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Notes on some famous economists

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[The following are shamelessly partisan notes I took years ago on some famous economists,
which I offer to the reader in all humility, hoping they may be mildly useful, or at least
occasionally amusing.]

Reading Howard Marshall’s The Great Economists: A History of Economic Thought

(1967), and Ernesto Screpanti and Stefano Zamagni’s An Outline of the History of Economic
Thought (2005). Unless I take notes I’ll forget everything. So here goes…
Mercantilism. The surplus or the deficit on the balance of trade between countries is what
makes the exchange rate vary. But rather than worry about the exchange rate, the state should
encourage exports and discourage imports. The excess of sales over purchases is thought to be
the sole origin of profit (for nations as well as individuals), so the goal of maintaining a favorable
balance of trade should guide the state’s economic endeavors. Therefore, protectionism! High
import duties and no export duties. The mercantilists also wanted population to increase so there
would be a sufficient labor supply for the expanding industries. They formulated the first
quantity theory of money: the higher the gold in circulation, the higher the prices. Later on they
modified the theory to state that the increase in money supply stimulates economic activity (i.e.,
output increases). There are two reasons for this: (a) incomes and consumption increase with the
increase in money supply; (b) the interest rate lowers at the same time (because “when money is
plentiful it is more easy to find some to borrow”), thereby reducing the price of credit and thus
the cost of financing investments, which encourages economic expansion. The mercantilist
theory of value relied on utility rather than the costs of production. It can be summarized as
follows: “First, the natural value of goods is imply represented by their market price. Second, the
forces of supply and demand determine the market price. Finally, the use value is the main factor
on which the market price depends.”

William Petty. He abandoned the subjective theory of value, replacing it with the concept
of “natural value”, viz., the costs of production. The prices of commodities tend to adjust to the
natural value by means of small oscillations. The costs of production are the utilization of land
and labor, but labor (embodied labor) is by far the most important. “[Petty’s] search for a unit of
measure to translate the value of land into labor is interesting, because in the process he managed
to define the natural price of labor. In fact, that unit of measurement consisted of the average
daily amount of food necessary to sustain a worker. [Anticipation of Marx.] But Petty did not
explain how and why wages tended to adjust to the subsistence level....” He anticipated the
classical economists with his concepts of rent and of surplus (which he interpreted as a product
of labor, since it was obtained only by the application of human energy).

John Locke, as you know, used Petty’s labor theory of value to justify private property.
(Individuals have a right to their labor and to the products of their labor, etc.) Dudley North
anticipated liberalism in his idea that “harmony of interests is derived solely from the fact that
nobody is able to look after the interests of an individual better than the individual himself, so
that if individuals are left free, they will prosper. On the other hand, any measure that interferes
with the individual’s attempts to pursue private goals hinders the achievement of the public
interest. [Therefore,] the best policy is no policy, no laws to regulate trade, none to regulate the
interest rate, nor to control the money supply.” Richard Cantillon borrowed Petty’s theory of
value but clarified the distinction between “intrinsic value”, which depends on production
conditions, and “market price”, which depends on the forces of supply and demand. “His
 2

explanation of the adjustment of the latter to the former was based on the hypothesis that the
market price is fixed by the seller and dynamically modified on the basis of his estimate of the
demand.”

François Quesnay and the physiocrats. “Three points in particular are worth underlining:
(a) the new, revolutionary concepts of productive and unproductive labor, which were introduced
in connection with a new concept of wealth (a concept by which the real source of wealth is the
net product obtained by applying labor to land); (b) the idea of interdependence among the
various productive processes and the related idea of macroeconomic equilibrium; (c) the
representation of the economic exchanges as a circular flow of money and goods among the
various economic sectors.” Agriculture is the only real source of wealth. Society is divided into
three classes: farmers, the productive class; manufacturers, the “sterile” class (so called because
the value of their output is equal to the overall value of the inputs); and landlords, the
“distributive” class (—by the expenditure of their rents, they get the circulation process of
money started). Because the circular flow of wealth throughout the economy has its own logic
and equilibrium, laissez-faire is the best political policy.

