Authors: David Smith
Ricardo and economics
Although the law of comparative advantage stands as Ricardo’s most enduring contribution, there was much more to his economics than that. Because of his expertise in finance, he was the first to take the subject beyond the polemic, ‘political economy’ approach of his day and into areas both more abstract and more scientific. With his complex ideas and ready intelligence, Ricardo was the first to introduce difficult mathematical concepts into the subject – a move that some say started the rot. Anybody trying to understand an equation-filled academic paper on economics today should perhaps blame Ricardo.
While the law of comparative advantage offered an upbeat assessment of the gains from trade, much of Ricardo’s vision, like that of his friend Malthus, was gloomy. He helped develop the law of diminishing returns, and like Malthus he also had a pessimistic view of the future. Ricardo’s ‘corn model’ was concerned with how wealth was distributed, not how it was created. In an approach that was to provide Marx with the basis of his economic theories, Ricardo saw the battle over the distribution of the economic cake as more important than the size of the cake itself. Income would be divided between wages, profits and landlords’ rents. If wages rose, profits would fall, and vice versa. In the long run, he suggested, landlords would be likely to gain at the expense of workers, whose wages would not rise much above subsistence level, and profits, which would be insufficient to encourage investment in new production. As a result, it was hard to be optimistic about long-term economic prospects.
Finally, Ricardo also gave us an approach that has gained favour in recent times. For years economists have puzzled about why, after Japan’s ‘bubble economy’ burst in the late 1980s, successive efforts by the Japanese government to boost the economy through tax cuts and extra public spending have failed. The answer, developed by modern-day American economists such as Robert Barro, is that such measures have no effect because people know they will have to pay for them later in higher taxes. An increase in the budget deficit is exactly matched by a rise in the surplus of the private sector. Because Ricardo suggested something similar, this is known as Ricardian equivalence. The classical economists, it seems, still have a great deal of relevance.
John Stuart Mill
John Stuart Mill, who has been described as the most important liberal thinker of the nineteenth century, is often not thought of as an economist at all. His greatest book,
On Liberty
, was a work of philosophy. There is a question of how much of an original thinker, and how much of an interpreter and popularizer Mill was on economics. Perhaps it was just a matter of timing. His
Principles of Political Economy
, published in 1848, was the standard text on the subject for nearly half a century.
Mill was always destined for great things. His father, James, was a well-known political economist and the Mill household regularly played host to Jeremy Bentham and David Ricardo, friends and mentors. It was an intellectual hothouse that, he reflected later in life, gave him a twenty-five-year head start on his contemporaries. The younger Mill was reading the classics in their original Greek at the age of eight, by which time he was already familiar with Latin. He began to study economics at thirteen and in his late teens edited Bentham’s writings into a five-volume collection,
On Evidence
, for which effort he suffered a nervous breakdown. Bentham, whose embalmed body is usually on display in the main entrance hall at University College London, the result of a bizarre stipulation in his will (although at the time of writing it was away for some repairs), was famous for ‘utilitarianism’. This sounds more forbidding than it need be. At its most basic, utility is merely usefulness. Used in the sense Bentham intended, however, it is, more than that, a way of expressing pleasure, happiness and satisfaction. And the principle of Bentham’s utilitarianism was ‘the greatest happiness for the greatest number’. It is easy to see how that principle still applies. When a new public project such as Terminal Five at Heathrow is planned, it is customary to conduct a cost–benefit analysis – if the benefits exceed the costs the ‘greatest happiness’ is achieved and the project goes ahead. If not it is abandoned. After the Chancellor unveils his Budget proposals each spring, there is always analysis of the ‘winners and losers’. Any Chancellor aiming for a long political life will always ensure the former exceed the latter. Later economists were to develop the Bentham–Mill framework into an entire field of the subject – welfare economics. Economists refer to a ‘Pareto’ optimal situation, after the French-born economist Vilfredo Pareto (1848–1923). This is a situation in which nobody can be made better off without making others worse off.
Mill built on this utilitarian tradition in his work (he soon got over his nervous breakdown and joined his father working for the East India Company, which seemed to offer plenty of opportunity for freelance thinking and writing). Apart from a slightly odd view about economic growth – he thought the industrial revolution was just a temporary interlude after which the economy would return to a ‘stationary state’ – his great contribution was in demonstrating that while economic laws applied in certain areas, they did not in others. ‘The laws and conditions of the production of wealth partake of the character of physical truths,’ he wrote. ‘There is nothing optional or arbitrary in them. It is not so with the distribution of wealth. That is a matter of human institution solely.’
How much was produced in an economy, in other words, was determined by economic laws. But there were no laws that set down how the wealth so created should be distributed among the population. This was new. Mill, taking Ricardo’s line that, unchecked, most wealth was likely to find its way to landlords, was unhappy even with the idea of private property. Most of all he thought that society could arrange the distribution of wealth in a way that would bring the greatest happiness to the greatest number. In this he was a ‘utopian’ socialist. Socialists seeking fairer shares for all took his analysis up more generally.
