Thursday, January 17, 2008

Adam Smith Was Not a 'Classical' Economist, Nor Associated with Equilibrium or Decreasing Returns

Dick Pountain [PC Pro] writes under the column title, ‘Idealog’, and two paragraphs that catch my intentions PCPRO (here):

That's where the connection with economics comes in, because classical economic theory has it that markets possess this same self-stabilising property - prices of some commodity may fluctuate wildly for a while, but will soon settle down to an equilibrium, at precisely the famous "market-clearing" price where supply exactly matches demand. Negative feedback is at work here because when something gets more expensive people buy less of it, which introduces that vital minus sign.

Smith described this effect 200 years ago as the invisible hand over, but it still dominates modern economic thinking in the form of neoclassical theory. The problem is that it's only partially true, but is held like a religious dogma by free-market zealots. It's always been clear to anyone not in thrall to such dogma that market equilibrium breaks down from time-to-time, but what's been recognised only recently is that economies exhibit positive feedback even in normal times, in the shape of speculative bubbles, winner-takes-all rewards and lock-in. The new wave of economists refer to such effects as "increasing returns", as opposed to the "diminishing returns" in classical theory responsible for market stability.”

This piece exhibits a mess of errors about Adam Smith in these two paragraphs, though what it ascribes to neoclassical economics may be correct in a sort of accidental way. The errors arise from merging the Chicago version of Adam Smith, whose connection with the Adam Smith born in Kirkcaldy is tenuous in the extreme.

‘Classical economic theory’ is not really the same as Adam Smith’s. It was a collective term invented by Karl Marx, and became a term of abuse in the hands of John Maynard Keynes.

If ‘classical theorists’ asserted that ‘markets possess this same self-stabilising property’ and ‘settle down to an equilibrium’ … ‘at precisely the famous "market-clearing" price’, it is up to them to justify this statement, which I suspect is shared by neo-classical economists too.

But not by Adam Smith!

But though the market price of every particular commodity is in this manner continually gravitating, if one may say so, towards the natural price, yet sometimes particular accidents, sometimes natural causes, and sometimes particular regulations of police, may, in many commodities, keep up the market price, for a long time together, a good deal above the natural price.’ (WN I.vii.20: p 77)

No economy since has operated as the models assume. Prices of the factors vary even in small locations; they often move in different directions too, and they are often not connected. Smith discusses these variations in wage labour

Smith explains it this way because his theory was complicated by the relationship between ‘natural price’ (where landlords, labourers and owners of the capital) receive their ‘normal’ rewards of rent, wages, and profits. But it was not an equilibrium in practice.

There is in every society or neighbourhood an ordinary or average rate both of wages and profit in every different employment of labour and stock. This rate is naturally regulated, as I shall show hereafter, partly by the general circumstance of the society, their riches or poverty, their advancing, stationary, or declining condition; and partly by the particular nature of each employment.’ (WN I.vii.1: 72)

Dick Pountain asserts: “The new wave of economists refer to such effects as "increasing returns", as opposed to the "diminishing returns" in classical theory responsible for market stability.”

Adam Smith laid the basis for increasing returns in his opening chapter on the division of labour and it lay, practically ignored, until the 20th century (Allyn Young, Economic Journal, 1928). After Adam Smith died in 1790, economics became dominated by the work of David Ricardo, whose perspective was dominated by the agriculture sector, still a major element ofBritain’s gross domestic product.

Diminishing returns was still taught at the end of the 20th century (I recall lectures in it as an undergraduate in the late 1960s. Its logic of a field having diminishing limits as labour and fertiliser was added and notions of a fishing boats becoming over-crowded with fishing rods so that marginal product of labour declined is compelling.

Yet cumulative improvements in productivity within the supply chains that contribute to a product (Adam Smith’s example was the common woollen labourer’s coat) (WN I.i.11: 22-23), would contribute increasing returns as unit prices fell among the final products’ inputs.

The famous pin itself over the years since its appearance in Wealth Of Nations

In 1820 there were 11 pin factories in Gloucester employing 1,500 people, out of a total population of 7,500, but by 1870 there was no longer a pin industry in Gloucester…By 1939 the number of manufacturers in the United Kingdom had shrunk to about twelve, and now [1978] there are only two, the Newey Group, with a pin factory in Birmingham, and Whitecraft Scovill, which has a factory in Gloucestershire. The concentration of the trade in the U.K. has evolved through mergers, take-overs, and firms leaving the trade.”

Professor Mike Munger (the source of these data) reports that there were “about 5,300 employees in pin factories in the U.S. in 2002, down from well over 8,000 in 1997. It’s hard to compare historically … but clearly the pin industry in the U.S. employed more than 50,000 in the late 1800’s.

Productivity per worker rises without useable practical limits over time. Think of knowledge; there are no limits.

In sum, Adam Smith did not assert equilibrium economics; mathematical general equilibrium is a myth in the real world; factor prices across a ‘neighbourhood’, let alone across an economy, vary; and Adam Smith was associated increasing not decreasing returns.


Blogger Mungowitz said...

Perhaps the most profound thing Smith ever said, at least in a chapter title, was the title of Chapter 3, Book I of WoN.

That the Division of Labor is Limited by the Extent of the Market.

It is tempting to interpret "Extent of the Market" as a hard constraint.

But in fact it is a dynamic, ever-changing limit, as Smith recognized. There is no such thing as market demand, or market supply, or a total number of consumers. It is all constantly changing with market conditions, costs of transport, cost of inputs, and political interference.

And, there is clearly no equilibrium. It took me years to appreciate Smith's insight, and I am still struck by its remarkable depth.

4:55 pm  
Blogger Gavin Kennedy said...

You are so right. It is by no means a restraint - it is something that the participants in the markets are always pressing outwards.

Allyn Young's article in the Economic Journal 1928 (available on line via his name from a Google search) shows exactly how the division of labour is cumulative along and among the supply chains which each producer provids inputs.

This produces increasing returns, not diminishing returns, not equilibrium (though neoclassical theorists have tried to make it so).

10:30 pm  

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