Ferdinando Galiani. Value depends on the utility and scarcity of goods; it derives from
the choices of economic subjects. “Value is an idea of proportion between the possession of one
thing and that of another in the mind of a man.” Since utility and scarcity depend on the needs of
individuals, “the same good has different utilities for an individual according to the quantity of it
that he has already consumed. The more of the good consumed, the lower the utility will be, up
to the point of becoming zero.” This is a theory of diminishing ‘final’ utility, anticipating the
marginalists. Other Italian economists (Beccaria, Verri, Ortes) anticipated Malthus and Bentham,
and even Smith (in his criticisms of the physiocrats).

David Hume. Because of the price–specie-flow mechanism, a surplus on the balance of

trade doesn’t produce permanent benefits, since it automatically activates a re-equilibrating
process. “The inflow of gold generated by the trade surplus causes prices in the country to rise,
while it decreases those of the competing countries in deficit. Owing to the consequent changes
in competitiveness, the trade balances gradually adjust. The free trade implications of this theory
are obvious.” Hume recognized that the mercantilists were partly right in at least one of their
theories: although prices rise (in a ‘transmission’ process from sector to sector) with an increase
in the money supply, output also increases in the short term, because as expenditure
incrementally rises with prices, production and employment expand.

Hume also attacked on two fronts, and succeeded in both. First, he denied that the
volume of international trade was fixed [as the mercantilists had thought], and
therefore that one country could increase its wealth only at the expense of another.
Rather, he maintained that an increase in the wealth of one country—to the extent
that it was an increase in real wealth, namely in the level of output—would lead,
through imports, to a parallel increase in outputs in other countries. Second, he
denied that the rate of interest would necessarily vary inversely with the money
supply. Instead, he observed that it was the increase in economic activity itself
that, by increasing the real capital stock of a country, would cause a decrease in
the rate of profit and, as a consequence, a decrease in the rate of interest.
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Hume’s four fundamental arguments—the price–species-flow mechanism, the

quantity theory of money, the theory of the growth of the volume of international
trade, and the explanation of the diminution of interest as a real phenomenon—
were to be accepted en bloc by English and European thought, and were to form
the pillars (even if in revised and corrected versions) of nineteenth-century free-
trade theories.

James Steuart. The quantity theory of money is wrong; what matters is the velocity of
circulation, which, “by means of variations of the amount of money hoarded, continually
changes in such a way that the quantity of money in circulation is always adequate for the needs
of trade”. Laissez-faire is not the way to go, because demand for goods isn’t always sufficient to
guarantee full employment. Furthermore, the introduction of machinery can create
unemployment, in that “the reabsorption of the work-force into other sectors doesn’t occur
immediately.” It’s the government’s job to ensure reabsorption, just as the government should
encourage exports to bring about full employment.

Adam Smith. The circle of economic growth: a greater division of labor leads to an
enlargement of the markets, which leads to an increase in labor productivity, which leads to a
greater division of labor. Capital is divided into fixed capital (machinery, buildings, etc.) and
circulating capital (which is used to buy raw materials and pay for labor). The wages fund is the
part of circulating capital that pays the workers. The bourgeois class has a high propensity to
save, since it wants to increase productive capital. Consequently, “the higher the proportion of
the national income going to profits, the higher the growth in the wealth of the nation. The
general interest of the nation, therefore, coincides with that of the bourgeois class.”
A good doesn’t have value unless it was produced by human labor. And the value of a
good is measured by the quantity of labor it exchanges for. Under capitalist conditions, in which
“capitalists and landlords take part in the division of the product, the exchange value of a good
must be such as to allow the payment of a profit and a rent besides a wage. This implies that the
quantity of labor the good can pay for must be greater than that employed to produce it. In a
capitalist society, therefore, embodied labor isn’t a good measure of the exchange value of
goods.” A commodity’s price is the sum of the incomes paid to produce it, namely wages, profits
and rent. There’s a difference, however, between the market price and the natural price: the
former is the real price of a good at a given moment, and depends on the forces of supply and
demand; the latter is what would allow for the payment of workers, capitalists and landowners at
normal rates of remuneration. It is, “as it were, the central price, to which the prices of all
commodities are continually gravitating” because of competition. (High demand = high market
price; excess supply = low market price.) Competition (under certain ideal conditions)
continually drives the market towards equilibrium. There’s a tension in Smith’s work between
‘objectivist’ and ‘subjectivist’ orientations—roughly, the macroeconomic and the
microeconomic sides of his work. For example, an explanation of wage differentials is the
“agreeableness or disagreeableness” of the work: the more disagreeable, the higher the wage will
be. On the other hand, another explanation is the high or the low cost of training: the higher the
cost, the higher the wage. The first is a subjective, the second an objective determinant.
Neoclassical economists seized on the subjective, microeconomic aspects of Smith’s thought,
while Ricardians and Marxists were more interested in the objective, macroeconomic aspects.
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Jean-Baptiste Say formulated Say’s Law: a general glut is impossible because supply
creates its own demand. “Say first restricted himself to observing that the value of the aggregate
production is necessarily equal to the aggregate value of the distributed incomes. This is an
accountancy identity that nobody would object to. As incomes are purchasing power, it is also
possible to say that the produced goods always create the purchasing power corresponding to
their value. From here to say that the production always creates its own demand may seem a
small step. In fact it is enormous. One must add that incomes are entirely and immediately
spent.” [See my summary, on [Link], of Robin Hahnel’s book ABCs of Political
Economy for more thoughts on why Say’s Law is wrong.]

