finalexam

History of Economic Thought

Notes for Week 11

This week’s notes cover the interesting period from the last decade of the 19th century

until the early 1930’s, even though some of the contributors to these traditions continued to

generate interesting theories clear into the 1960s. These two traditions are the Institutionalists,

whom we’ll discuss by focusing on Thorstein Veblen’s most famous work, The Theory of The

Leisure Class, and the Cantabrigians, specifically Arthur Pigou, Piero Sraffa, and Joan

Robinson. John Maynard Keynes can also be added as an important contributor to the

Cantabrigian tradition, but because his work was so monumental, specifically his The General

Theory of Employment, Interest, and Money, we’ll discuss him separately, in another set of

notes.

Both camps, the Institutionalists and the Cantabrigians, represent an interesting departure

from the hegemonic neoclassical perspective that had been dominating the discipline, and still

does, since the 1870s. We’ve focused on Walras and Marshall as representative examples of the

Neoclassical tradition, but by the first two decades of the 20th century, there were scores of other

intellectuals, such as Jevons, Menger, Edgeworth, Vilfredo Pareto, John Bates Clark, Irving

Fisher, and many others, who were also making important contributions to this tradition. While

there were differences among these theorists, they tended to have in common a utilitarian view of

human behavior, optimization as an appropriate characterization of people and firms, and perfect

competition as the asymptote toward which all markets are tending. The conservative

inclinations of the discipline were in full bloom.

Yet, despite the dominance of neoclassical economics, there emerged a popular

counternarrative, generated by intellectuals in the Institutionalist tradition, such as Veblen,

Commons, and Mitchell, which sought to explain economics from a non-utilitarian perspective,

rooted in history and sociology, and critical of the deductive arguments used to justify free

market ideologies. These intellectuals gained considerable popularity in the US during the first

three decades of the 20th century and many of their followers occupied important positions in

government, instituting progressive policies at the federal or state level. Commons and his

students, for example, were active in instituting a series of progressive policies for the state of

Wisconsin under the guidance of Governor Robert M. LaFollette, Sr. who also served as the

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senator from that state in the U.S. Congress. Young Institutionalist economists also occupied

important positions within the New Deal Administration of Franklin Delano Roosevelt, during

the 1930s. The Institutionalist tradition was closely aligned with the progressive movement

taking place in the U.S. during that era.

In contrast, the Cantabrigians, while nowhere nearly as popular as the Institutionalists,

were nevertheless important in providing an intellectual framework which countered the

conservative implications of Marshallian economics. What’s interesting about this group of

intellectuals is that they had been students of Marshall but found his theories wanting and, in

response, critiqued his ideas and pushed for the development of an economics free of Marshall’s

moralizing. While these theorists were not well known to the general public, unlike the

Institutionalists, they were more influential within the discipline and were responsible for

introducing a dose of realism into theories of price and social welfare. Thus, to this day, the work

of the Cantabrigians is still noted in econ courses, though not necessarily in the way they would

have wanted, while the work of the Institutionalists is generally ignored; unless you attend a

heterodox economics program, such as the one at CSUSB.

The Institutionalists: Thorstein Veblen

The Institutional or Evolutionary school of thought was the only truly unique school of

economic thought developed in the U.S. It thrived in the U.S. from the last decade of the 19th

century until the 1940s. Then it experienced a hiatus for a few decades until it was revived in the

late 1960s by the formation of the Association for Evolutionary Economics (along with the

resuscitation of Marxian economics in the form of the Union for Radical Political Economics).

This school of thought still exists and has several active professional associations and a well-

known journal – The Journal of Economic Issues. Nevertheless, evolutionary economists are

generally ignored by the mainstream and, oddly enough, has become more popular in Europe

than in the U.S. during the last 30-some years.

