’s dominant economic
approaches in the 20th century. ■

Bull and bear markets more optimistic about Universal competition,
economic prospects and or the effort to always
As whole economies grow and buy shares in companies, so produce more, and always
contract, markets within them fuelling rising asset values. at a lower price… has been
rise and fall. Markets that As the economy falters, the a dangerous system.
show sustained price rises process goes into reverse. Jean-Charles Sismondi
are sometimes known as bull Investors become “bearish”
markets; those in which prices and start to sell assets as the
are falling as bear markets. market falls. US stocks were
These labels are usually in a bull market in the 1990s
applied to assets such as with the dot-com boom. A
shares, bonds, or houses. Bull major bear market took place
markets—for example, a rising during the Great Depression
stock market—often occur of the 1930s.
during periods of economic
growth. Investors become

TRADE IS

BENEFICIAL

FOR ALL

COMPARATIVE ADVANTAGE



82 COMPARATIVE ADVANTAGE

IN CONTEXT Making a product entails Even if Country A
costs. One of these costs can do everything better
FOCUS than Country B, it will profit
Global economy is time. most by focusing on the
things it does best. It is
KEY THINKER Both countries benefit too costly to sacrifice time
David Ricardo (1772–1823) from a comparative
on something it does
BEFORE advantage, which makes the less well.
433 BCE The Athenians impose most efficient use of their
trade sanctions on the time and resources. This allows Country B,
Megarians in one of the first which is good (but not
recorded trade wars. Overall, more goods are the world’s best) at making
produced, giving consumers the products Country A
1549 John Hales, an English does not make, a chance
politician, expresses the a wider range of products to make them without
widely held view that free at lower prices. undue competition.
trade is bad for the country.
Trade is
AFTER beneficial for all.
1965 US economist Mancur
Olson shows that governments
respond more to the appeal of
a concentrated group than one
that is more dispersed.

1967 Swedish economists
Bertil Ohlin and Eli Heckscher
develop Ricardo’s trade theory
to examine how a comparative
advantage might change
over time.

T he ideas of the renowned Elizabethan times. Ricardo thought to growing crops. However, as the
18th-century British that in the long run such protectionist war temporarily came to an end in
economist David Ricardo policies were more likely to restrict 1802, the price threatened to fall
were clearly shaped by the world he the ability of the country to increase back so the landowners—who also
inhabited and by his personal life. its wealth. controlled Parliament—passed
He lived in London, England, at a Corn Laws to restrict the importation
time when mercantilism (pp.34–35) Early trade protection of foreign wheat and place a “floor,”
was the dominant economic view. Ricardo was particularly concerned a bottom price, on grain. When the
This held that international trade by the introduction of a British tax wars ended in 1813, the Corn Laws
should be heavily restricted. As a known as the Corn Laws. During were used to raise the floor price
result governments introduced the Napoleonic Wars (1803–15) it again. The laws protected farmers
policies that aimed to increase was not possible to import wheat but also pushed the price of bread
exports and decrease imports in from Europe so the price of wheat beyond what poorer people could
an attempt to enrich the nation in Britain had risen. As a result pay at a time when newly returned
through an inflow of gold. In many landowners increased the soldiers and sailors were unable
England the policy dated back to proportion of their lands dedicated to find work.

THE AGE OF REASON 83

See also: Protectionism and trade 34–35 ■ Market integration 226–31 ■ Dependency theory 242–43 ■
Exchange rates and currencies 250–55 ■ Asian Tiger economies 282–87 ■ Trade and geography 312

50% 20% countries would benefit from
specializing and trading when one
If Worker A is Worker B is not party had an absolute advantage in
20 percent better better than Worker both goods. Would it be worth
at making hats A at anything, but trading if one country could produce
but 50 percent he is better at both more wine and more wool per
better at making making hats than worker than the other country?
shoes, he should shoes. If he makes
focus on shoes. hats, he will have Another way of looking at this is
That is the most a competitive to consider whether a person who is
profitable way advantage and can better at making both hats and
to use his time. trade with Worker shoes than someone else should split
A for shoes. his time between the two jobs or
Ricardo vigorously opposed the choose one job and then trade with
Corn Laws, despite being a wealthy of resources than a competitor is the less-skilled worker, who makes
landowner himself. He claimed that said to have an “absolute advantage.” the other product (see diagram, left).
the laws would make Britain poorer, Smith said that both Britain and Suppose that the superior worker
and developed a theory that has Portugal would profit most by is 20 percent better at making hats,
become the mainstay for all those specializing in what they did best but 50 percent better at making
wishing to justify free trade and trading the surplus. Ricardo’s shoes—it will be in the interest of
between countries. contribution was to extend Smith’s both of them if he works exclusively
argument to examine whether at making shoes (the product he
really excels in), and the inferior man
works in making hats (the product
he is least bad at making).