David Ricardo. He was the first to formulate the doctrine of comparative advantage, or at
least to bring it to relative maturity. (If one country is more efficient than another at producing
both wine and cloth, both countries will nonetheless reap advantages if they each produce only
the good they’re most efficient at producing. So one produces wine, the other cloth.) Whereas
Smith was preoccupied with the problems of production, Ricardo was more concerned with
distribution. How are the payments to land, labor and capital determined?

As capital accumulated, the demand for labor would increase, bringing with it an
inevitable rise in money wages. This increase in the market price of labor would
lead in turn, just as Smith had suggested, to a rise in the population, with an
eventual expansion in the labor force. But here Smith and Ricardo parted
company. For where Smith had seen the rise in the supply of labor acting as a
restraint on higher wages, Ricardo saw the expansion of the total population as
impinging on the means of subsistence. Just as Malthus had pictured the growth
of the population as leading to an ever rising cost of living, thus worsening the
standard of living for the majority of population, so also did Ricardo fear the
effects of this expansion in population.
Wages would not be restored to their previous lower levels by the increase
in the size of the labor force. Why not? Because the added numbers made
necessary a permanent rise in the cost of living. Since the natural level of wages
was geared to this cost of living, a rise in that cost would inevitably produce a rise
in the natural level of wages. As the natural rate of wages was thereby increased,
the rate of profits would inevitably decline. The time would eventually come
when the rate of profit would decline to the point where no further accumulation
of capital would take place. When this happened, all economic growth would
cease and the stationary state would emerge.
The capitalist would not benefit from this process because his rate of
profits declined steadily as the process continued. The worker would not benefit
in the long run either, although he might benefit for indeterminate periods as the
market price for his services soared above the natural subsistence wage. In the
long run, wages would settle to the subsistence level. It was the third class, the
landlords, who really benefited. As the demand for the means of subsistence rose,
increased cultivation of both and intensive and extensive nature became
necessary. The more fertile lands were increasingly capable of yielding a surplus
paid to the landlord in the form of rent.
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In capsule form this is the essence of Ricardo’s famous theory of rent.

Note its dependence on the Malthusian principle of population. If higher wages
did not produce an expansion in population faster than the means of subsistence
were able to be increased, the entire picture would change....

Rent is the result not of fertility itself (as Malthus thought) but “of the fertility of one piece of
land when compared with others also under cultivation”.
Value is determined by the amount of labor in a product. (Capital is merely stored-up
labor.) Ricardo thus rejected Smith’s labor-command theory of value in favor of his “labor-jelly”
theory. Specifically, value is determined by the amount of labor expended on the “final unit of
the commodity”—i.e., the labor under the most difficult, least efficient conditions of production.

Nassau Senior is most famous for his capitalist apologetics: profit is a reward for
“abstinence” on the part of the capitalist, namely the abstinence involved in his postponing
pleasure for the sake of investment. 1 (The authors call this theory the “mother of all the
neoclassical theories of capital”.) He also anticipated the principle of marginal utility. Samuel
Bailey criticized Ricardo’s cost-of-production theory of value; he thought that “the value of a
good is nothing more than the valuation given to it by economic agents, and that, as a
consequence, ‘value’ only denotes an effect in the mind”. Hermann Heinrich Gossen shared
Bailey’s preoccupation with utility:

He formulated two laws that still today form the basis of the neoclassical theory
of consumer behavior. The first law establishes the principle of decreasing
marginal utility: the pleasure obtained from a good decreases as the amount
consumed increases until, eventually, satiety is reached. The second law is more
important. It states that the individual will choose to demand the various goods in
such proportions that the satisfactions they give him are equal at the moment at
which he stops consuming them; or, rather, that the individual will continue to
exchange two goods until the values of the last units he possesses of them become
equal. ....Gossen had in mind what today is known as the theorem of equality of
the weighted marginal utilities.

