POLITICAL ECONOMY OF GROWTH SECSP 01 CFU 9

POLITICAL ECONOMY OF GROWTH SECS-P 01, CFU 9 Finance and Development academic year 2016 -17 4. CLASSICAL THEORIES Roberto Pasca di Magliano Fondazione Roma Sapienza-Cooperazione Internazionale roberto. pasca@uniroma 1. it

Economic Classical Theorist (XIX century) • Adam Smith (1723 -1790) • David Ricardo (1772 -1823) • Thomas Robert Malthus (1766 -1834) • Karl Marx (1818 -1883)

Origins of Economics: the Liberalism of Adam Smith • The father of liberalism is considered Adam Smith who published in 1776 “The Wealth of Nations”, the birth of modern economics • Smith’s theories designed the modern economic thought by discovering the superiority of the free market over any other structure • Among the many ideas put forward by Smith, one was particularly successful: that of the famous metaphor of the “invisible hand” THE INVISIBLE HAND • The metaphor of the invisible hand is the basis of the liberal view of the market economy • The market (as if it were guided by an invisible hand), if left free to operate according to its own rational logic, produces an unexpected result that is also desirable at the same time: it maximizes the wealth of the entire society • Such a result is reached without anyone explicitely pursuing a collective goal. Rather, the collective goal is reached thanks to the selfishness of individuals Roberto Pasca di Magliano 2016 -17 Pagina 3

Adam Smith and the divison of labour (I) An Enquiry into the Nature and Causes of the Wealth of Nations (1776) -> Optimistic view in contrast with the other classical economists Major Contributions: • Division of labor The specialization and concentration of workers on their single subtasks leads to greater skill and greater productivity on their particular subtasks than would be achieved by the same number of workers each carrying out the original broad task. • Specialization of labor + Increasing of the labor productivity + Increasing returns Divison of labor allows: 1) improvement of the dexterity of the workman increases the quantity of the work he can perform; 2) advantage gained by saving the time commonly lost in passing from one sort of work to another; 3) everybody must be sensible to how much labor is facilitated by the application of proper machinery. • Example: pin makers were organized with one making the head, another the body, each using different equipment!

Adam Smith and the divison of labour (II) • • • Prevalent in industries where, thanks to division of labor, productivity has been increased In agriculture and mining, instead, decreasing productivity, because of the fixed factor earth The growth of the product depends on the investments and the accumulation of capital: I = f (S) generated by industrial and agricultural profits, and the degree of specialization of labor Division of labor determines the level of labor productivity, but the division of labor is limited by the size of the market, which in turn depends on the division of labor itself (interactive cumulative process): “As it is the power of exchanging that gives occasion to the division of labour, so the extent of this division must always be limited by the extent of that power, or, in other words, by the extent of the market. When the market is very small, no person can have any encouragement to dedicate himself entirely to one employment, for want of the power to exchange all that surplus part of the produce of his own labour, which is over and above his own consumption, for such parts of the produce of other men's labour as he has occasion for” (Book I, Chapter III)

Adam Smith and the increasing returns to scale (I) • • • Agriculture it produces surplus essential for industrial growth… but it is characterized by diminishing returns Technical progress in agriculture is essential to increase yields Contribution from the supply side: the free agriculture workers less productive in industry that will benefit from increasing returns 18° century was a period when the agricultural revolution was spreading before the advent of the industrial revolution Contribution from the demand side: the growth of the agricultural surplus allows the increase in demand for non-agricultural products that can be bought by exchanging the surplus generated from agriculture Size of the market The market is limited as a result of trade restrictions and therefore the division of labor can not manifest all its benefits Therefore, support the need to free enterprise accompanied by free trade (laissez-faire and laissezpassé) inside and outside Importance of agricultural exports for growth

Adam Smith and the increasing returns to scale (II) • Engine model is the accumulation of capital profits generated by industrial fuel investments • If the rate of profit falls, it reduces the incentive for investment ambiguity: • On the one hand, if the capital stock grows (k), the rate of profit is decreasing as a result of the competition between capitalists and wage growth • On the other hand, new investment opportunities are generated and the rate of profit may increase or decrease depending on whether the investments are made in new or old technologies Then the rate of profit may increase or decrease and there is no reason to think that we are moving towards a steady state or, worse, that it is inevitable (Malthus, Ricardo, Marx) • Smith's theories have had great influence, for example of Myrdal, Hirshman, Lewis and Kaldor

