Changing Institutions and the Roots of Modern Economic Systems

1. Changing Institutions and the Roots of Modern Economic Systems I. The Classical View –Smith, Ricardo, Mill, Malthus • Change is a gradual process • Growth is primarily a function of capital accumulation • Malthusian model: • The iron law of wages (wages will always tend toward subsistence because whenever a surplus is available, population would grow) • Due to diminishing returns, output would generally increase at a slower rate than population, so per capita output will fall, putting downward pressure on population thru starvation. • Ricardian model: • economy will eventually stagnate; as population increased, agri land would become more scarce and food more expensive. Rising food costs, rising land rents, rising nominal wages, falling profits, falling investment rates. • Tendency toward equilibrium • Pessimistic view of econ development-econ growth would be limited by diminishing returns; stagnation was the likely result

2. II. The Neoclassical View Walras, Alfred Marshal, etc Marginal utility, utility, profit max The neoclassical view is much more optimistic Focus is more on improvements in human capital rather than on additions to physical capital and diminishing returns Same view of gradual, equilibrating change, but growth can be perpetual. Growth is a gradual result of: --Investment in physical capital --Technological progress resulting from the incentive to invest in research and development --Improvements in human capital resulting from individual incentives to invest in skills and education --Improvements in efficiency resulting from efforts to increase profits.

3. International trade and finance has a potential role in neoclassical view: --Governments of countries will engage in global competition --Firms are encouraged to produce more efficiently, and economic growth occurs from specialization and exchange. --The flow of goods, services, and capital between countries favors higher returns and lower costs. --As a result the forces of supply and demand tend to lead towards an equalization of prices, wages, interest rates, and policies across nations, and thus tends to lead towards increasing economic convergence. Convergence–that different ESs will become more similar over time b/c of the fundamental imperatives of econ growth & development.

4. III. Marxist Theories of Economic Change • 1) Karl Marx (1818-1883) • Born in Prussia of Jewish family converted to Christianity • Marx grew up in a learned family that prized education. • Father was a respected lawyer who advocated a Republican Germany

5. When Marx was 17 years old, he wrote a letter to his father, in which he pondered the choices that a young person must make when choosing a profession: "...But the chief guide which must direct us in the choice of a profession is the welfare of mankind and our own perfection. It should not be thought that these two interests could be in conflict, that one would have to destroy the other; on the contrary, Man's nature is so constituted that he can attain his own perfection only by working for the perfection, for the good, of his fellow men. If he works only for himself, he may perhaps become a famous man of learning, a great sage, an excellent poet, but he can never be a perfect, truly great man." Influenced by the philosopher Hegel Much of his work in London in collaboration with Friedrich Engels concept of dialectical materialism The Communist Manifesto “the triumph of the working class “ was not only desirable but inevitable

6. 2) Marx’s view on econ change: Economic change is evolutionary even revolutionary process, and one which determines social and political structures. Dialectical materialism: All progress (social and econ change) takes place because of a “struggle of opposites,” a naturally occurring process that cannot be influenced by individuals. People make social decisions solely in response to their econ needs and, thus, over time, the characteristics of a society are determined by its economic structure. Within a particular culture, classes arise based on people's relationships to the means of production. (e.g., there are owners, managers, workers, and so on) Marx saw history as determined by materialism and the struggle b/w socioecon classes In historical materialism, productive forces (econ forces, capital and labor) determine the relations of production (socioecon relationships people have to production), which in turn determines the superstructure (institutions, society). The dialectical process is that as productive forces change, contradictions b/w productive forces and the relations of production emerge and accumulate, and leads to qualitative (sudden and noticeable) change over a short period. Each econ system (thesis) carries inside it the seeds of its own opposite (antithesis) and therefore of its own destruction. Replacement of an old economic order with a superior one Capitalism is a qualitative leap over feudalism Socialism is a qualitative leap over capitalism Societies advance according to a predetermined pattern–primitive production, feudalism, capitalism, socialism, and communism

7. 3) Marx’s view on capitalism Inefficient feudalism replaced by far more efficient capitalism As capitalism emerges, there is an accumulation of capital (wealth) by the bourgeoisie (the capitalists) and the creation of a free labor force, the proletariat; Capitalism is a system of exploitation of one class of people by another. Extreme dichotomy between capital and labor Sets up two classes which must eventually conflict.