There were many other forerunners of neoclassical theory.

John Stuart Mill. His goal being mainly to clarify and modernize established theory, he
wasn’t extremely original. He agreed with Ricardo’s theory of rent (viz., that rent is due to
differences in fertility). He accepted Malthus’s population theory and considered the law of
diminishing returns “the most important proposition in political economy”. He also adopted
Senior’s “abstinence” theory of profit, while at the same time recognizing that profit is due to the
surplus produced by labor. As for wages: he held a “wages-fund” theory, according to which
1
See Marx’s footnote in Capital: ‘....In the “Letters on the Factory Act,” [Senior] makes the whole net gains
including “profit” and “interest,” and even “something more,” depend upon a single unpaid hour’s work of the
labourer. [See the section in Capital called ‘Senior’s “Last Hour”’.] One year previously, in his “Outlines of
Political Economy,” written for the instruction of Oxford students and cultivated Philistines, he had also
“discovered, in opposition to Ricardo's determination of value by labour, that profit is derived from the labour of the
capitalist, and interest from his asceticism,” in other words, from his “abstinence.” The dodge was an old one, but
the word “abstinence” was new....’
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capitalists, through their abstinence, stockpile money for wages. In fact, “capital itself is nothing
else but the wages fund set aside in preceding periods in order to sustain the workers who
produce the means of production”. Since the size of the wages fund is at any given moment
predetermined by the amount of capital accumulated for wage payments, the level of wages
depends on the number of workers employed: the more there are, the less will their average wage
be. This idea has quite a few implications that I won’t go into. (Mill eventually decided he was
wrong.) He held a cost-of-production theory of value. And he believed in Say’s Law. And he
agreed with his colleagues that the ultimate future of the economy lay in stagnation, because “As
the population increased, the cost of the means of subsistence would gradually rise. With this rise
would come the need for higher real wages and such rises could be achieved only at the expense
of profits. As the rate of profits declined, a point would come when further new investment
would be unprofitable and at this point progress would cease.”

The neoclassical system. “One characteristic of the new system was the disappearance of
interest in economic growth, the great theme of the economic theories of Smith, Ricardo, Marx,
and all the classical economists. Attention, instead, was focused on the problem of the allocation
of given resources. ....The central argument of the theoretical research in this period was the
study of a static equilibrium system.” The revolutionary aspect of the system lay not in the
argument that the prices of goods are determined by utility (since this idea had been formulated
much earlier), but in the principle that “human behavior is exclusively reducible to rational
calculation aimed at the maximization of utility”. Marginalists considered this principle
universally valid. (That is, they were vulgar Benthamite utilitarians.) Since the economic agents
had to be capable of making rational decisions to maximize utility and profit, the collective
agents—social classes and political groups—that the mercantilists and classical economists had
placed at the center of their systems disappeared in favor of decision-making units like
households and firms. (Marginalism, therefore, served useful ideological purposes, in that it
deflected attention from class conflict.) Also, economic laws attained the status of natural laws,
comparable to laws in physics, universally valid because of the eternal nature of the problem
posed by neoclassicism, viz., that of scarcity. “Thus, while individualistic reductionism had led
to the elimination of social classes, the anti-historicist reduction led to the elimination of social
relations—which obviously meant that the study of their change also lost importance.” Adding
yet another idiocy into the mix, marginalists substituted a subjective theory of value for an
objective one; they argued that all values are individual and subjective.

The principle of subjectivity implies that a value is such because somebody has
chosen it as an end; whereas the principle of individuality postulates that there
must be a particular individual to which that end can be attributed. In the opposite
conception, that of objective value, values exist independently of individual
choices. The individual can accept or reject values but he is not able to establish
their cogency. An important consequence of the neoclassical approach in regard
to the question of value is that the theory of the distribution of income becomes a
special case of the theory of value, a problem of determining the prices of the
services of the productive factors rather than of sharing out income among the
social classes.