The institutionalist or evolutionary school of thought being explored here traces its roots to

the work of Thorstein Veblen (1857-1929), John Roger Commons (1862-1945), and Wesley

Claire Mitchell (1874-1948). One of its characteristic features is a tendency to focus on the social

nature of economic activity. It pays a lot more attention to social institutions and habits of

thought in structuring economic behavior than is common to the neoclassical tradition. But, in

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addition, it’s suspicious of purely deductive modes of thought (a characteristic of neoclassical

economics) and is much more insistent on inductive approaches that rely on historical and

empirical knowledge. What’s more, and consistent with their suspicion of purely deductive

methods, they are not impressed with equilibrium approaches to understanding economic

behavior. They instead argue that economic activity, at the individual, firm, industry, national or

global level, is forever unfolding in an on-going process of cumulative causation, forever moving

through historical time but not necessarily toward some equilibrium state. Moreover, this school

does not presume that society has an automatic tendency to move toward some optimal state

(efficiency, full employment, maximum output, etc.) or that history is somehow unfolding in the

direction of some future good.

It should be noted that the institutionalist school being explored here should not be

confused with another school of thought of that same name which has emerged from within the

neoclassical tradition in the last fifty years. This latter school of thought has little in common

with the perspective being explored here. Perhaps the most obvious difference is that the new

institutional perspective tends to see social institutions emerging out of obstacles, such as

transactions costs, to exchange among self-interested individuals. Rather than seeing social

institutions as molding behavior, these new institutionalists can’t imagine the existence of social

institutions in the absence of obstacles to individual exchange. They are, in short, utilitarian in

their view of human behavior. In contemporary economic literature it’s common to refer to

Institutionalist Economics of the Veblen, Commons and Mitchell variety as Original Institutional

Economics (or OIE for short) and the more recent neoclassical variant as New Institutional

Economics (or NIE for short). We will not be exploring the NIE version.

Veblen argued that institutions, i.e., habits of thought, structure the way we interpret reality

and organize our lives. That is, we are thoroughly social creatures, and the actions we carry out,

and justifications used to explain them, are heavily influenced by our culture, education, our

socialization and need to belong. This does not mean we are automatons reproducing whatever

beliefs and actions are common to the social milieu of which we’re a part; individual actions and

beliefs can differ from the group. Yet, it’s the actions and beliefs of the group and society, the

institutions of society, that structure social life and the patterns of thought and behavior common

to the individuals of a society.

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Veblen believed that two broad types of institutions governed social behavior: those that

deal with the problem-solving aspect of life, the technologies developed by humans to

domesticate plants and animals, build tools, furniture, dwellings, invent things, etc.; and those

that seek to explain or justify the way power is organized to distribute work and the output of

that work. The first set of institutions were progressive in the sense that they sought to improve

on the current way of doing things, facilitating and improving the process of social provisioning.

The second set of institutions were conservative since their primary aim was to reinforce belief

systems and ways of doing things.

Both sets of institutions were seen as evolving out of fundamental, biologically given,

characteristics of humans. He tended to refer to these fundamental characteristics as instincts, but

a more appropriate term would be proclivities or propensities; that is, behavioral characteristic

that are common to humans regardless of their cultural or social context. Thus, the sex drive is

innate to humans, but the form it takes and the way it’s expressed varies across cultures and

social settings.

Veblen identified several propensities or instincts. There was the instinct of workmanship,

the parental bent, idle curiosity, as well as the predatory instinct. The instinct of workmanship

dealt with the human need to work and create things, while the parental bent referred to the

inclination to care and provide for one’s children and provide them with the requisite set of

social skills (socialize them into the various institutions needed to thrive in society). The instinct

of idle curiosity referred to the human tendency to imagine how things work, to seek answers to

the question why, or to explore how sounds, colors or ideas interact. The predatory instinct

referred to not simply the human capacity to inflict harm on other humans, animals and the

environment, but the capacity to belittle, denigrate, ostracize and shame others. An odd feature of

the predatory instinct is that it carries with it the tendency to envy or glorify those whom we

perceive as our betters.

It’s important to note that the above extremely short outline of Veblen’s view of human

behavior underscores the extent to which he did not accept the utilitarian, and thus neoclassical,

view of humans. He did not believe that humans were passive hedonists motivated only by the

pursuit of pleasure and the avoidance of pain, doing nothing unless the marginal benefit of action

outweighs the marginal cost of exertion. Like Marx, but also to some extent Smith, Veblen saw

humans as purposeful creatures forever molding their physical and social environment. What’s

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more, they derive pleasure and meaning from work. The instinct of workmanship involved more

than simply doing things, it also carried with it the sense of pride and accomplishment that

comes from a job well done, a well-executed dance routine, song, painting, sculpture, or an

interesting and impressive feat of engineering, scientific discovery, etc. We are, in short, doers.