The logic behind this argument
has to do with the relative costs of
making a product in terms of the
amount of production time taken or
lost. Because the superior worker is
so good at making shoes, the cost of
his making hats is high—he would ❯❯

Comparative advantage
Adam Smith (p.61) had pointed out
that the climate differences between
Portugal and Britain meant they
would benefit from trade. A worker
in Portugal could produce more wine
than a worker in Britain, who in turn
could produce more wool than a
worker in Portugal. Any person or
state able to produce more per unit

In 1819, a crowd of 80,000 gathered
in Manchester, England, to protest
against the Corn Laws, which kept the
price of wheat high by limiting imports.
The protest was brutally suppressed.

84 COMPARATIVE ADVANTAGE

The increased importation of tires
from China (left) led the US to impose
trade restrictions in 2009. This, in turn,
led to a full-blown trade battle and a
deterioration in diplomatic relations.

have to forfeit a lot of valuable shoe advantage, more goods are produced that it comes from countries’ relative
production. Although in absolute in total, and trade delivers more and abundance of capital and labor.
terms the inferior worker is worse cheaper goods to both nations. Capital-rich countries will have a
at making shoes and hats than the comparative advantage in capital-
superior worker, his relative cost Comparative advantage resolves intensive products such as machines.
when making hats is lower than for a paradox highlighted by Adam Labor-rich countries will have a
the superior worker. This is because Smith—that countries that are comparative advantage in labor-
he forfeits less shoe production per inferior at producing goods (they intensive products such as farming
hat than the superior worker would. are said to have an “absolute goods. The result is that countries
The inferior worker is therefore said disadvantage” in them) can tend to export goods that use their
to have a “comparative advantage” nonetheless export them profitably. abundant factor of production;
in hats, while the superior worker has capital-abundant nations such as
a comparative advantage in shoes. 20th-century advantage the US are most likely, therefore,
When countries specialize in goods What determines comparative to export manufactured goods.
for which they have a comparative advantage? Swedish economists Eli Heckscher and Ohlin’s analysis led
Heckscher and Bertil Ohlin argued to another prediction. Not only
would trade tend to reduce the
differences in prices of goods in
different countries, it would also
reduce wage differences: the
specialization in labor-intensive
sectors by labor-abundant
economies would tend to push up
wage rates, while an effect in the
other direction would be seen in
the capital-abundant country. So
despite the overall increase in the

David Ricardo Considered one of the world’s economists of his day, including
greatest economic theorists, David Thomas Malthus (p.69) and John
Ricardo was born in 1772. His Stuart Mill (p.95). He retired
parents moved to England from from the stock exchange in 1819,
Holland, and at the age of 14 and became a member of
Ricardo began working for his Parliament. He died suddenly of
father, a stockbroker. Aged 21, an ear infection in 1823, leaving
Ricardo eloped with a Quaker, an estate worth more than $120
Priscilla Wilkinson. Religious million in real terms today.
differences between the families
resulted in both sides abandoning Key works
the couple, so Ricardo started his
own stockbroking firm. He made a 1810 The High Price of Bullion
fortune betting on a French defeat 1814 Essay on the Influence of
at Waterloo (1815) by buying a Low Price of Corn
English government bonds. 1817 On the Principles of
Ricardo mixed with notable Political Economy and Taxation

