Why do we need a theory of value?

The theory of value and distribution is at the heart of economics. To be clear, when I say that it is at the center, it means that discussions of almost any topic in economics, in one way or another, depend on a certain theoretical position about the theory of value and distribution. However, most economists have no clue about it, about the centrality of value. Not only they don't understand the original and now infamous labor theory of value (LTV), that dominated between Petty and Ricardo (and Adam Smith too, even though that tends to surprise and puzzle most economists),* but also they misunderstand the dominant marginalist paradigm. Some economists actually think that you don't need a theory of value at all, and some don't even understand that they use a conventional (some vulgar form of supply and demand) theory of value. Hence, the reason of this post is to try to help clarify some very basic issues related to the necessity of a theory of value for proper theorizing in economics.

In a sense, this topic was discussed here before, in my post on Sraffa, Marx and the LTV. But it is worth revisiting, and thinking in broader terms, beyond the LTV, to understand why a theory of relative prices is needed in general, to understand almost everything in economics.

Let me start with the authors of the surplus approach. In fact, a bit earlier with the economists that would eventually be known as Mercantilists (if you can talk about a school). If we are allowed to generalize and simplify, the latter believed that the wealth of nations depended essentially on maintaining trade surpluses, and accumulating precious metals. Profits were essentially the result of buying cheap and selling dear, or profits upon alienation, which indicates that, for Mercantilists, profits were generated in the exchange process.

Classical political economy authors, starting with William Petty, emphasize the determination of profits in the process of production, as a residual of output, once the conditions for the reproduction of the productive system were satisfied. So profits are not the result of selling high and buying low, something that could result from the mere fluctuation of market prices, but from the ability to produce beyond what was needed for the simple material reproduction of society. Note that to obtain profits, part of the residual, the surplus over and beyond reproduction requirements, one needs to know the prices of the means of production. That is, one needs to be able to account for the normal prices of the goods that went into the production of all commodities. And these prices would include a normal profit. Again, not the extra gain that might occur from a high market price. So the normal rate of profit is needed to determine prices, and prices are needed to determine the normal rate of profit. This was well understood by both Ricardo and Marx.

Value (the relative prices of commodities) and distribution (the normal rate of profit) are intertwined. Smith knew that the simple LTV (amounts of labor incorporated) was not correct other than in very rudimentary economic systems, with essentially no produced means of production. His solution was to adopt the idea of labor commanded (more on that on my post on Sraffa, and the one on the standard commodity). Ricardo solved this problem, in his corn essay, by assuming that the surplus and the means of production advanced to produce output where all in physical quantities of corn, hence profits could be determined independently from relative prices, as a physical quantity. And Marx adopted the simple labor theory of value in volume one of Capital. Both believed, for slightly different reasons, that their main arguments would hold even if the LTV was not precisely correct.

I am not concerned with the problems with the LVT in Ricardo and Marx (worth noticing that the mathematical solution was not known in their time, and was essentially developed in the late 19th and early 20th centuries) or Sraffa's solution. It is worth insisting that the LTV does have an analytical solution that is unique, and stable (see my post on the standard commodity for the former, which suggests a Smithian, i.e. labor commanded, version of the LTV is perfectly fine).** That's good, btw. It suggests that the classical political economy notion that there are prices that guarantee the reproduction, and, beyond the the expansion (or accumulation), of the economic system do exist.

Here I want to emphasize the importance of the LTV for the analysis of other aspects of the economy. Ricardo saw the problems of the Smithian adding up theory. That's the notion that prices were composed by the sum of natural wages, profits and rent and that prices would go up if one of its components went up.  In order to determine the rate of profit properly, Ricardo noted the explanation of value was essential. The rate of profit was central because in his view the processes of accumulation depended on the rate of profit. Hence, proper discussion of accumulation and growth depends on a proper theory of value and distribution. Btw, all classical authors assumed that real wages were exogenously determined by institutional and historical circumstances (so there was a role for history and institutions in their theory; also, for accumulation that was seen as too complex to be theorized in the same level of abstraction that value). But even if one is less keen than Ricardo on the role of profits in accumulation, it is undeniable that distribution affects accumulation, and, hence, a proper theory of value and distribution is needed.