Lastly, the neoclassical method is distinctive. It’s based on the “substitution principle”: “in the
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theory of consumption, the substitutability of one basket of goods for another is assumed; in the
theory of production, the substitutability of one combination of factors for another. The analysis
is carried out in terms of the alternative possibilities among which the subjects, both consumers
and producers, can choose. And the objective is the same: to search for the conditions under
which the optimal alternative is chosen.”
Another way to conceptualize marginalism is to say that it adopted the opposite
perspective of Ricardo vis-à-vis the Smithian theoretic dualism: whereas Ricardo had tried to
free the macroeconomic element in Smith from the microeconomic, the marginalists tried to do
the opposite. “Their revolution consisted in this: they freed microeconomics, understood as a
theory of rational individual choices, from classical macroeconomics.”

William Stanley Jevons. One of the three founders of marginalism; mentally retarded.
Possibly his most impressive work was in his studies of business cycles, which he attributed to
solar disturbances (sunspots). “Two explanations of this interrelation were deemed possible.
Either the sunspots produced alternating waves of optimism and pessimism in businessmen, thus
leading them to overexpand and overinvest, with a subsequent period of retrenchment and
caution to follow, or the sunspots caused variations in agricultural productivity, which in turn
produced repercussions in the industrial sector.” This fruitful hypothesis has unfortunately
proven difficult to test.
He was a fanatical laissez-fairean, believing that all conflicts of interest between
capitalist and worker could be resolved through competition (!). “Competition would cause
capital to be remunerated at the market rate of interest, while the worker would receive ‘only the
value that he has produced’”. Hence, the natural state of a market economy is social harmony.
Problem solved. (Of course he “criticized the Ricardian theory of the inverse relationship
between profits and wages as ‘radically fallacious’, wishing in this way to demolish the
theoretical foundation of class struggle”.) Not surprisingly, his idols were Malthus, Say, Senior,
and Bastiat.
He finally solved the problem of value that had baffled economists since William Petty,
namely by taking the bold step of ignoring it. He simply equated value with price, thus throwing
the issue out the window. And then he stated categorically that “value depends entirely upon
utility”. He made much of the principle of marginal utility in explaining the behavior of
individual consumers, and he also tried to use it in an explanation of exchange on the market.
Unfortunately he didn’t explain how prices are determined, instead taking them for granted. He
used his concept of the increasing marginal disutility of labor to explain how the amount of
production of any good is determined: “Labour will be carried on until the increment of utility
from any of the employments just balances the increment of pain.” Okayyyyyy....? Soooooo....?
(I have to admit, I’ve never quite understood the significance of the concepts of marginal utility
and disutility. They seem either truistic or wrong.)

Léon Walras. While he was one of the originators of the concept of marginal utility, he’s
most famous for his theory of the general economic equilibrium. Given his assumption of perfect
competition, the theory is simply common sense, i.e., a collection of trivialities.

An economy is in a Walrasian competitive equilibrium when there is a set of

prices such that: (1) in the each market the demand equals the supply; (2) each
agent is able to buy and sell exactly what he planned to; (3) all the firms and
 8

consumers are able to exchange precisely those quantities of goods which

maximize, respectively, profits and utilities.

....The markets must be interrelated so as to make the choices of all the economic
subjects compatible. A subject who is unable to achieve the goal of maximizing
his satisfaction (or welfare) will have excess demands for some goods and excess
supplies for others. By means of exchange, the individual will use the excess
supplies to eliminate the excess demands. A state of general economic
equilibrium is one in which the prices are such as to allow all individuals to
maximize simultaneously their own objectives, with excess demand vanishing.

The model of price-formation underlying Walras’s theory of exchange is one of

competitive bargaining. According to this model, markets are conceptualized as
auctions, in which there are, on the one hand, stockbrokers and, on the other, the
auctioneers. [The auctioneer shouts prices; if at the shouted price there’s excess
demand, he’ll lower the price, and if there’s excess supply he’ll raise the price,
until supply and demand are in equilibrium.] Let us now turn to the ‘Sisyphus
entrepreneur’. Walras considered that a firm is in equilibrium when the profit is
reduced to zero owing to the competition among entrepreneurs.... “In a state of
equilibrium in production, entrepreneurs make neither profit nor loss”, writes
Walras. Profit depends on exceptional circumstances; from a theoretical point of
view it must simply be ignored.