THE AGE OF REASON 85

The diminution of money damaged US export industries. Other economists have questioned
in one country, and its The jobs of some US tire workers whether trade always helps
increase in another, do may have been saved, but in the developing countries. The US
not operate on the price wider economy many more jobs economist Joseph Stiglitz (p.338)
of one commodity only, were lost. argues that developing countries
but on the prices of all. often suffer from market failures and
David Ricardo Protectionism today institutional weaknesses that might
The US economist Mancur Olson make a too rapid liberalization of
short run, ultimately there may has helped to explain why politicians trade costly for them.
be losers as well as winners, and continue to impose policies that are
consequently opposition to the likely to damage the overall economy, There are also contradictions
opening up of trade. even though the costs are widely between theory and practice. When
known. He points out that those the government of India removed
The cries for protectionism against the tariffs—a small number tariffs on imports of cheap palm oil
are as loud today as they were in of large domestic producers and from Indonesia, for instance, it had
Ricardo’s time. In 2009, China their workers—suffer a visible the positive effect of raising the
accused the US of “rampant impact from cheap imports. living standards of hundreds of
protectionism” for imposing heavy However, the potentially larger millions of Indians, in line with
taxes on imported Chinese car number of consumers who have to Ricardo’s theory, but it destroyed
tires. The decision to increase pay higher prices because of tariffs the livelihoods of 1,000,000 farmers
tariffs came after pressure from US and those workers in affiliated who grew peanuts for oil, which was
workers, who had seen tire imports industries who might lose their jobs now passed over for palm oil. In a
grow from 14 to 46 million from through connected impacts are perfect Ricardian world the peanut
2004–08, reducing US tire output, dispersed around the economy. farmers would simply transfer into
causing factory closures, and the production of other goods, but
creating unemployment. However, Contemporary trade in practice they can’t because their
the US had previously accused Today, most economists support investment in capital is immobile—
China of unfairly subsidizing its the basic Ricardian position on a machine that processes peanuts
own tire industry, so tensions trade and, in particular, believe that has no other use.
mounted. China’s response was it helped today’s industrialized
to threaten retaliatory increases in countries. US economists David Ricardo’s critics argue that in
import taxes on US cars and poultry. Dollar and Aart Kraay have argued the long run these kinds of impacts
Tariffs produce effects that ripple that over the last few decades trade might hamper the industrialization
through economies. Any protection has helped developing countries to and diversification of poorer
gained for US tire producers from grow and reduce poverty. They countries. Moreover, although rich
the tariffs on tires, for example, was claim that the countries that cut industrialized countries became
counteracted by other negative their tariffs have grown faster and successful traders, they did not
impacts. Higher tire prices increased have seen less poverty. practice free trade when they
the costs of US cars, making them were first developing. How
less competitive and reducing the countries build up comparative
numbers bought by US consumers. advantage over the long run may
The retaliation by China also be more complex than Ricardo’s
model suggests. Some argue that
Europe and then later the Asian
Tigers (pp.282–87) built it up
through trade protection
in which skills were developed
before trade opened up. ■

Goods made in Asia are transported
to Western countries in vast container
ships. It is estimated that 75 percent of
goods in a typical US shopping cart are
exported to the US from Asia.

INDUSTR
AND ECO

REVOLUT

1820–1929

IAL
NOMIC

IONS

88 INTRODUCTION

Antoine Cournot John Stuart Mill Karl Marx publishes Carl Menger establishes
introduces the roles of advocates both trade the first volume of the Austrian School,
function and probability Capital; subsequent
to economics and is the and social justice, which defends free
first to express demand laying the foundation volumes are published market economics
and supply as a graph. for liberal economics. posthumously against the ideas

by Friedrich Engels. of socialism.

1838 1848 1867 1871
1841 1848 1871 1874

The phenomenon of Karl Marx and William Jevons Léon Walras
economic bubbles is Friedrich Engels describes the marginal sets out the basis
described in Charles utility theory of value,
Mackay’s Extraordinary publish the of the general
Popular Delusions and the Communist which sees value as equilibrium theory,
Manifesto. coming from a product’s
Madness of Crowds. claiming that free
value to its buyer. markets are stable.