Note also, that other things that depend on relative prices are crucially affected by the theory of value and distribution. Classical authors assumed that the process of competition, by which they meant only free entry and not the size or the number of firms in an industry, would lead to a uniform rate of profit. In that sense, the forces of competition were central in forging the structure of production, and, hence, the determination of technological change or to understand the patterns of trade specialization, which cannot be understood without the determination of relative prices. In fact, perhaps the most famous and the most controversial issues coming out of Ricardian economics dealt with international trade and the effects of technical change (the so-called machinery question), and are directly connected to the theory of value.

Even the most crucial macroeconomic problem, the question of output determination (and employment, for a given technique) is affected by the theory of value. Note that classical political economists assumed output as given for the determination of the surplus. And Ricardo accepted Say's Law as a way of determining output and employment (not Marx, btw, so it's NOT a requirement of the surplus approach). But as much as for accumulation understanding of distribution is central for the determination of the level of output, as it is explicit in the Kaleckian effective demand model. the classical long term prices are compatible with levels of output that do not guarantee full employment. And the parametric role of distribution in affecting the size of the multiplier is crucial for output and employment determination. So unemployment is possible in the long run, as a regularity of market economies.

In other words, for a coherent theory of output, accumulation, international trade, technological change and more (taxation, etc.) you need a theory of value and distribution. That is also the case in the mainstream. Marginalism developed in the last quarter of the 19th century, both as a result of the lack of analytical solution in that period for the problems of the LTV and as a reaction to radical revival of the theory (Marxism). The important distinction is that while classical political economy authors dealt only with objective factors, and considered demand as given when determined value and distribution, marginalism incorporated subjective preferences as central for the explanation of long term normal prices, and prices and quantities were determined simultaneously.

Beyond the problems with the marginalist solution for the existence of long term prices (see this on the capital debates) and their switch to the intertemporal approach, which basically only deals with short term prices, their theory is also central for almost everything in economics. In a sense, given that in marginalist analysis distribution is determined by supply and demand, and by the relative scarcity of factors of production, the theory of value and distribution is even more central for other parts of their theory than in the surplus approach. Here the theory of distribution does not affect indirectly the level of output and the process of accumulation. Here the level of employment and, for a given technology, output determination is the same as the theory of distribution. Real wages and the level of employment are determined in the labor market simultaneously. Everything derives from that.

Before getting to the reason why the theory of value and distribution, central for everything, is often ignored, let me note briefly the possibility of a third alternative to value and distribution, beyond the surplus approach and marginalism. That would be the markup theories of pricing. Note that theories of markup pricing essentially describe how firms determine prices. Most of these theories were developed as a result of the imperfect competition literature sparked by Sraffa's famous (1926) critique of Marshallian price theory (see an old post on that here).

First, as it would be known for the readers of this blog (at least the ones that have been reading for a long while), markup pricing is actually dealing with a different set of issues, and Franklin Serrano suggested here that they are different than the classical political economy normal long term prices (the Marxist prices of production or Sraffa's prices), and that Fred Lee and Marc Lavoie were right about that. He argued that some Sraffians (I won't name names), and I would add probably Fred too, thought that Sraffian prices were compatible with the full cost pricing tradition, and I could have included myself in this group.*** Note that what I mean by that is simply that the behavior of firms must be compatible in the real world with the logic of gravitation in classical analysis. In other words, if prices of production imply a normal profit over the full cost for a given technique, then firms somehow must be trying to do that.