Veblen used this framework to explain the political economic behavior of advanced

capitalist societies, specifically the USA in the late 19th and early 20th century. In his Theory of

the Leisure Class, he explains the emergence of the upper class, what he calls the leisure class, in

evolutionary terms. Prior to the emergence of human civilizations, sometime around 13 to 15

thousand years ago, humans lived in extremely precarious situations as a result of their crude

understanding of things, technology had yet to advance toward a stage where surpluses could be

generated from work. This is the era referred to as primitive communism by Karl Marx. During

that era, Veblen imagined that the distribution of peaceful proclivities (i.e., parental bent,

workmanship, idle curiosity, etc.) predominated over predatory proclivities with a greater

emphasis on cooperation and sharing than on exploitation and subjugation. But once humans had

developed technology to the point where surpluses could be generated (through the

domestication of plants and animals and the creation of tools and dwellings) then the predatory

inclination began to dominate the structure of society. With the emergence of surpluses there

now was something worth fighting for and, in consequence, the emergence of class divided

societies, mound and temple building cultures, slavery and warfare.

The emergence of surpluses provided an opportunity for predatory proclivities to gain

dominance in the organization and culture of human societies. A warrior class emerges seeking

to gain control of the surpluses by regulating the working activity of those who labor in its

production. The warrior class appropriates the surplus through brute force, warfare. But, over

time, they develop justifications for their privileged status by claiming to be descendants of gods,

or to be gods themselves. Religious temples are created to praise and eulogize the order and

civilization brought about by the warrior class; and a priestly class emerges to sanctify the

actions of the warriors with rituals and ceremonies. Distinctions begin to emerge between those

who labor in the production of the surplus and those who live off the surplus: the warriors and

their growing entourage of sycophants, priests, priestesses, and all of those who attend to the

whims of the powerful. The upper class distinguishes itself from the masses by the fact that they

do not work; they instead engage in war, sports, religious ceremonies and temple building (more

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accurately enlisting the energies of architects and workers to build the temples). In contrast, the

toiling masses work and gradually come to see the upper class as worthy recipients of the

surpluses. Working activity comes to be seen as less glorious and edifying than the exploitative

activities of the warrior classes; and evidence of work in the form of calloused hands and work-

soiled clothes come to be seen as unflattering. In the meantime, exploit and warfare, athletic

prowess and ceremonial (religious) leadership, come to be seen as praiseworthy; while

uncalloused hands, manicured fingernails and toenails, and clothing unsuitable for work come to

be seen as signs of merit and refined social standing. The entire culture takes on a predatory tone

and competition and envy, instead of cooperation and solidarity, come to dominate society.

Veblen views the class divisions in the USA in the late 19th and early 20th centuries as the

evolutionary outcome of the patterns that emerged early on in human history. The leisure class

distinguishes itself from the common person by engaging in predatory behavior and conspicuous

consumption. They achieve their fortunes through sabotage, chicanery, exploit and theft, but

justify their actions by appealing to stories of merit, industry, religious piety and free enterprise.

One way they display their power is through conspicuous consumption, that is, purposefully

making a show of what they can afford by consuming goods and services that will never be

within the reach of the common person. Indeed, the more expensive and less useful the item, the

better. It underscores the power of the wealthy, their capacity to use resources on meaningless

trinkets that serve no useful social purpose other than to highlight their exalted status. It also

underscores their capacity to move resources away from the production and distribution of goods

that enhance the quality of social life and employ them instead in the production of luxury goods

that only serve to highlight the power of a tiny minority.

In the meantime, the common person comes to see the conspicuous consumption of the

leisure class as evidence of their superiority and good social standing. They then go about doing

their best to emulate their behavior by also going out of their way to purchase items that mimic

the conspicuous consumption of the wealthy. Just as the wealthy are intent on displaying their

social status through conspicuous consumption, the common person displays his/her social

repute by imitating the consumption patterns of the wealthy. But the problem is that, unlike the

leisure class, which abstains from work – indeed non-work is a sign of their superiority, the

common person must work for a living and can seldom afford to purchase the luxurious trinkets

so beloved by the wealthy. So, they purchase cheaper versions of the same and/or go into debt so

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as to obtain the symbols of status they so desperately need for social esteem. The net result is

that the working class ends up on a treadmill, forever working harder and harder, to purchase

items that serve little utilitarian purpose but provide them with a fleeting sense of social repute.