As we have looked at how consumers go about deciding what and how much to buy, and how the various components of gross domestic product fit together, it has so far been taken for granted that firms will always be willing to supply goods and services. That is not a bad description of the way things are. In real life there is always somebody willing to meet the needs of customers, to fill a ‘gap in the market’. Adam Smith’s ‘the butcher, the brewer and the baker’ are driven to provide us with meat, beer and bread by the prospect of making money – and if they did not, somebody else would. If we were not sitting in this particular restaurant there would surely be another, owned by different people, but probably every bit as good. In many instances, firms will themselves create the market through new products, advertising and promotion. That is the way the capitalist system keeps ticking over. That observation does not, however, help us much in terms of explaining what makes businesses function, how they go about deciding how much to invest, how much to produce and at what price. Perhaps we should start by asking a very basic question. Why do we have firms at all?
Companies and individuals
We consume as individuals, or families, so why don’t we produce in the same way? Actually, many of us do. There are about 3 million self-employed people in Britain, effectively one-man or one-woman businesses, including everything from plumbers and electricians through to IT contractors, journalists and top entertainers. The process by which businesses grow can easily be seen if we start with a one-man business. John the builder begins on his own, putting up garden walls. Soon somebody, impressed with his work, asks him to build a house extension. He is happy to do so but needs to take on a couple of staff. The job is successful and more orders result. Soon he has three house extensions on the go at the same time. Not only does he take on more workers but he effectively becomes the manager, supervising all three projects but doing much less of the building work himself. A contract to build a house follows, then another. Then, with the help of the bank and one or two friends with money to invest, he buys a plot of land to turn into a housing development. Now he does not just employ builders but accountants and marketing people. A few years down the road and John has become a public limited company, a plc, quoted on the Stock Exchange and with housing developments across the country, his bricklaying days long gone.
Most firms can trace their history in something like that way. Many other one-man businesses, of course, remain happily in that state. There are many more self-employed people than firms employing others, and there are roughly ten times as many employees as there are self-employed people. Some self-employed people eventually opt for what they see as the security of employment. The majority of people work for somebody else, whether it is a firm or a public sector organization. To find the reason for this, we need look no further than Adam Smith. He explained, with the example of the pin factory, how specialization, the division of labour, increased efficiency and thus dramatically lowered costs. A sole trader could still produce pins but would be unable to compete on price with the factory. That is why many self-employed people and very small businesses emphasize the special or bespoke nature of their service – you pay more but you get something better, or at least more individual. In many cases production is simply outside the scope of an individual. Much as I would love to write, edit, design and print a national newspaper, it is not a task that can be undertaken by one person. The fact that there are certain minimum personnel requirements in many areas of production, and in quite a lot of service industries, does not necessarily mean that people have to be organized into what we usually think of as a firm, with an owner-manager, or with managers and outside shareholders. Journalists and printers could, for example, organize themselves as a collective. There are partnerships and member-owned mutual organizations, such as the traditional British building society, although they are a dying breed. The John Lewis Partnership, a very successful retailer, is owned by its employees. Even so, it is useful to think of firms in the conventional way and of their main motivation being that of generating profits.
Counting costs
The costs of running a business are easy enough to determine and consist of wages, raw materials and components, power, distribution (getting the goods to customers) and rent. There is also the cost of investment, expressed in terms of ‘depreciation’. If a business buys a computer costing £1,000 and it is reckoned to have a five-year life, its annual cost averages out at £200. It depreciates in value by £200 every year until, by the end of five years, it is worth nothing. It is usual to split the costs faced by a firm into ‘fixed’ and ‘variable’. Fixed costs will include those of buildings and of equipment already bought. Variable costs include wages, which vary according to the number of people employed and the hours they work (although in many companies the basic salaries of permanent staff are effectively a fixed cost). Other variable costs include those for materials and components, energy use and distribution. Variable costs rise in direct proportion to the amount produced, unlike fixed costs. The bigger the output of the firm, the smaller the amount of fixed costs for each unit produced. The costs for every car produced of the premises in which they are made go down as the rent for the factory is divided among a larger output. Fixed costs per unit of output start rising only if production gets to a level where the original factory is not big enough and a new one has to be acquired.
Spreading fixed costs over a larger amount of output is one of the most important sources of
economies of scale
, the tendency for the cost per unit to fall as output rises. Big firms can do things more cheaply than small firms. Assembly-line cars are cheaper, even if they do not have the same cachet, than hand-made ones, because the more specialized a task – for example fitting the hubcaps on a car – the more efficient an individual worker becomes at doing it. There are other sources of economies of scale – a full lorry does not cost much more to run than a half-full one, but the full one’s costs are spread across twice the amount of goods. Management costs, and those of advertising, are similarly spread over a larger amount of output. This process does not, however, continue indefinitely, or else the ideal situation in every industry would be one giant firm, a monopoly.
Diseconomies of scale, rising unit costs, also apply after a certain point. One would be the cost of acquiring another factory, described above, although if the new factory quickly became employed to full capacity that would soon pass. Another would be the tendency, above a certain size of company, for lean and efficient management to be replaced by layers of bureaucracy. A growing firm will also have to look further afield for its customers. Transport costs may rise and markets become more distant from the source of production. Wage costs may rise, because the pool of workers with the right skills is used up and because big firms are more likely to be unionized.