But it is clear that the full cost pricing of a particular firm might not be the long run equilibrium price around which market prices gravitate, with free mobility, that is, with competition in the classical sense. In a way, the same circularity suggested above reapers, costs depend on prices (and that involves the profit related to the markup), and prices depend on costs. The firm's individual prices might not be the prices that are required for the reproduction of the economy as a whole. In that sense, markup theories must be grounded on some surplus approach understanding of value and distribution, and they are essentially theories about market prices, meaning short run behavior. In that sense, they run into the same problem than the intertemporal marginalist models, the Arrow-Debreu type, that became more popular after the capital debates, and that led to what Garegnani famously referred to as the change in the notion of equilibrium (that is the abandonment by the mainstream of the notion of long run equilibrium). Some heterodox groups see this as a positive development, but again it implies that they cannot say anything clear about distribution and relative prices, and that has implications for almost any other theory.

I might add here, which is more concerning for some heterodox groups, is that many of these theories are also compatible with marginalist interpretations of the theory of value and distribution. Many imperfect competition theories just suggest simple inverse relations between markups and the price elasticity of demand. This again fall into the type of situation I discussed recently regarding Karl Polanyi, of well-meaning critics of the marginalist mainstream, using marginalist or neoclassical concepts w/o knowing they are doing it (if it's conscious acceptance of the mainstream model, then it's something different).

One last thing in this regard, while markup theories must be grounded on some theory of value and distribution, and my take is that the surplus approach is where it would make sense, the opposite is not true. There is no need for a theory of the firm, of individual behavior, to understand long term prices. Classical political economists certainly discussed behavior, but that essentially entailed some notion related to class, to general social norms, not about what is going on in someone's brain. Even Smith that was certainly concerned with the issue of the role of self-interest in determining the equilibrium outcomes in the market, cannot be assumed to be a precursor of the rational maximizing agents of the mainstream, or of methodological individualism. The same could be said of utilitarian views and Ricardo, who was, to some degree, close to many utilitarians including Bentham. Here too, many heterodox economists think that an alternative theory of behavior is central for economics, and that is why many see behavioral economics as somewhat heterodox.

Finally, getting, even if briefly, to the point of why most economists remain oblivious to the relevance of value and distribution. I would suggest that this is a recent phenomenon. It is the result of what I have discussed here before, the return of vulgar economics (for example, here or here), and that the mainstream has abandoned the long run, and provides only a theory of short run prices. But at the same time the mainstream must revert to the old model in order to promote economic policy. Note that only in that model you can guarantee that markets provide efficient allocation of resources (w/o imperfections), and the price system signals the direction of adjustment. It is often missed by the heterodox groups that resist old classical political economy (often for incorrectly assuming that it is a precursor of marginalism) that their theory of value and their long term prices provide something completely different, an understanding of the conditions for the reproduction of society. That notion, btw, is alive and well in other social sciences (see here or here). Not in economics.

* It survived in the fringes and it was rediscovered by Marx and then much later Sraffa, who actually provided a coherent solution to some of its logical limitations. But after Ricardo, the LTV was never dominant again.

** On the gravitation of market prices towards normal prices see the work by Bellino and Serrano here.

*** My fondness for the subject in part derived from having worked for Wynne Godley at the Levy for two years, who was a disciple of P. S. W. Andrews one of the key authors of the Oxford Economists' Research Group (OERG) behind full cost pricing theories.

Alternative Theories of Competition

New book by Cyrus Bina, Patrick Mason and Jamee Moudud has just been published. A few friends from the New School and elsewhere, and at least one alumnus from the University of Utah. From the jacket:

"The history of policymaking has been dominated by two rival assumptions about markets. Those who have advocated Keynesian-type policies have generally based their arguments on the claim that markets are imperfectly competitive. On the other hand laissez faire advocates have argued the opposite by claiming that in fact free market policies will eliminate "market imperfections" and reinvigorate perfect competition.