Thomas Malthus (I) •

Thomas Malthus (II) As growth occurs, the population rapidly increases and reduces the per-capita income • The rate of profit is being eroded by the growth of industry in agricultural prices, resulting from the increased demand diminishing returns in agriculture, as well as an increase in costs • The application must grow in line with the production capacity, which depends on investment, but there is no assurance of sufficient savings to the investment necessary • Possibility that the per capita income to settle the existence or is caught in a "trap equilibrium Low Level” • Pessimistic view of economic growth

David Ricardo (I) Principles of Political Economy and Taxation (1817) 1) Inevitable steady state, without growth, again as a result of diminishing returns in agriculture; 2) As in Smith, growth depends on capital accumulation, which depends on reinvestment of profits; 3) Profits are sacrificed by subsistence wages and payment of rents to landlords, which tend to grow due to the increase in agricultural prices due to diminishing returns and growth of the marginal costs (non productive lands); 4) Theory of distribution according to the participation in the process of production: capitalists/rentiers/ workers

David Ricardo (II)

David Ricardo (III) • With employment equal to L, and a total product equal to ORZL, rent is determined by the difference between the average product and the marginal labor (Przy) • The subsistence wages are set at OWXL • Profits are equal to the difference between the average yield and yield more wages (WPYX) • Profits are destined to disappear as the average product is decreasing while the subsistence wages are obviously hard • In equilibrium the rate of profit is equal to that in agriculture and in industry, since the rate of profit in agriculture decreases, the capital moving to industry, causing a decline in the rate of profit in industry • Profits in industry tend to decrease because wages in terms of food increase for livelihoods • But according to Ricardo (unlike Malthus), there are no problems of effective demand because (as will later say J. B. Say) supply growth creates its own demand

David Ricardo (IV) • Profits are engine of growth investments ensure the accumulation of capital; • There are no limits on the accumulation until the return is positive • When you cancel the profitability in the industry (due to increased wages and a reduction in the average product) we arrive at steady state • Any factor that reduces the accumulation anticipates steady state • So he was contrary to taxes, tariffs on production, as well as duties on imports, especially of food • Campaign for the abolition of the Corn Laws • If food prices remain low, wages do not rise and leaves the steady state In fact erroneous assumptions because: • It is said that the average product decreases in manufactury (industries), but he did not consider the role of technical progress!

Karl Marx (I) Das Kapital (1867) the collapse of capitalism • Like all classics, he believes that the rate of return on capital is going to reduce as the economy grows, but Classics provide different motivations: - According to Smith competition between capitalists; - Ricardo it depends on the reduction in yields in agriculture and the reduction in profits forced in wages (up to the increase in agricultural prices) Marx the limit to growth is not the steady state but the rise in the organic composition of capital (see below). For Marx the heart of the capitalist system consists in the process of capital accumulation: D-M-D '. In the cycle of money-commodity-increment money.

Karl Marx (II) Labor theory of value surplus value generated in the exchange between labor and capital Market value vs. use-value Marxists argue that the value of goods should be calculated in terms of the amount of labor that went into their production. Conventional economics does not do this; it takes as value whatever will be paid in the market place! The amount of capital and labor purchased by the capital is greater than the amount of labor embodied in goods purchased from wages (subsistence).

Karl Marx (III) • The quantity D (MONEY) is spent in: • C, means of production, constant capital. It does not generate surplus; transmits value unchanged to the good product; • V, labor (variable capital) produces surplus (surplus workday on time socially necessary to produce subsistence) generates surplus (surplus product over wage goods) surplus value (through the sale of surplus production).

Karl Marx (IV) • • • The value of a commodity and therefore given by the amount of work embedded in it: c + v + s. s / v: rate of surplus value, and 'the relationship between surplus and variable capital measuring the degree of exploitation of labor c / v: organic composition of capital, and the ratio of constant capital and variable capital. The rate of profit is given by the ratio between the quantity of labor embodied in the built-in surplus and total capital: r = s / (c + v) = (s / v) / (1 + c / v) is all the greater as greater is the rate of exploitation and therefore the lower is the organic composition of capital. Marx argues that a rising organic composition of capital is a necessary effect of capital accumulation and competition in the sphere of production, at least in the long term. This means that the share of constant capital in the total capital outlay increases, and that labor input per product unit declines.

Karl Marx (V) • • Cyclical crisis: Capital accumulation reduces the reserve army of labor (workers) the wage increases by reducing s / v capitalists react by substituting capital for labor the army of unemployed workers is reconstituted but not be able to consume goods produced by overproduction crisis (lack of effective demand in the field of consumer goods). Final crisis: Competition among capitalists leads to adopt new techniques capital-intensive rising organic composition of capital. The positive effect of s / v of technical progress incorporated into constant capital is not enough to offset the increase in c / v falling rate of profit!