Profit, the raison d’être of capitalism, should be ignored. –What would Marx have thought of
these economists! ‘Business cycles are due to sunspots, social harmony is the natural state of the
market, economic laws are eternal, profits should be ignored!’
I’m glad I Am Not the Walras.
These sentences got me thinking about methodology again: “Menger [supported]
methodological individualism, the view that all propositions about the behavior of collective
agents must be reducible to propositions about the behavior of their individual components.
[According to] holism, the collective terms of social science represent social entities which are
absolutely emergent with respect to their individual components. The classical economists and
Marx, according to this point of view, were supporters of methodological holism: they believed
that it is impossible to understand the operation of the economic system on the grounds of a
theory of the behavior of single agents, and this would explain their use of the category of social
class.” While I still find it hard to conceptualize emergence, I remain convinced that it’s
necessary. How else can you explain business cycles? (Surely it’s significant that neoclassical
theory, far from explaining business cycles, doesn’t even address them! –The only time it does,
in the sunspot “theory”, it has to look for a cause outside the system, a cause that acts
‘individualistically’ on each businessman.) Anyhow, philosophical qualms should be less
important than explanatory success; and Marx’s holistic theories are far more fruitful and
predictively accurate than marginalism.

Carl Menger. He explained both supply and demand in terms of marginal utility. While
Jevons and Walras had focused on demand, Menger wanted to show that production and demand
were two sides of the same problem, both explicable through the concept of utility.
 9

With his theories of imputation and opportunity cost, Menger resolved costs into
utility. His starting-point was a classification of goods according to their distance
from final consumption: the “higher-order goods”, or the “factors of production”,
derive their utility from the goods of the “first order” (consumer goods) they
contribute to produce. This indirect utility can be imputed to each productive
factor by taking into account the marginal contribution it makes to the production
process. In this way the actual cost sustained to produce a certain good becomes
an opportunity cost, namely the cost represented by the sacrifice of utility of those
other goods that could have been obtained from the resources actually used to
produce the good in question. The production costs are evaluated no longer in
absolute but in relative terms, i.e. in terms of sacrificed alternatives.

[Menger’s theory also explains the formation and distribution of income, since]
what is a cost for the firm is an income for the owners of the productive factors.
Wages, profits, and rents depend, ultimately, on the demand and the prices of the
consumer goods and are therefore determined by utility. In this way the
distribution of income ceases to be a separate chapter in economic theory, as it
was in the classical approach, and just becomes a section of the chapter dealing
with theory of prices.

Alfred Marshall. “The method of partial-equilibrium analysis was his great invention and
personal contribution to economics.” It involves confining the analysis to a particular commodity
produced by the average firm in an industry small enough to leave the rest of the economy
unaffected by changes in output. (I.e., the prices of other commodities are assumed to be
constant.) Walras and Marshall differed in how they conceptualized perfect competition (the
notion of which, by the way, is attributed originally to Cournot).

In the Walrasian conceptualization, the agent in perfect competition is a price-

taker: he considers the prices as given and not capable of being directly
influenced by his own behavior. Marshall, on the other hand, believed that a
perfectly competitive market is one in which a large number of agents operate;
each has objectives which conflict with those of the others, and will try to pursue
them without entering into coalitions or blocs and without using special
bargaining powers. Marshall’s ‘perfect competition’ does not presuppose that
each agent takes the prices of goods as given, nor that the firms are identical (even
though they must be ‘similar’). The small differences among firms play, in
Marshall’s system, the same role as that of the genetic variations in Darwinian
theory.

Marshall is the guy who made famous the demand and supply “scissors”. In the very short-run,
price is set by the level of demand because supply is perfectly inelastic. In the long run, though,
value comes close to the cost of production, as the classical school thought, because supply
approaches perfect elasticity.
Marshall recognized that there were forces acting to increase the size of firms. They were
of two kinds: internal economies and external economies. The former include efficiencies
 10

associated with large-scale production, mass advertising and so on. The latter result from the
expansion of the relevant industry or from economies experienced by supplying industries. He
attributed business cycles to the mismanagement of money and credit. He thought they were
exceptional; the normal state of the economy approximates equilibrium. He believed in the
quantity theory of money. All in all, his importance is that he systematized and popularized
neoclassical thought—and communicated a few important insights in the process.

