EC412 FALL 2003—LECTURE NOTES designed to support chapter 2 in Ekelund & Hebert

The following Notes treat of the same topics as Ekelund & Hebert do, but with my spin, which is slightly different than theirs. You are responsible for both.

Someone asked me what level of detail did I expect students to remember at test-time? My answer to this question is “yes. ” Seriously, every detail is potentially of some significance to understanding the course of the history of economic thought, although the relative importance of various details varies. What this means for the grade in this class is that there are positive returns to memorization throughout the range of possibilities; a good memory for details is, ceteris paribus, to your advantage at grade-time. On the other hand, perfect memorization of all the little details is not strictly necessary in order to pass this course. I don’t expect you to remember what color socks David Hume wore on the day he died, but it would be nice if you would remember who he was and why he was important (by the way, like the average Scot of his time, I don’t believe Hume even wore socks).

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Ruminations on Things Economic Amongst the Ancient Greeks

This is a complex sub-topic of great interest to a host of serious scholars, who have produced a veritable mountain of detailed studies. Rather than becoming mired in minutiae, I will merely survey some of the relatively more interesting “crest-line hexes” on this mountain. [Note that while much of the following covers the same aspects of these early contributions, as does the Ekelund-Hebert textbook, there are a large number of differences, too. You are responsible for both at test-time.]

I. An outline of major themes

The following insights of the ancient Greeks were particularly important in the sense that they exerted a direct influence on the thinking of the writers of the eighteenth century “Scottish Enlightenment” (and, by this route, modern economics). I will focus 3 writers in particular:

PLATO (447-327 BCE); ARISTOTLE (384-322 BCE); XENOPHON (427-355 BCE).

a) THE DIVISION OF LABOR

PLATO (in his Republic and elsewhere) understood the basic advantages of the division of labor in production. Productivity can be increased by specialization. His reading of Plato directly influenced Adam Smith when formulating his own famous account of the division of labor in WN.

XENOPHON, writing in his Cyropaedia, also understood the division of labor, and understood the idea in a very sophisticated way. He explained that the division of labor is limited by the extent of the market, an important notion usually attributed to Adam Smith.

In fact, Adam Smith used exactly the same examples of the division of labor as Xenophon, suggesting that the former may have directly influenced Smith (a classical scholar).

b) PROPERTY RIGHTS

PLATO (again, in the Republic) had a rudimentary understanding of the importance of secure property rights in generating maximum output in society.

XENOPHON (in his Hiero) argued that the aggregate wealth of the state could be enhanced by the use of prizes to stimulate higher general levels of agricultural production. His discussion clearly articulated a very modern-sounding account of the role of incentives in stimulating economic behavior.

ARISTOTLE (in the Nicomachean Ethics) argued that abolishing private property would increase violent conflict in society, rather than reduce it, because property rights provided a set of rules for peaceful exchange.

o He also thought that any attempt by the state to engage in egalitarian wealth redistribution was a violation of justice.

o He appears to have understood that exchange is fundamentally about trading property rights, not physical objects.

 c) THE THEORY OF DEMAND

ARISTOTLE understood that PRICE was partly determined by DEMAND, and that DEMAND was a function of UTILITY. This implied that goods were only valuable because individuals gained in utility by consuming them, i.e., subjective value theory. This utility was subject to change, and hence the value (i.e., price) of goods changed over time.

II. DEVELOPMENTS IN ECONOMIC THOUGHT AFTER THE ANCIENT GREEKS:

Scholastics (the Schoolmen): medieval philosophers who combined the ideas of the ancient Greeks (particularly Aristotle and Plato) with Catholic theology.

· Most of these writers were employees of the Roman Catholic Church. Why, then, should we not dismiss scholasticism as simply Church propaganda?

· The Church had powerful incentives to allow freedom of inquiry on the part of its "employees"; sound economic analysis encouraged efficient public policy, fostering economic growth and development, which benefited the Church.

While there were dozens of different writers in the Scholastic tradition, SIX stand out in the history of economic thought.

1. Albertus Magnus (1206--1280)

-- Recognized that the value in exchange of a good must comply somehow with the cost of production.

--- Thought that the economic value of goods was measured in relation to labor. However, he understood that other costs besides labor costs could also have an influence. He noted that if market price could not cover costs of production, production would eventually stop. Costs, in other words, were a regulator of value.

2. Thomas Aquinas (1225--1274)

-- He argued that price varies with need (indigentia). This idea was new, and anticipated the economic concept of elasticity of demand. Aquinas, however, merely hinted at the concept of elasticity.

Aquinas also promoted (although he did not invent) the idea of "just price"; price is unjust when it exceeds the quantity of value in an article of exchange.

3. Henry of Friemar (1245--1340)

Introduced the idea that indigentia could be an aggregate measure (Aquinas’s notion referred only to the individual level). This was a major step towards the modern notion of market demand, the expression of the desire and ability to pay of all buyers of a good.

 4. Jean Buridan (1295--1358)

Anticipated the modern notion of effective demand. Extended the idea of indigentia beyond "necessities" to also include "luxuries." Indigentia was clearly defined as desire backed by ability-to-pay.