B y the early 19th century in the number of firms producing Smith had assumed that men
the effects of the Industrial goods, many of which were offering behaved rationally in an economy,
Revolution were spreading shares of their business for sale in but this also came into question as
from Britain to Europe and across the stock markets. These provided investors rushed to buy shares in
North America, transforming the competitive market that was companies whose worth had been
agricultural nations into industrial the focus of the “classical” view of exaggerated. This caused bubbles,
economies. The change had been economics, in which the operations contradicting the idea of a stable
rapid and dramatic, bringing about of the market are central. However, economy based on reasoned
a fundamental shift in the structure as market economies developed behavior. Despite this, some
of economies. The focus had and grew, new problems began economists, such as Léon Walras
shifted from the merchants who to emerge. For example, as Adam (p.120) and Vilfredo Pareto (p.131),
traded in goods to the producers, Smith (p.61) had warned in 1776, argued that the market economy
the owners of capital. As well as there was a danger that large would always tend toward
a new way of thinking about producers would dominate the equilibrium, which would in turn
the economy, capitalism also market and operate either as determine the levels of production
brought with it new social monopolies or as cartels, fixing and prices. Their contemporary
and political issues. prices at a high level and keeping Alfred Marshall (p.110) explained
production low. Although regulation supply and demand and how these
Distorting the market could prevent such practices, in and prices interact in a system
Most noticeable of the social instances where only a few of perfect competition.
changes was the emergence of a producers operated, they could
new “ruling class” of industrialist easily develop strategies to distort The question of price was one
producers, and a steady growth the competitiveness of the market. that concerned many economists
at the time because it affected both

INDUSTRIAL AND ECONOMIC REVOLUTIONS 89

Robert Giffen Social campaigners Vilfredo Pareto formulates Arthur Pigou Joseph Schumpeter
introduces the Beatrice and Pareto efficiency, argues that describes the vital
concept of Giffen Sidney Webb a state in which no companies should
goods, for which publish their be taxed for role of the entrepreneur
consumption individual can become the pollution as an innovator
rises with price. landmark History better off without making they make. who moves
of Trade Unionism. industry forward.
another worse off.

1870S 1894 1906 1920 1927
1890 1899 1914 1922

Alfred Marshall In The Theory of the Friedrich von Ludwig von Mises
publishes his Principles Leisure Class, Thorstein Wieser describes criticizes communist
of Economics, bringing opportunity cost, planned economies in
Veblen describes the which measures the
new mathematical conspicuous value of choices that Socialism: An
approaches consumption have been rejected. Economic and
to economics. of the rich. Sociological Analysis.

producers and consumers in the for capitalist employers. Looking prosperity—although tempered
new capitalist society. Taking their at value in this light, Karl Marx to some extent with measures to
lead from the moral philosophers argued that the inequalities of a compensate for its injustices.
of the previous generation, they market economy amounted to an Following a mathematical approach
began to see the value of goods exploitation of the working class to economics that focused on
in terms of their utility (the by the owners of capital. In the supply and demand, and as a
satisfaction they would give), Communist Manifesto and his reaction against the ideas of
rather than the labor that added analysis of capitalism Capital, socialism, an Austrian School
value to raw materials. The idea Marx argued for a proletarian of economic thought emerged,
of marginal utility—the gain revolution to replace capitalism stressing the creative power of
brought about by the consumption with what he saw as the next the capitalist system.
of a particular product—was stage in economic development:
explained in mathematical terms a socialist state in which the The free market economy was
by William Jevons (p.115). means of production are owned soon to receive some hard knocks
by the workers, and an eventual after the Wall Street Crash of
Marx’s theory of value abolition of private property. 1929. However, the theories
The theory that the value of a of neoclassical economists, and
product is determined by the labor Although Marx’s ideas were the Austrian School in particular,
involved in producing it still had subsequently adopted in many later resurfaced as the model
some adherents, particularly as parts of the world, market for economies in the Western
it concerned not the producers economies continued to operate world in the late 20th century
or consumers so much as the elsewhere. Generally, economists and even came to replace
workforce producing the goods continued to defend capitalism most of the world’s communist
as the best means of ensuring planned economies. ■

90

HOW MUCH SHOULD
I PRODUCE, GIVEN
THE COMPETITION?