The working class, Veblen’s common man, is thus burdened with not only the disrepute

associated with having to work for a living (as opposed to being a corporate magnate seeking

ways to exploit others) but the obsessive envy-induced need to buy, buy, and buy, items whose

sole function is to assuage his/her sense of social repute.

Veblen views all of this as contributing to the dissatisfaction endemic to the working

classes and to the waste that’s central to predatory societies and, in particular, capitalism.

Industry will end up producing all the items of conspicuous and emulative consumption

demanded by the capitalist and working classes, but even if industry delivers those items at rates

that meet the needs of the consumers, and even if the items are sold at prices that match their

minimum average cost, the system would still be wasteful because resources would be allocated

to the production of things that serve little, if any, utilitarian purpose and seldom enhance the

quality of social life. So, resources are spent on the production of conspicuous and emulative

consumer goods instead of on the production of things that enhance the provisioning of the

community; in short, resources are wasted.

The Cantabrigians

The term “Cantabrigian” is used to refer to those who come from, studied or taught at,

Cambridge University, in Cambridge, England. In the case of economics, the term is used to

refer to people like Alfred Marshall and his students, who taught or studied at Cambridge. Here,

we’ll focus on those students of Marshall who ended up modifying, or rebelling against, his view

of things: Arthur Pigou (1877-1959), Piero Sraffa (1898-1983), and Joan Robinson (1903-1983).

John Maynard Keynes (1883-1946) also falls into this camp, but since we’ll be exploring his

contributions later on, we’ll delay an examination of his role in the revolt of the Cantabrigians

until then.

Arthur Pigou extended Marshall’s contributions by giving birth to the field of welfare

economics. Central to this way of viewing economics is the idea that competitive markets do not

always bring about its touted benefits. As a result, government can and should be used to craft

policy that remedies the problems markets are either incapable of solving or do so very poorly.

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Thus, Pigou explored the conditions under which national income could be redistributed from the

wealthy to the poor as a way of counterbalancing the inequities that are common to free market

systems.

Likewise, Pigou explored the role of externalities in capitalist economies and brought

attention the fact that there are numerous areas in which the free market does not assign the

proper cost and benefits to the participants of an exchange. This has the effect of encouraging the

over production of goods that impose a cost on the community while under producing goods that

generate a social benefit. In short, in the context of externalities (which are in fact quite common,

if not ubiquitous) competitive markets do not allocate goods efficiently. Since free competitive

markets do not incorporate the social costs and benefits of economic activity (focusing only on

the private costs and benefits), the amounts produced and exchanged through free competitive

markets will inevitably exceed or fall short of the amounts that would maximize social welfare.

For example, consider the case of an industry that, in the process of producing and selling a

commodity, pollutes the environment by discarding the waste generated from production into the

surrounding community. To keep things simple, we’ll imagine that the firms incur no cost in

dumping the waste into the environment (we can think of it as a byproduct that the firms are

indifferent to or unaware of). The firms will end up selling the commodity at prices that match

their private marginal cost of production. But if the waste product has the effect of negatively

affecting the quality of life to the community, then the true marginal cost of production, the

social marginal cost, will actually be higher than its private marginal cost. That is, the free

market (which only considers private costs and benefits) has the effect of encouraging firms to

overproduce commodities that generate a negative externality by allowing them produce and sell

commodities at prices that are lower than their true social cost.

Pigou suggested that this inefficiency could be remedied by government, through the

imposition of a tax on the polluting firms that captured the difference between the social and

private costs of production. This would have the effect of increasing the price of the commodity,

reducing the quantity demanded by consumers and, consequently, reducing the level of

production. The tax collected from the polluting firms could then be used to clean up the mess

left by the polluting firms.