8. 4) The Model History is driven by class conflict. Marx models an internal contradiction which sets up the conflict between classes. Marx proposes a “labor theory of value” Long run value V is determined by three things amount of labor used to produce the good, or direct labor cost (variable capital) v indirect labor through capital and intermediate inputs (fixed capital) c the capitalist’s surplus (surplus value or profit s) V = c + v + s Where does this surplus values come from? Workers are paid a subsistence wage Employers compel workers to produce a value above that needed to generate subsistence wage The workers get the subsistence wage, the capitalist gets the surplus the “Reserve Army of the Unemployed” keeps wages at subsistence level and continually threatens employed workers, pushing them to work hard to produce for the capitalists. exploitation of labor

9. Example a worker in a factory is given $30 worth of material, and after working 3 hrs producing a good, and using $10 worth of fuel to run a machine, he creates a product which is sold for $100. According to Marx, the labor and only the labor of the worker increased the value of the natural material to $100. The worker is thus justly entitle to a $60 payment, or $20 per hour. If the worker is employed by a factory owner who pays him only $15 per hour, according to Marx the $5 per hour the factory owner receives is simply a rip off. The factory owner has done nothing to earn the money and the $5 per hour he receives is “surplus value” representing exploitation of the worker. Even the tools which the factory owner provided were, according to Marx, necessarily produced by other workers. According to the labor theory of value, all profits are the rightful earnings of the workers, and when they are kept by capitalists, workers are simply being robbed. On the basis of this theory, Marx called for the elimination of profits, the workers to seize factories and for the overthrow of the “tyranny” of capitalism.

10. Marx models an internal contradiction, which sets up the conflict between classes • Let the “Rate of Labor Exploitation” is: • s' = s/v (profits divided by wages) • Let the “Organic Composition of Capital” is: • q = c/(c+v) (the ratio of fixed to total costs) • Let the “Rate of Profit” is: • p = s/(c+v) (the ratio of surplus to total costs) • Using the expressions for s', q, and p, we have: • p = s'(1 - q) • the rate of profit is: • directly related to the exploitation of labor • inversely related to the organic composition of capital— As the organic composition of capital rises, the rate of profit falls

11. 5) Marx identified three laws that made the collapse of capitalism inevitable: The law of concentration of capital Each firm in cut-throat competition for each other’s business Driven to gain temporary competitive advantage over others The way to do this is to introduce labor saving innovations (that is, replace labor with capital) But innovation diffuses quickly through economy, dissipating innovator’s advantage Thus, throughout the economy, capitalists are driven to accumulate capital in order to replace labor with capital But as labor is replaced with capital, the organic composition of capital rises As the organic composition of capital rises, the rate of profit falls Capitalists try to keep up rate of profit by exploiting labor more and more More and more firms fall behind and fail bankrupt capitalists lose their capital and join the swelling ranks of the proletariat

12. The law of a falling rate of profit Competition and increasing productivity would lead to decreasing returns on investment, making it harder to make a profit, so Capitalists would not invest in new production. Companies don’t hire new workers, so employment and profits both fall. Capitalists try to keep up rate of profit by exploiting labor more and more The law of disproportionality: tendency toward overproduction workers too poor to buy much capitalists too busy saving (accumulating capital) economic depressions become more and more severe These three laws represent contradictions Marx believe were inherent in the capitalist system. Marx developed this as a theory of relations within, not between societies.

13. Revolution The stage is set for revolution proletariat swelling and becoming increasingly exploited bourgeoisie shrinking and becoming increasingly cut-throat the proletariat rises up in revolt, replacing the bourgeoisie as the dominant class and creating the new socialist order What happens after the revolution? Dictatorship of the Proletariat (working class) Socialism: government acts in the interest of the proletariat to eliminate capitalism. Markets replaced by more rational planning. State ownership replaces private ownership. Workers become more productive, and scarcity is eliminated. Socialism would follow the rule, “From each according to his ability, to each according to his labor.” Communism would follow, “From each according to his ability, to each according to his need.” Emergence of Advanced Communism: self –organizing and socially –interested. Markets, planning, money, classes, and government all no longer necessary Capitalism is a necessary step on the road to socialism and eventually communism

14. Implications of the model • Contradictions between classes will be more intense in the most advanced capitalist countries, and the revolution would occur in the most advanced capitalist countries (Germany, UK). • Did it? NO • Revolution occurs in Russia • hardly a mature capitalist economy • Lenin later extended the model to explain this inconsistency • Weaknesses (contradictions) of Marxism: • Capital accumulation does not lead to falling profit rates. • The revolution did not come first to the most advanced capitalist economies. • Value cannot simply come from labor, or management, capital, entrepreneurship, luck, et cetera would not matter. Instead, it comes from scarcity–what people are willing to give up on the margin to have it. • Not foreseeing the flexibility and adjustability of capitalism (increased government role, labor unions, etc.).

15. IV. Lenin’s Contributions • Vladimir Lenin (1870-1924)--born of educators/government bureaucrats • a member of the bourgeoisie • a well educated intellectual • deeply committed to welfare of the common man

16. A Problem with Marx’s Theory Theory implies that revolution will occur where capitalism the most advanced No sign of revolution in most advanced capitalist economies by the 1910s in fact, there is greater and greater prosperity Great Britain Germany United States Instead, revolution occurs in Russia. Why?