The goal of this book is to enter into this important debate by raising critical questions about the nature of market competition in both the neoclassical and Kaleckian traditions

By drawing on the insights of the classical political economists, Schumpeter, Hayek, the Oxford Economists' Research Group (OERG) and others, the authors in this book challenge this perfect versus imperfect competition dichotomy in both theoretical and empirical terms. There are important differences between the theoretical perspectives of several authors in the broad alternative theoretical tradition defined by this book; nevertheless, a unifying theme throughout this volume is that competition is conceptualized as a dynamic disequilibrium process rather than the static equilibrium state of conventional theory. For many of the authors the growth of the firm is consistent with a heightened degree of competitiveness, as the classical economists and Schumpeter emphasized, and not a lowered one as in the conventional 'monopoly capital' and imperfect competition perspectives."

Contributions by Rania Antonopoulos, Serdal Bahc¸e, Cyrus Bina, Scott Carter, Benan Eres, Jason Hecht, Jack High, William Lazonick, Andrés Lazzarini, Fred S. Lee, J. Stanley Metcalfe, Jamee Moudud, John Sarich, Anwar Shaikh, Persefoni Tsaliki, Lefteris Tsoulfidis, and John Weeks.

Microfoundations and the capital debates

Steve has commented on the ongoing debates about microfoundations of macroeconomics, mainly between Paul Krugman and Simon Wren-Lewis (for my comments and Simon's reply on his blog go here, and scroll down to the last comments). I just want to further clarify what I think is, from the point of view of the history of ideas, a significant confusion in the debates about microfoundations, and one (oh yes, here he comes again) that is ultimately related to the capital debates (the Rosetta Stone of the history of economics ideas; if you prefer Sraffa's PCMC, as I tell my students, is the Rosetta Stone. To get an idea of what is the meaning of the capital debates go here).

Microfoundations are first and foremost about the determination of relative prices, the core of what we now call microeconomics, and used to be called before the theory of value. Individual behavior, rational or otherwise, is relevant to the extent that one thinks that behavior of individual agents is central for price determination, and that was at the core of the Marginalist Revolution.

The point is that if individual workers (using the figure of a representative rational utility maximizing worker), for example, in the labor market, confronts rational individual profit maximizing firms (again a representative firm), the free play of the market would produce an optimal outcome. Krugman is very clear why he thinks microfoundations are important. He says:

“if the assumption of perfect rationality breaks down even in the most standard of micro settings — if consumers behave in a way inconsistent with full maximization even when doing something as mundane as choosing which type of gas to put in their tank — how absurd is it to insist that, say, Keynesian stories about the economy can’t be right because we can’t fully derive them from intertemporal maximization?”

In other words, if workers say are not concerned with maximizing utility in terms of higher real wages, but in terms of relative wages, or if firms have limited knowledge about the workers willingness to work, and have an incentive to pay wages above the reservation wage (the one that compensates workers for the trouble with parting with leisure time), then the imperfection implies that the labor market will not clear and you might have unemployment. This is basically the efficiency wage story that New Keynesians use to justify unemployment (note that unemployment does result from real wages above the equilibrium level, and not from lack of demand as in Keynes).*

The capital debates show that even if you have workers trying to maximize utility in the normal fashion, and firms too have full information, that is, in the absence of any imperfection, there is no guarantee that lower real wages would imply more intensive use of the labor ‘factor.’ It is actually quite simple, if commodities are produced with commodities, then a reduction in wages also reduces the price of all goods, since they are produced with labor too, and there is a possibility that the fall in the price of commodities that do not use too much labor falls more than proportionally, so the increase in their demand does not lead to an increase in the hiring of new workers. Also, as wages are central for the consumer’s demand, the income effect of any reduction in wages would trump any (if it is positive) substitution effect. In other words, why would a firm hire more workers (even cheap ones) if nobody buys their products?

