Cameron Luke Wilson

WLSCAM003 – Cameron, Wilson – 3 – 4. 1. Marginalism and Market Liberalism 1.1 Marginalism The Free Market Foundation (FMF) was founded in 1975 in response to increasing government intervention, implementation of protectionist policy, high inflation, price controls, and the racial discrimination of the 1970s (FreeMarketFoundation.com). The FMF advocates liberty, equality before the law, and freedom to operate in the market to alleviate poverty through economic growth. They are a libertarian movement that draws many of their ideas from marginalism and market liberalism. Marginalism, as explained by the Austrian School of Economic Thought, is; “​For each good, the utility of a larger quantity is greater (or at any rate not less) than that of a smaller quantity, whereas the marginal utility of the larger quantity is less (or at any rate not greater) than that of the smaller.” (Menger, 2003:532) Simply put, larger amounts of a good are preferred to smaller amounts of a good, however, the additional benefit or value (utility) derived from an additional unit of a large amount of a good is less than the additional utility derived from an additional unit from a small amount of a good. Mathematically, marginalism can also be explained by words, that is, “any real number increased by 1 is equal to 1 increased by that number.” (Menger, 2003:532). This can be shown by; x+ ​ 1 = 1 + ​x 1.2 Marginalism and Market Liberalism It is said that for firms to maximise profit they must operate where their marginal revenue (MR) is equal to their marginal cost (MC). That is, the cost of producing one additional good equals the revenue generated by that one additional good. By operating on this frontier, firms capture all the economic rent possible. If firms produce more than this, they will begin making losses per additional good produced, and if they produce any less than this, they will have unrealised profits on each additional good produced. For firms to operate where MR = MC, they would need to operate in a market that allows for-profit maxing firms. A degree of market liberalism would have to be present for firms to operate on the margin. Such liberties would be free markets, limited or no government intervention or policies that allow for more economic freedom of the firm. Thus, it is seen that marginalism only truly has a place in liberal markets. It is by marginalism that goods derive their value in the market, how firms decide to optimise operations and how consumers choose what to purchase. 1.3 Hayek, Market Liberalism, and Policy Friedrich Hayek was an Austrian economist who opposed central planning and advocated free markets and market liberalism. Hayek believed in rule of law, private property, constitutionalism, and individual liberty, which he drew from the political ideas of Hume and Kant (Jacobs, 1991:34). Hayek is not opposed to government policy so long as it promotes free markets, private property, and freedom to contract. He places great emphasis on the rights and duties placed on market participants to maintain a just system that results in no exploitation. Hayek says that this is possible through a sound constitution, equal access to the law as well as a judicial system separate from the market that enforces the rights and duties of market participants (Jacobs, 1991:36). 1.3 Polanyi on Hayek and the “impossible Utopia” Karl Polanyi was an Austro-Hungarian academic who specialised in the social sciences, from economics to social philosophy. Polanyi viewed the idea of economics being a separate entity from society as absurd. He argues that society and economics are “embedded”. That is, the economy is reliant on society, and society’s dependency on goods and services results in society’s dependency on the economy (Dale, 2010:189). Polanyi argues that the economy cannot be studied in isolation from society. It is from this idea of “embeddedness” that Polanyi drew the idea of a free market being an impossible utopia. Some believe that Hayek’s free market would require a “disembedded” economy from society, playing by its own rules (self-regulation), treating labour and capital as pure commodities. However, Polanyi’s view on Hayek’s free market is harsh at best. Hayek never thought of the free market as a utopian solution, nor did Hayek propose a “disembedded” economy from society to achieve a free market system. Hayek relies on a sound constitution and a just judiciary to maintain free markets. Thus, Hayek’s libertarian view of the market is embedded in society, relying on proficient policy, law enforcement and an upright constitution, all of which are required foundations for a free and functioning society. 1.4 Conclusion The FMF draws their ideology from an Austrian School of thought, relying on liberty, private property, and freedom to contract in order to promote economic growth and employment. The libertarian market relies on the idea of marginalism and how firms would require market liberalism to operate on the margin, that is, MR = MC. It is through marginalism that the economy and markets determine value; how firms determine value and how consumers determine value. Through marginalism does the economy marry value, producers, and consumers. Hayek was a proponent of market liberalism and believed that sound social foundations were required to eliminate exploitation whilst ensuring a liberal market. Polanyi argued that market liberalism was an impossible utopia due to the embeddedness of society in economics and how economics cannot be studied in isolation. Finally, it was discussed how Hayek’s market liberalism relied on government policy, a sound constitution, and liberty to work, thus requiring the social foundations of a free and functioning society. This demonstrated that Hayek’s free-market was socially embedded. 2. Cambridge Capital Controversy, its Contributors, and its Implications for Economic Policy 2.1 Introduction to the Cambridge Capital Controversy The Cambridge Capital Controversy (CCC) came to be after the Marginal Revolution. Jevons, Menger and Walras introduced the idea of marginalism, now diminishing marginal returns. It was the idea that an additional unit of a scarce good has greater value than an additional unit of an abundant good. This solved Adam Smith’s “diamond-water” paradox (Cohen & Harcourt, 2003:201). The CCC argued the controversy of capital: how to accumulate it, how to measure it, how to aggregate it, and how to value it. Two schools of thought argued the CCC; in the English Cambridge Corner (Classical School) were Piero Sraffa, Joan Robinson, Luigi Pasinetti and Pierangelo Garegnani. In the American, Massachusetts Cambridge Corner (Neo-Classical School) were Paul Samuelson, Robert Solow, Frank Hahn, and Christopher Bliss (Cohen & Harcourt, 2003:200). The Controversy began when Robinson wrote of the problems of the production