17. Lenin’s “Monopoly Capitalism”— ”Imperialism the higheststage of capitalism,” 1916 Monopoly "Monopoly is the transition from capitalism to a higher system.'' "Monopoly is exactly the opposite of free competition; but we have seen the latter being transformed into monopoly before our very eyes, creating large-scale industry and eliminating small industry, replacing large-scale industry by still larger-scale industry, finally leading to such a concentration of production and capital that monopoly has been and is the result." As capitalism advances more and more firms fail and are taken over Markets become increasingly monopolized Uneven development Most advanced economies need to find new sources of raw material and labor they start to colonize under-developed countries imperialist expansion/capitalist imperialism less advanced capitalist states like Russia cannot compete Advanced states bribe the domestic proletariat with share of surplus buying domestic stability Labor exploited fully in the colonies colonial labor powerless to overthrow a foreign power

18. Russia is a weak link advanced enough not to be colonized itself but not enough to be a colonizer cannot export labor exploitation like the more advanced, imperialist powers Thus the Marxian scenario can be played out only in a weak link like Russia Even without bribe, proletariat not revolutionary by nature must be led by bourgeois intelligentsia like Lenin! Combination of a weak-link economy and a Lenin-led intelligentsia and the result is the Russian Revolution of 1917

19. Characteristics of Capitalism in Marxist-Leninist Thought Extreme inequality of income Vulnerability to macroeconomic instability Law of disproportionality Law of concentration of capital Law of falling rate of profit Imperialistic tendencies Marxist-Leninist Theory conditions socialist philosophy importance of equality in distribution of income importance of economic stability prominence of imperialism in socialist attacks on capitalism

20. V. Creative Destruction 1.) Joseph Schumpeter. • The driving force of evolution in the capitalist economy is innovation (the development and implementation of new products, new ideas and new ways of doing things) • Fundamental condition of financial development, the role of the Entrepreneur, and the process of Creative Destruction in producing technological progress and economic growth. (process of new ideas replaced the old) • The decline in entrepreneurial activity would be a fundamental reason for eventual decline of capitalism

21. VI. The New Institutional Economics The New Institutional Economicsfocuses on how institutions evolve and on the effect of this evolution on econ performance. The New Institutional Economics was inspired by: Friedrich A. Hayek-argued that economic organizations arise according to a spontaneous order in which new organizations, laws, regulations, and customs are tested by daily econ life. Coase: organizations (e.g. business enterprises) are created when transactions costs of market transactions are too high.

22. 2. New Institutional Economics (Douglas North, Mancur Olsen, etc.) explain institutional change by examining property rights; transaction costs, and rent seeking. a) Douglass North—the idea is that societies choose among available alternatives that work best to solve their particular problems. Over time, more efficient economic systems evolve due to this selection process. b) The basic principle of this theory is the economic evolution—is not just an idea that economic and social change occurs over time; it is a theory about how and why those changes occur. c) The New Institutional Economics views institutional change as being dictated by econ variables, whose course of change cannot be predicted in advance. The path depends on the starting point (initial conditions) and on the course of transaction costs, property rights, and other factors. d) Whereas Marx viewed institutional change as inevitable and as following a predetermine path, the NIE views institutional change as being dictated by econ variables, whose course of change cannot be predicted in advance.

23. VII. Change in Capitalist Economies Change is more gradual and less visible than change in socialist econ, which comes from above. 1. Property Rights Privatization-property that have been state-owned is transferred to private owners Nationalization-when privately owned property becomes publicly owned 2. Competition State competition policies: Relaxation of trade barriers to international trade Deregulation Antitrust policy Growing international competition and deregulation should increase the degree in competition in capitalist economies.

24. 3. Income Redistribution by the State Tax system Progressive tax (income tax-tax’s share of income increase with income) Regressive tax (on goods-tax’s share of income decrease with income) Distribution of transfer payments to low-income recipients (social security, welfare programs) 4. Worker Participation Fixed wage contract Profit-sharing contract 5. Government Intervention Fiscal and monetary policies Indicative planning- the market is the principal instrument for resource allocation, but a plan is prepared to guide decision-making Industrial policy-general strategy of development worked out by government agencies

25. VIII. Change in Socialist Economies 1. Socialist Reform Models Improving the planning mechanism Implication of more sophisticated computer technology, better info channels, and better planning methods Organizational reform Introduction of intermediate organizations (b/w ministries and enterprises—associations; shift from sectoral to regional planning) Decentralization Shifting a decision –making authority and responsibility from upper to lower levels. IX. Transition Strategies: Shock therapy-the transition must occur on all fronts as quickly as possible. Gradualism-the transition must occur gradually and not on all fronts simultaneously