There is much more that can, and should, be mentioned about Pigou, but this is enough to

give you a sense of his contributions. However, it must be emphasized that, despite later on

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defending the full employment potential of free markets – in response to Keynes’s critiques,

Pigou moved the mainstream of the discipline away from its faith-like insistence that free

markets always bring about some kind of long-term benefit. He was willing to explore the

conditions under which that might not be true (such as income inequality and externalities) and

offer practical solutions that could be used by governments intent on improving social welfare.

Indeed, the idea that government should be used as a vehicle to enhance social welfare gained

currency within the discipline in large measure because of his work.

Piero Sraffa has had an enormous impact on the discipline, mostly as a critic of the

neoclassical school of thought, despite having been a student of Alfred Marshall. He is most

well-known for his book The Production of Commodities by Means of Commodities, originally

published in 1960, which resolved a central problem of David Ricardo’s theory of value and set

the context for the huge Capital Controversy debate of the 1960s. The book also became the

basis for the development of alternatives to neoclassicism, bolstering the Neo-Ricardian and Post

Keynesian schools of thought, and setting the context for a reexamination of the Marxian

transformation problem. But, before this contribution, Sraffa had already made a name for

himself through a devastating critique he made in 1926 of Marshall’s theory of long run costs

(“The Laws of Return under Competitive Conditions”, The Economic Journal, vol. 36, no. 144,

(Dec. 1926), pp. 535-550) and for his role, along with Maurice Dobb, in amassing and editing

The Works and Correspondence of David Ricardo (1951). Here we’ll only focus on his critique

of Marshall’s theory of long run cost.

As you may recall, Marshall believed that competitive markets could continue to operate in

the long run, with the representative firm selling its output at a price that equaled minimum

average cost, even in the presence of increasing returns to scale. He arrived at this conclusion by

imagining that the reduction in average cost brought about by increasing returns to scale would

somehow be the result of economies that are external to the firms making up the industry, but

internal to the industry in question. Under such conditions one could envision the existence of

numerous firms competing against each other within an industry, bringing about the long run

competitive result of prices equaling minimum average cost. But this is impossible, since

economies external to a firm but internal to an industry are non-existent. Increasing returns to

scale are inevitably internal to a firm and this, by its very nature, means that firms can increase in

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size and, over the long run, bring about a transformation of the industry and corresponding

market, from one characterized by competition to one characterized as oligopoly or monopoly.

In short, it’s not true that leaving markets alone will ensure they’ll remain competitive and

bring about the classic result of price equaling minimum average cost. Instead, what might, and

actually does happen, is that leaving some markets and industries alone (those whose

technologies and organization are subject to increasing returns to scale) will inevitably lead to

their transformation into oligopolies or monopolies. And if this is the case then leaving markets

alone will instead lead to situations where price is consistently above minimum average cost,

even in the very long- run. Free markets, in short, do not necessarily bring about the efficiency

outcomes touted by their cheerleaders.

Because of this, Sraffa favored abandoning the assumption of price taking as a way of

characterizing the behavior of firms. He felt that a more appropriate, and truthful, way of

characterizing firms was to assume that they are price setters. The standard practice, going back

to the Classic era of political economy, was to imagine price-taking firms as a way of capturing,

as a first approximation, the behavior of markets in the context of free enterprise. But Sraffa

pointed out that a better first approximation would be to imagine that firms are price setters, even

though that also means having to abandon the efficiency claims traditionally made by supporters

of free markets.

Joan Robinson picked up on Sraffa’s suggestions and published The Economics of

Imperfect Competition in 1933 wherein she explored the case we now refer to as monopolistic

competition. The term monopolistic competition was actually introduced by Edward Chamberlin

in his book The Theory of Monopolistic Competition (1933) published in the same year as

Robinson’s book, even though both were initially unaware of each other’s work. Robinson

preferred to use the term imperfect competition, but because the term monopolistic competition

is more commonly used nowadays, we’ll stick with it when discussing Robinson’s work.

The point Robinson was trying to make was that the vast majority of firms do not operate

as price takers, even if they are not full-blown monopolists. She wanted a more accurate

representation of competitive markets, one that did not take the extreme case of price taking

behavior, but acknowledged that, in the real world, most firms exercise enough power to set a

price for their product that differs in varying degrees from the competition.