function. She wrote, “… the production function has been a powerful tool of miseducation”, saying that students were taught that output was determined by hours of labour and ‘some’ measure of capital without ever being taught what capital is measured in (Cohen & Harcourt, 2003:199). Round one of the CCC covered the “Meaning and Measurement of Capital in the Scarcity Theory of Price”. Writings as early as 1936 from Sraffa to Robinson highlighted the “reswitching” and capital reversing problem. That is, for any value of the rate of interest, firms will operate at an optimal ratio of capital to labour (K/L), thus ensuring maximum output. However, with a change of rates of interest, firms would have to change their K/L structure to operate at an optimal point. This reswitching immediately undermines the soundness of an aggregate production function, as the changing of capital structures for firms does not provide the aggregate production function model with a homogenous measure of capital. Demonstrated below is the reswitching problem: Suppose a firm has production methods ​a a​ nd ​b. ​At rates of interest above 100%, ​a is preferred to ​b. ​At rates of interest between and including 50% and 100%, ​b is preferred; and at rates of interest below 50%, ​a ​is preferred. This is capital reversing. Figure 2.1: Capital reversing or “reswitching” due to changes in rates of interest (Cohen & Harcourt, 2003:203). Another problem with measuring the value of capital is that it is said that capital‘s value is dependent on the rate of interest, yet capital is used to determine the rate of interest-based on the good it produces (Cohen & Harcourt, 2003:204). There is a circularity in reasoning, and a problem arises in the valuation of aggregate capital in the production function. Round two highlights the difficulty in measuring capital accumulation. Robinson argued the trouble of comparing stocks and flows of capital. She says that you cannot take stocks at different points in time and proceed to play them as if they were a movie (Cohen & Harcourt, 2003:204). This adds to the trouble of calculating growth using ‘some’ measure of capital in the production function. In round 3 the Neoclassical school fights back. Solow defends the production function but admits that the problem with measuring capital arose due to the “intertwining of past, present, and future” (Cohen & Harcourt, 2003:205). Solow uses wit to defend the model further by saying, “if God had meant there to be more than two factors of production, He would have made it easier for us to draw three-dimensional diagrams.” Capital was explained to also be malleable, nicknamed “putty capital. That is, capital could be turned to goods and back to capital again, flowing to equalise rates of return (Cohen & Harcourt, 2003:205). The Neoclassicals also attempted to argue with empirical evidence but it was deemed not to be satisfactory as the evidence disallowed capital-reversing. Round four argued the general equilibrium model. These models aimed to explain all prices including factor prices by relative scarcity. The models explicitly took preferences, endowments, and technology into account. The problem with the general equilibrium model is that it did not support the idea that inputs to production would be cheaper if more of it were available (Cohen & Harcourt, 2003:207). Finally, general equilibrium relied upon simultaneous equations to find solutions thus is circularly reasoned by nature. There appear to be no winners in the CCC as both sides still have many unanswered issues, however, the debate brought to light the problems of capital and how policy regarding capital should be carefully made. 2.2 Capital and its Policy implications Policy implementation that affects the microeconomy will change how firms in respective sectors choose to operate. By reswitching to a new method of production, firms ultimately change their aggregate production function. This does not help policymakers as the intended policy is aimed at firms’ current production functions. The reswitching problem highlights the difficulty of proposing policy based on a sector’s aggregate production function. It can thus be argued that aggregate production functions do not exist and hold little value as policy implementation tools. Instead, policy should be aimed at how firms would best respond to the proposed policy. On the macroeconomic level, rates of interest also affect production and accumulation of capital. However, capital also determines rates of interest. Therefore, it must be understood that this is circular by nature. By changing rates, capital production and accumulation will change in response, which will influence the future determination of rates in the long run. Setting rates will result in the Wicksell reswitching problem as discussed above. Equilibrium in the credit and capital markets is affected by flows of capital. This means that equilibrium is always moving with the flow measure of capital accumulation. Therefore, policy implementation based on the stock measure of capital and its respective equilibrium will result in unintended outcomes. This problem becomes apparent when capital and credit markets are out of equilibrium and policy makers wish to get back into equilibrium. However, once policy is implemented (through rate changes), the equilibrium point that policy-makers wish to get to will have changed due to the effects rates of interest have on capital accumulation. Thus, it needs to be noted how the economy will best respond to such policy implementations. 2.3 Conclusion The CCC highlights the issue of measuring capital and its accumulation. It is important to understand the circularity of these capital models. Thus, chasing equilibrium would be futile by using interest rate policy only. It is imperative to implement policy that relies on behavioural economics. It is also equally important to understand how firms will best respond to policy implementation. References Free Market Foundation. ​About us, who we are. A ​ vailable: http://www.freemarketfoundation.com/About-Us-Who-WeAre [2017, April 27] Karl Menger, 2003. ​Karl Menger, Austrian marginalism and mathematical economics. A ​ vailable: https://link.springer.com/chapter/10.1007/-_46#page-2 [2017, May 01] Struan Jacobs, 1991. ​Rationalist or anti-rationalist? Chandran Kukathas’s Hayek and modern liberalism. A ​ vailable: http://www.cis.org.au/app/uploads/2015/04/images/stories/policymagazine/1991-autumn/1991-7-1struan-jacobs.pdf [2017, May 01] Gareth Dale, 2010. Karl Polanyi. ​The limits of the market. ​Polity Press. Cambridge, UK. Avi J. Cohen and G. C. Harcourt. 2003. ​Whatever happened to the Cambridge capital theory controversies? ​The journal of economic perspectives, vol. 17, no. 1 (Winter, 2003), pp. 199-214. American Economic Association. Available: http://www.jstor.org/stable/pdf/-.pdf [2017, May 03]