EFFECTS OF LIMITED COMPETITION

IN CONTEXT B y the second half of the high. French economist Antoine
17th century economists Cournot wanted to find out what
FOCUS had begun to observe the happened when there were only a
Markets and firms effects in markets of monopolies few firms selling similar products.
and of fierce competition. They
KEY THINKERS found that monopolies tended to Dueling duopolies
Antoine Augustin Cournot restrict output to keep prices and Cournot created his model based
(1801–77) profits high. Where there was on a duopoly of two firms selling
Joseph Bertrand (1822–1900) plenty of competition, prices were identical spring water to consumers.
driven down to the level of costs, The two firms are not allowed to
BEFORE profits were low, and output was form a cartel by working together,
1668 German scientist Johann
Becher discusses the impact If there are just two … each firm knows that the
of competition and monopoly competing firms (a duopoly) other firm’s output will
in his Political Discourse. producing identical goods… affect their own profits.

1778 Adam Smith describes Each firm reacts by
how perfect competition selecting its best output
maximizes social welfare. given the level of output the
other firm chooses (plotted
AFTER
1883 French mathematician on a reaction curve).
Joseph Bertrand changes the
strategic choices in Cournot’s The market will be in a This is how much the
model from quantity to price. Cournot equilibrium firm should produce,
where the two reaction given the competition.
1951 US economist John
Nash publishes the general curves meet.
definition of equilibrium for
game theory, using Cournot’s
duopoly as his first example.

INDUSTRIAL AND ECONOMIC REVOLUTIONS 91

See also: Cartels and collusion 70–73 ■ Monopolies 92–97 ■ The competitive market 126–29 ■ Game theory 234–41

no other firms can enter the industry Cournot’s model uses
(because there are no other natural
springs), and each firm has to If Firm A thinks Firm B will two reaction curves to
decide, simultaneously, how many 30 produce 30, Firm A will illustrate the output
bottles of water to supply.
produce zero (to avoid losses) decisions of two firms,
The total output of the industry
is the sum of the two firms’ output where each firm is aware
decisions. Each firm must choose
the output that maximizes its profit 25 of the other’s existence
based on what it thinks the other but does not know how
firm’s output will be. If Firm A
thinks that Firm B will produce Firm A much the other intends
nothing, Firm A will select the low 20 to produce.
output of a monopolist to maximize
profits. On the other hand if Firm A FIRM B’S OUTPUT 15
thinks that Firm B will produce a Cournot equilibrium
high output, Firm A may choose to (the perfect production point)
produce nothing—because prices
would fall too far to make production 10 If Firm A thinks Firm B will
worthwhile. Cournot represented produce zero, Firm A will produce 15
the decisions of both firms on a (to make a monopoly level of profit)
“reaction curve.” The equilibrium
of the market is where the two 5
reaction curves intersect. At this
point each firm is selling the most Firm B
profitable amount given what the
other firm is doing. This notion of 0
equilibrium became known as the 0 5 10 15 20 25 30
Nash equilibrium, and it is a
central plank of game theory, the FIRM A’S OUTPUT
branch of modern economics that
analyzes strategic interaction model was developed by French competition. This is because any
between firms and individuals. economist Joseph Bertrand, who firm that sets a high price will be
showed that if firms choose by their undercut by another, who will then
Cournot used mathematics to desired price levels rather than steal all its buyers. In this way the
find this equilibrium and prove that output, the equilibrium for price will be driven to the most
the duopolists would choose an duopolists equals that of perfect competitive level. ■
output that was higher than would
occur in monopoly, but lower than Antoine Cournot works that pioneered the use
with perfect competition. In other of mathematics in economics,
words a few firms would be better An insatiable reader, Antoine before going blind. His work was
for society than a monopolist, but Augustin Cournot was born in not well received in his lifetime
worse than perfect competition. France in 1801. Although because of its reliance on novel
relatively poor, he studied mathematical notation. Today he
From this starting point, Cournot mathematics at one of the best is regarded as a profound thinker
extended the model to show how, schools in the country and who advanced prophetic ideas.
if the number of firms increases, completed a PhD in engineering.
the industry output reassuringly After spending some time as a Key works
moves closer to the level expected private tutor and as a secretary
for perfect competition. Cournot’s for one of Napoleon’s generals, 1838 Researches into the
he became a university lecturer Mathematical Principles of the
and then professor. Cournot was Theory of Wealth
plagued by eye problems but 1863 Principles of the Theory
managed to publish several of Wealth