5. Gerald Odonis (1290--1349)

He developed a theory of wage differentials based on the understanding that different skills varied in their contribution to production, and that those skills required relatively different costs to acquire.

6. Bernardino of Siena (1380-1444)

Bernardino was important because he represented the high point in the development of

Scholastic economic doctrine. In some respects, his thought was even more advanced.

He argued that price resulted from the interaction of raritas (scarcity), virtuositas (objective utility, i.e., contribution to productivity), and complacibilitas (subjective utility). This was important because it was apparently the first statement of the proposition that price was a function of the interaction between Supply and Demand.

Popular Themes in Scholastic Thought About Commerce

1. THE GOVERNMENT SHOULD GENERALLY BUTT OUT.

Scholastic writers were highly critical of government interference in the market. The main exception was that most of these writers were also worried about monopoly, and thought that governments ought to regulate markets to eliminate, or at least mitigate the effects, of monopoly power.

Unfortunately, the idea of "monopoly" was left poorly defined, so it was not quite clear what criteria government should use to so intervene. Scholastic enthusiasm for “anti-trust regulation” was tepid.

The popular impression of Scholasticism as hostile to and dismissive of capitalistic production is wrong. Compassion for the poor was not generally combined with hostility towards wealth.

2. THE JUST PRICE (Justum Pretium).

Scholastic writers were persistently fascinated with the moral evaluation of market prices. This would seem to imply that these writers regarded commerce as morally dubious. However, the reality was that concern about the “justice” of prices wasn’t (typically) combined with hostility towards business and markets

Early accounts of the idea of "just price" were confused and hard to interpret. According to some writers, a price might be "unjust" even if it resulted from a voluntary trade if that price was substantially higher than it had been recently -- a change that might often be expected to result from changing conditions of scarcity. There was no simple standard for price "justice." The "just price" doctrine in part reflected a concern with the problem of monopoly power, which Church writers failed to precisely define.

But from Aquinas on, a price was presumed to be "just" under most circumstances if it was the result of a voluntary trading.

IN MODERN TERMS, THE "JUST PRICE" WAS DEFINED TO MEAN THE NORMAL COMPETITIVE PRICE.

3. USURY DOCTRINE: drag on the economy or just window dressing?

The concept of usury was a major exception to the general pattern we see in Scholasticism of insightful anticipation of modern economic doctrines. The usury doctrine was an unfortunate lapse. However that might be, the usury doctrine was carefully hedged, and its potential adverse impact on economic development was largely unrealized.

The doctrine of usury held that the earning of interest on loans was morally wrong. At the risk of some oversimplification, the practice of usury was held to be a mortal sin because it violated a Scriptural dogma

-- The Rate of Interest is, in modern economics, the price of waiting. People prefer to consume now rather than later, so if you want me to lend you some of my money for some period of time, you will have to pay me something over-and-above the amount lent to get me to agree to lend to you, rather than spend my money now.

-- However, in several passages in the Old Testament of the Bible, the rate of interest (which was called "usury") is condemned as morally wrong.

· Aquinas' explanation, in the 13th century, was that no individual could sell time because time can't belong to any individual.

Many historians have argued that this doctrine was economically irrational, and was a serious impediment to economic growth in medieval Europe. It would seem to imply that no capital markets could exist. If lenders could not expect to be paid interest to compensate them for waiting, there would be no incentive to defer consumption, and lending would cease.

Once again, the actual interpretation and implementation of the doctrine looked very different. Charging X+n for a loan was OK, as long as the +n was not the "price of waiting".

-- The principal cost of the usury doctrine was probably the time and intellectual effort wasted in interpreting it in the most innocuous manner

INDEMNITY: OK to charge for a loan if you can show that lending money is somehow costly, and the payment in excess of the principal is covering these costs.

-- Compensating the lender for risk does not constitute usury.

-- Normal profit (opportunity cost) was gradually agreed to be a form of indemnity. Compensating the lender for his opportunity cost was not usury.

In discussion of the nature of usury, the idea of opportunity cost was first articulated in economics.

Since as a practical matter it was nearly impossible to clearly distinguish a risk premium from normal profit from a reward for waiting, the usury doctrine could not be effectively enforced.

USURY RESTRICTIONS WERE EASY TO EVADE. An “industry” emerged by the 14^th century that was dedicated to providing various forms of ‘smokescreen’ behind which lending might take place without directly contravening the teaching of the Church.

MACROECONOMICS received relatively short shrift by the Church-affiliated writers. A notable exception was Jesuit priest Luis Molina. He not only understood that an abundance of (commodity) money raised prices and a scarcity reduced prices, he also understood that (commodity) money flows from a country with high prices to countries that have lower prices. (This foreshadowed the classical idea, expressed in the writings of Richard Cantillon and David Hume, of the price specie-flow mechanism).

By devoting so much attention to the economic writngs of the Scholastics, I risk fostering the impression that these writers had significant influence on the development of modern economics. In fact, they did not. Rather, Scholastic economic thought is simply interesting in its’ own right.

The almost total lack of influence on the later development of economic theory is an interesting historical problem in and of itself. Much of this literature was notably more sophisticated than the writings of contemporary or even later secular writers; for example, contrast Bernardino on value with the thinking of Adam Smith on the same topic two centuries later.