Making profits
Why do firms aim to make profits? While there is a body of literature that says managers are motivated by a range of things – the size of the firm, or their part of it, the size of their office, the size of their company car, even the attractiveness of their secretary (which can apply equally to male and female managers) – profit is at the root of it. Without profit, why should anybody set up in business, when a more lucrative and less stressful life would be available working for somebody else? And why would any investor put cash into a business that makes no money, when it could generate a safe return in the bank? It is not, perhaps, as clear-cut as that. Many people set up in business because the option of paid employment is closed off to them. Think, for example, of former bankers, clutching redundancy cheques, who fulfil their lifetime ambition to open a restaurant. The failure rate of such ventures, not surprisingly, is quite high. As for investors and profits, the willingness of people in the second half of the 1990s to put money into dot.com firms that were not making money, and had little hope of doing so, appeared to give the lie to the view that investors are interested only in profitable companies. Then again, investors would doubtless have said they were investing, not on the basis of current profits but because of future potential. They probably also believed that, because they spotted that potential sooner than everybody else, there would be every opportunity to make substantial capital gains on their shares.
Leaving such quibbles aside, the textbook aim of firms is to maximize profits. It is also, pretty much, the real-world aim. This seems simple enough. ‘Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness,’ said Dickens’s Mr Micawber. ‘Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.’ But, while Dickens pointed out that being in the black is better than being in the red, there is a little more to it than that. Fortunately, economists can help. They can explain to firms how to maximize their profits, and it is surprisingly simple. To do so, we need just two tools.
The first is concerned with expenditure, or costs, the second with income, or revenue. The idea that costs vary with the amount produced has already been touched upon. Fixed costs tend to fall per unit of output as production increases. Variable costs are likely to rise in proportion to output but may then start to increase faster. For example, it is necessary to pay workers overtime rates, higher than basic pay, to increase output above a certain level. At every level of output it will be possible to calculate the
marginal
cost – the cost of producing one extra unit. A typical pattern would be that marginal cost will tend to fall up to a certain level, so that it costs less and less to produce each extra unit, but then begin to rise. Marginal cost, then, is our first essential tool.
The other is marginal revenue, its direct counterpart on the income side of the firm’s accounts. Just as it is possible to calculate marginal cost, so the same can be done for revenue. Marginal revenue is simply the extra revenue, at any point, from an additional sale. Think, say, of new season winter clothing. A few fashion victims will buy it as soon as hits the stores, in August or early September. Many others will wait until the mid-season sale in October or November, when prices are first cut. Plenty more will hold on until the January sales, when they are cut further. Finally, some who care nothing of fashion will buy in the spring at a factory outlet sale at rock bottom prices. Each time the marginal revenue, the income from each extra sale, declines.
So how do you know how much to make to maximize profit? The answer is not only easy but it is also, unlike some economics, sound common sense. You stop increasing production when you are on the point of losing money on any extra sales. You do not, in other words, sell anything at a loss. As long as the extra revenue from an additional sale exceeds the cost to you of generating that sale, carry on raising output. Once the extra revenue merely equals your additional cost – marginal revenue equals marginal cost – it is time to call a halt. Actually, this is easier than it sounds for most businesses. The example of the clothing firm is one in which the price varies and the firm controls how much it varies over time. For most companies that does not occur. The market – the collective decisions of competitors and consumers – determines the price. Marginal revenue (price) remains the same. All that is necessary is to ensure that output does not rise above the point where marginal cost is equal to that price. Any further increases in output will mean that you are subsidizing customers by selling at a loss. You can make this point with diagrams but I do not want to make this look like a textbook. For those who are curious, most textbooks will provide a picture.
Let me just clarify one thing that puzzles a lot of people. By increasing production to the point where marginal revenue merely equals marginal cost firms are still making profits. This is because before they get to that point they will have made many sales where marginal revenue exceeds marginal cost, probably by a substantial amount. By producing to the point where there is no additional profit, they are ensuring they have squeezed every bit of profit out of the market they are in.
Do businesses actually behave like this?
I have met very many business people over the years, some excellent and others not so good. The better ones, incidentally, are usually pretty hot on economics. The mediocre ones tend to converse in some kind of horrible management-speak, talking of ‘growing the business’, ‘re-engineering’, ‘low hanging fruit’ and the rest. But, good or bad, I cannot recall a single businessman telling me that his aim in life was to make sure his marginal revenue equalled his marginal cost. There are a few reasons for this. One is that economics has to try to simplify a complicated real world. Businesses will operate a number of strategies, for example deliberately selling at a loss over a number of months or years in order to build market share and drive out competitors. Such strategies are easier, of course, if the business can draw on financial support from another part of the operation. Or, to take another example, supermarket chains often sell certain goods, so-called ‘known-value’ items such as bread and milk, below marginal cost, in the knowledge that they can recoup the lost profits elsewhere, in products where consumers are less aware of the prices. Another reason is that not all businesses maximize profits, even when they think they are doing so.