PHONE CALLS

COST MORE

WITHOUT

COMPETITION

MONOPOLIES



94 MONOPOLIES A monopoly is a situation be rich if they wanted. For
where one firm has control economists the story warns of
IN CONTEXT of a particular market, the potential power of monopoly.
such as the cell phone market. The
FOCUS firm may be the only supplier Market power
Markets and firms of a product or service, or it may In 1848, the English political
have a dominating market share. scientist John Stuart Mill published
KEY THINKER In many countries a firm is said to his Principles of Political Economy.
John Stuart Mill (1806–73) have a monopoly if it controls more It drew together much of the
than 25 percent of a market. thinking about whether a lack of
BEFORE competition caused prices to rise.
c.330 BCE Aristotle’s Politics The suggestion that monopolies The general view was that some
describes the impact of can cause the price of goods to be industries were likely to tend
a monopoly. higher than they would be if many toward a lack of competition.
companies were supplying them has This trend was created either
1778 Adam Smith warns of existed for millennia. It dates back through artificial means, such
the dangers of monopolies in at least as far as Aristotle (384– as the introduction of a tax by
The Wealth of Nations. 322 BCE), who warned about the governments on imported goods,
problem in a story about the Greek or through natural means, as a
1838 French economist philosopher Thales of Miletus. The consequence of firms growing ever
Antoine Cournot analyzes the public taunted Thales for practicing larger. Large firms had begun to
impact on price of a reduction philosophy, which they said was a dominate the market because late
in the number of firms. useless profession that made no 19th-century industry required
money. To prove them wrong, Thales ever-increasing amounts of capital.
AFTER bought up all the local olive presses The firms that could grow by
1890 Alfred Marshall develops in the winter when they were cheap, capturing enough of the market to
a model of monopoly. and then—using his monopoly finance the necessary investment,
power—sold them at very high had the ability to use their market
1982 US economist William prices in the summer when the power to drive their smaller
Baumol publishes Contestable presses were needed. In doing so he competitors out of business and
Markets and the Theory of made himself rich. For Thales the to charge higher prices.
Industry Structure, redefining moral was that philosophers could
the nature of competition.

Competition between … and drives But monopolies, like
producers increases down prices. some telephone companies,

output… have no competition.

Phone calls cost They can produce less
more without and charge higher prices.
competition.

INDUSTRIAL AND ECONOMIC REVOLUTIONS 95

See also: Cartels and collusion 70–73 ■ The competitive market 126–29 ■
Economies of scale 132 ■ Creative destruction 148–49

During the Industrial Revolution coal, the labor market too. He pointed John Stuart Mill
railways, and water supply all showed to the case of goldsmiths, who
a tendency toward concentrated earned much higher wages than Born in London in 1806,
ownership. In mining the ownership workers of a similar skill because John Stuart Mill grew up in
of the land was concentrated in just they were perceived to be a wealthy family that was to
a few hands. In the case of railways trustworthy—a characteristic that become a great intellectual
and water supply there was no is rare and not easily provable. This dynasty. His father was an
alternative to a limited number of created a significant barrier to entry overdemanding parent, who
firms offering services because the so that those working with gold educated Mill at home on a
scale of the infrastructure required could demand a monopoly price for difficult and accelerated
was so great that if there were any their services. Mill realized that the program that included Greek
more than a few firms, no one would goldsmiths’ situation was not an from the age of three. The aim
be able to cover their costs. Like isolated case. He noted that large was for Mill to carry on and
Adam Smith (p.61) before him, Mill sections of the working classes develop his father’s work on
believed that these features of were barred from entering skilled philosophy. The pressure of
markets did not inevitably lead to professions because they entailed his upbringing was at least
monopoly. The most likely outcome many years of education and partly responsible for the
was collusion between firms, training. The cost of supporting mental health problems Mill
allowing them to fix high prices. someone through this process was suffered in his early 20s.
Such arrangements would lead to out of reach for most families, so
high costs for consumers in the those who could afford it were able One of the great minds of
same way as monopolies. to enjoy wages far above what ❯❯ the day, he was willing to
speak out in defense of
Monopoly workers The railways were an example of a difficult and unpopular causes
Mill realized that it is not only monopoly industry at the time Mill was such as the French Revolution
within the goods market that a lack writing. New lines were expensive and and women’s rights. He was
of competition is able to push prices impractical on routes that were already also an eloquent opponent of
up. Monopoly effects can emerge in serviced by existing companies. slavery. A 20-year affair with
Harriet Taylor, whom he
credited with inspiring much
of his written work, caused
scandal in his own private life.
He died in 1873, aged 66.