Arthur Pigou. Marshall’s student. He was a welfare economist, which means that he
acknowledged, with Marshall, the existence of market failures and thought governmental
intervention could correct them. Interpersonal comparisons of utility, he thought, are possible,
and he based his theories on this Benthamite assumption. He distinguished between the private
costs and the social costs of the production and sale of a commodity: the former are those borne
by the producer, the latter those borne by the society. The problem is that social costs are
sometimes greater than private costs. (For example, smoke from a factory is a social cost.)
Whenever this is the case, the government should intervene. Taxes and subsidies are desirable if
they encourage industries with increasing returns to become larger and discourage industries
with decreasing returns from becoming larger. However, since Pigou thought (with Say) that
savings are all channeled automatically into investment, he warned against taxes that might
threaten savings, such as property, estate, and progressive income taxes. Redistributions of
income are also risky, in that they might diminish incentives for investment and thus hamper
economic growth. In general, “the output of the economy is maximized when private net product
and social net product are equal, and costs are best allocated when marginal private cost equals
marginal social cost”. (Whatever that means.)
[That’s as far as I got in my summaries. But I’m copying below my notes on an article
that criticizes Milton Friedman’s influential “Methodology of Positive Economics” (1953).]

Milton Friedman famously argued that scientists should and do base their theories on
unrealistic assumptions: “Truly important and significant hypotheses will be found to have
‘assumptions’ that are wildly inaccurate descriptive representations of reality, and, in general, the
more significant the theory, the more unrealistic the assumptions (in this sense).” But this
argument is wrong. So is its corollary: “The only legitimate way to criticize an economic theory
is to point out that its predictions are at variance with the facts”. In his article “Unreal
assumptions in economic theory: the F-twist untwisted” (1981), Alan Musgrave explains why. I
wrote an outline of the article for my social science course:

I. Criticism of Friedman: he is unclear about the status of assumptions in theories.

A. There are three different kinds: negligibility assumptions, domain
assumptions, and heuristic assumptions.
II. Negligibility assumptions.
A. A scientist declares that a given factor that might be expected to
influence the phenomenon he’s investigating has in fact a negligible
effect.
1. Example: Galileo assumed that air resistance has no detectable
effect on bodies falling through short distances.
B. Friedman is right that a theory containing a negligibility assumption
can be evaluated only by testing its consequences. [I disagree.]
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C. He is wrong that a good hypothesis must have descriptively false

negligibility assumptions—or, as he puts it, “the more significant the
theory, the more unrealistic the assumptions”. For negligibility
assumptions need not be false.
D. Thus, he is wrong to conclude that theories do not even aim to be
accurate descriptions of reality (a view called instrumentalism).
III. Domain assumptions.
A. These are used to specify the domain of applicability of a theory.
1. The same wording is used to express a negligibility assumption
as a domain assumption. Example: “assume the government has a
balanced budget” may mean either that an actual budget imbalance
has a negligible effect on the phenomenon in question or that it has
a significant effect, and that the given hypothesis is therefore valid
only if there’s no imbalance. In this latter case, the assumption
restricts the theory’s domain.
B. The presence of a domain assumption, in making a theory less realistic,
makes it less testable.
C. Therefore, concerning domain assumptions, Friedman’s statement that
“the more significant the theory, the more unrealistic the assumptions” is
wrong. On the contrary, the theory is significant if it’s more widely
applicable.
IV. Heuristic assumptions.
A. These are ways of simplifying the exposition of a theory.
1. Example: when Newton wanted to discover what his theory
predicted about the solar system, “he first neglected interplanetary
gravitational forces by ‘assuming’ that there was only one planet
orbiting the sun”. This was a heuristic assumption.
B. Friedman’s central thesis is wrong in this case too.

When an economist “abstract[s] important features from economic life”, he’s basically making
negligibility assumptions: the things he’s abstracting from are negligible,2 at least at this point in
the exposition of his theory. (In this respect he’s also making heuristic assumptions—provided,
that is, that he intends to explain the phenomena abstracted from later on, once he’s laid the
foundation of his theory.) Marx’s use of abstraction signifies a combination of negligibility and
heuristic assumptions.

2
To be clearer: they’re ‘comparatively’ negligible. They may actually be very important, but they’re not as
important as the features he’s picking out for analysis.

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