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The basic conclusion that emerges from Robinson’s discussion of monopolistic

competition is that markets characterized by such behavior tend to be inefficient. While

monopolistically competitive markets possess many of the classic properties of competitive

markets (large number of competing firms and relatively easy entry and exit into and out of the

industry), the major difference is that each firm possesses a certain degree of monopoly power

due to the existence of differentiated products or services. That is, each firm possesses a product

or service, or has unique characteristics, that set it apart from the competition and provides it

with enough power to set a price that differs from the competition. It’s important to note,

however, that unlike contemporary expositions of this theory, Robinson did not see her theory as

explaining one of multiple market types that populate capitalist economies. She instead saw it as

a way of capturing the behavior of most markets in capitalist societies. What’s more, rather than

explaining capitalist economies by starting out with the assumption of perfect competition,

which is still popular in the teaching of economics to this very day, she was hoping that

economist would start their explanations with the more realistic case of monopolistic

competition.

Monopolistically competitive markets are inefficient because they tend to be populated by

too many firms. Another way of saying the same thing is that too many resources are allocated to

the production of goods or service emanating out of monopolistically competitive markets. The

existence of excess capacity means that the typical firm in monopolistically competitive

environments tends to operate with a certain level of waste, more capital is allocated to the

delivery of the output than is really necessary. What’s more this outcome occurs even if the

typical firm (or representative firm, to use Marshall’s preferred phrase) is selling its output at a

price that matched average cost. What happens is that even though price is equal to average cost,

it’s not equal to minimum average cost. As a result, the representative firm in a monopolistically

competitive environment will tend to operate, in the long run, at a level that’s below the point for

which the firm’s productive capacity was designed for maximum efficiency, i.e., below

minimum average cost. The productive capacity of the firm is too big for the volume of business

normally undertaken.

If these kind of market structures are common in capitalist economies, which Robinson

believed they were, then the claim that competitive markets bring about efficiency, in the sense

that price equals minimum average cost and no more capital is allocated to their production than

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is necessary, is incorrect. Instead, the usual outcome of competitive markets (characterized by

monopolistic competition) is one of inefficiency, with too much capital allocated to the

production and delivery of the product than is really necessary.

Consistent with her critique of Marshall’s price taking firm as a first approximation to

understanding product markets, Robinson also introduced a critique of the price taking firm in

the labor market. As we’ve already seen, Sraffa had noted that the discipline should start

teaching economics by building on a theory of the price setting firm, instead of the price taking

approach that had dominated Marshallian economics. Robinson picked up on this idea by

introducing not only the notion of monopolistic competition, but the idea of monopsony as well.

Rather than imagining that, as a first approximation, the firm is a price taker in both the output

and input markets, as is still commonly done to this very day, Robinson was pushing for the

development of an economics which postulates a price setting firm in both markets.

While still employing the techniques of neoclassical economics, i.e., optimization,

Robinson introduced the theory of monopsony to note that firms with price-setting abilities in the

labor market move toward an equilibrium wherein the number of workers employed falls short of

the amount that would be hired under conditions of perfect competition while, at the same time,

paying a wage that’s lower than the marginal contribution of labor – the wage which would

presumably be paid to labor in a competitive environment. This was clearly a rebuttal of the

Marshallian claim that firms hire labor up to the point of their marginal contribution. And it

underscored the possibility of inefficiencies not only in the output markets, because of

monopolistic competition, but inefficiencies in the labor market as well, as a result of

monopsonistic power. The vision of market competition that emerges with Robinson’s work is

that capitalist market competition is one in which price setting is much more common than price

taking and, furthermore, the outcome of such competition is not efficiency, but rather varying

degrees of inefficiency.

Sraffa and Robinson were pushing for a more realistic understanding of market

competition, one which acknowledged the price-setting abilities of firms and the inefficiencies

such competition brings about. This was clearly at odds with the Marshallian faith in the

beneficial outcomes of free competition; a faith which is still central to the discipline. Sraffa and

Robinson were hoping to rectify this by putting economics on a more realistic, and less

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ideological, plane. That the discipline has not heeded their advice says more about the ideology

of the discipline than the science of Sraffa and Robinson.