Key works

1848 Principles of Political
Economy
1861 Utilitarianism
1869 The Subjection of Women

96 MONOPOLIES

Monopoly The lower the price of a good, the greater willingness to pay will equal the
the demand for it. In a theoretical state of perfect price, and no more apples can
competition between firms, a good will sell at the be sold. The welfare loss of
price it costs to produce. This is the highest demand monopoly comes from the fact that
and lowest price possible. In a monopoly, the price is fewer apples are sold compared
set at a higher level and demand is reduced. to the amount that would have
been sold in perfectly competitive
Supply in markets. Essentially, this means
monopoly that there are apples that could be
supplied to the market, that would
Supply in perfect generate consumer surplus, but
competition they never appear on the market.

PRICE Demand
will always
Perfect be higher Advantages of monopoly
competition at lower Monopolies also create more
prices complex price and welfare effects.
0 Marshall suggested that a
0 QUANTITY Perfect competition monopolist might actually cut its
Monopoly prices to attract customers to
His consumer surplus from the its phone network, for example,
might be expected. Similarly, purchase of the apple is 30 cents. since people will likely keep using
some historians have viewed the In a market with many firms, they the service once it is connected,
guilds of the medieval era as an compete on price and together even though rival technologies such
example of privileged craftsmen supply an amount of apples that as cell phones offer alternatives that
attempting to shut out competition generates a certain amount of are at least as good.
from other workers. overall consumer surplus. For an
apple sold to the last consumer his Some economists have pointed
From the late 1890s British out that monopolies can have
economist Alfred Marshall (p.110) Monopolists, by keeping benign effects. In many markets
rigorously analyzed the effects of the market constantly a monopoly would have lower costs
monopolies on prices and on than the total costs of a set of
consumers’ welfare. Marshall was understocked… sell their smaller firms because a monopolist
interested in determining whether commodities much above would spend less on advertising
the higher price and lower output and make full use of economies
that result from monopolies cause the natural price. of scale. For these reasons a
a loss in total welfare for society. Adam Smith monopolist may enjoy higher
In his Principles of Economics, profits even when its price is lower
Marshall formulated the concept than would be the case if many
of consumer surplus. This is the firms—with higher costs—were
difference between the maximum competing. In this case the lower
amount that a consumer would be prices might help consumers and
willing to pay for a good and the help to drive economic growth.
amount he actually pays. Suppose
the consumer buys an apple for In a similar fashion large firms
20 cents when he would have can attempt to gain monopoly
been willing to pay 50 cents. profits, driving out rivals by
aggressively cutting prices in the
short run. Economists call this
predatory pricing. In the long run it
can hurt consumers as the market
becomes monopolized. However,
in the 1950s and 60s US economist
William Baumol claimed that it

INDUSTRIAL AND ECONOMIC REVOLUTIONS 97

Operators work the switchboards of This idea led to an acceptance Whatever renders a
the AT&T company in New York in the of national monopolies in the larger capital necessary
1940s. Because of the company’s size public utilities in many countries. in any trade or business,
and dominance, it was considered to Even so, governments began to limits the competition
be a natural monopoly. intervene in these markets to
counteract the possible monopoly in that business.
does not matter if there is a monopoly effects. The problem is that in the John Stuart Mill
as long as there are no barriers to case of a natural monopoly,
entering and exiting the market— the fixed costs are so high that through advertising and marketing,
the mere threat of competition compelling the firm to charge a and through large firms innovating
means that the monopoly will set competitive price might make the and creating new products.
the price at a competitive level. firm unprofitable. Solutions to this
This is because a higher price problem include the wholesale Slightly apart from this school
might attract new entrants to the nationalization of industries or of economists, Austrian economist
market, who would take market the establishment of regulatory Joseph Schumpeter (p.149) also
share from the monopoly. For this organizations that place limits stressed the dynamic potential
reason prices may be no higher on price increases, helping of monopoly as firms compete to
under a monopoly than in a market consumers but also ensuring the create new products and dominate
with many competing firms. economic viability of the industry. entire markets because of the
potential profits. What economists
Natural monopolies Mainstream economists argue agree on is that true competition
One argument that began to take that monopolized markets fall short is good for consumers. It is less
shape during Marshall’s lifetime is of the perfectly competitive ideal. certain whether or not monopoly is
that some monopolies are “natural” This view has led to government incompatible with this. In the early
because of the enormous cost anti-trust policies, which seek 20th century German economist
advantages of having a single firm. to move markets toward Robert Liefman claimed that
Many public utilities are natural competitiveness. This has meant “only a peculiar combination of
monopolies, including telephone the introduction of measures aimed competition and monopoly brings
networks, gas, and water. The at preventing monopolies from about the greatest possible
fixed cost of setting up a network abusing their market power, satisfaction of wants.” ■
of gas distribution pipes is huge, including the breakup of monopolies
compared to the cost of pumping and the banning of mergers of firms
an extra amount of gas. that would create monopolies.

The modern Austrian School,
including US economist Thomas
DiLorenzo (1954– ), are critical of
this approach. Both argue that real
market competition is not the
passive behavior of perfectly
competitive firms operating in a
state of equilibrium. It is about
cut-throat rivalry between an often
small number of large businesses.
Competition takes place through
price and non-price competition,

In 1998, the US pharmaceutical
industry asserted its monopoly on
an AIDS drug by taking legal action
against the South African government,
which had been buying cheaper,
generic versions of the drug.

98

CROWDS BREED
COLLECTIVE
INSANITY

ECONOMIC BUBBLES

IN CONTEXT I n 1841, the Scottish journalist any intrinsic value they might
Charles Mackay published have. When assets rise in such an
FOCUS Extraordinary Popular Delusions uncontrolled way, the situation is
The macroeconomy and the Madness of Crowds, a called an economic bubble. Like
classic psychological study of actual bubbles, in an economic
KEY THINKER markets and the irrational behavior bubble prices rise upward but
Charles Mackay (1814–89) of people acting in “herds.” The become more and more fragile—
book looks at some of the most and they inevitably burst.
BEFORE famous examples of frenzied
1637 Dutch nurseryman P. speculation in history, including Tulipomania
Cos publishes The Tulip Book, Tulipomania (1630s), John Law’s The Dutch tulip mania of the 1630s
which provides raw data for Mississippi Scheme (1719–20), and is one of the earliest and most
the future prices of tulips. the South Sea Bubble (1720). notorious instances of an economic
bubble. At the beginning of the 17th
AFTER Mackay’s hypothesis was that century tulips from Constantinople
1947 US economist Herbert crowds acting in a collective frenzy became popular with the wealthy
Simon writes Administrative of speculation can cause the prices of Holland and Germany, and soon
Behavior, introducing the idea of commodities to rise far beyond everyone wanted them. Tulips were
of “bounded rationality”—poor seen to bestow the qualities of
decisions are due to limits in Hendrik Pot’s painting of tulip mania wealth and sophistication on their
ability, information, and time. (1640), shows the goddess of flowers owners, and the Dutch middle class
riding with drunken, money-weighing became obsessed with collecting
1990 Peter Garber critiques men. Other people follow the cart, rare varieties. By 1636, the demand
Mackay’s work in his essay, desperate to keep up with the group. for rare species of tulips was so
Famous First Bubbles. intense that they were traded on
Amsterdam’s stock exchange.
2000 US economist Robert
Shiller publishes Irrational Many individuals grew suddenly
Exuberance, analyzing rich. A golden bait hung temptingly
the causes and policy out before the people, and
interventions that might everyone—from noblemen to
prevent the occurrence of maidservants—rushed to the tulip
future economic bubbles. markets, all imagining that the
passion for tulips would last forever.
But when the rich stopped planting