Further, PCMC does provide a sound way of determining relative prices. Long term normal prices are determined by the technical conditions of production, given one distributive variable (either real wages or interest, or if one prefers, for a given wage-profit frontier). It does take long term patterns of demand as given obviously, since producers would not supply, in the long term, goods and services for which there is no demand. The analysis of the determinants of effectual demand, the long term patterns of demand, are at a lower level of abstraction, and include all the institutional factors associated to fashion, conspicuous display of power, the effects of marketing, etc., that Veblen, Galbraith (father) and other institutionalist authors suggested were relevant.

Also, workers are rationally trying to obtain a fair wage, and to consume according to their tastes and the other social and institutional factors that determine their behavior. But those are taken as given for the determination of long run prices. And firms do maximize profits, and this implies that they add a mark up on their full costs. These models were developed by the authors of the Full Cost Pricing School, and the literature on barriers to entry, e.g. Sylos-Labini, Steindl and others, and the empirical evidence tends to be favorable.

In that sense, heterodox (classical-Keynesian, by which I mean Sraffa’s prices cum Keynes/Kalecki’s effective demand) does have a coherent determination of long run prices, based on rational behavior, as the foundation of the macroeconomic theory. Markets do not produce optimal outcomes and unemployment of productive resources is the normal, long run, position of the economy. In fact, the capital debates not only say that classical political economy (the surplus approach) provides sound microfoundations, but also that it is NOT possible to do so within the neoclassical/marginalist paradigm.***

* Interestingly enough Krugman’s argument for the current recession is not a rigidity in the labor market, but one in the money market, that is, a rate of interest that does not allow for investment at the level of full employment savings, the so-called Liquidity Trap.

** And yes there is empirical evidence in favor of this view, since there is no support for the effect of lower real wages and higher employment. Real wages tend to be pro-cyclical, go down in a recession, and up in the boom.

*** Arrow-Debreu also does not provide a way out of this conundrum.

PS: For the implications of Sraffa's contribution for Keynesian economics see this paper, and this post.

Stock-Flow with Consistent Accounting (SFCA) models

Gennaro Zezza, student and co-author of the late Wynne Godley and currently responsible for the Levy Institute macroeconomic model, gave an interesting talk on the usefulness of Stock-Flow with Consistent Accounting (SFCA) approach to macroeconomic modeling. He refers to the models as stock-flow consistent (SFC), but I prefer to emphasize that the consistency is not just about the relation between stocks and flows, but also the fact that these models provide the full set of accounts (website for those interested in this approach here).

SFCA proved to be considerably more successful than conventional, in particular Dynamic Stochastic General Equilibrium (DSGE) models, in predicting the Great Recession (see here paper by Dirk Bezemer).

As noted by Gennaro, the fundamental principle of SFCA models is that:

"in the economy – and therefore in models representing the economy - everything comes from somewhere and goes somewhere else: 'there are no black holes.' This obvious principle has relevant implications: one is that the debt of somebody is a credit for somebody else."

Note that this fundamental principle has more to do with the fully consistent accounting part of the model, than with the relation of stocks and flows. But stock-flow relations are also essential, since flow decisions of spending are tied to stocks. Private agents can spend if they have access to stocks of credit, of accumulated assets, that is, some stock of wealth. The State often has the power to spend and accumulate a stock of debt, since it can decide (Functional Finance and Chartalist approaches, which are implicit in Godley's work, become important here) the token in which debts are denominated.

One of the questions raised in the presentation was about the supposed lack of behavioral assumptions and expectations in the SFCA (as compared with DSGE models). First, it should be forcefully noted that there are behavioral assumptions, and those are strictly speaking based on Post-Keynesian (classical-Keynesian, I would say) principles. So agents autonomous decisions to spend create income, and in the models, I would add, investment follows an accelerator, so it tends to be derived demand, with the stock of capital adjusting to the flow of income (a relatively stable stock-flow relation, associated to the normal degree of capacity utilization).*

While DSGE models presume that an exogenous potential product (determined by supply side factors in a Ramsey/Solow/Lucas/Romer tradition) drives the economy, and deviations from it are corrected by price and wage flexibility, these models have an endogenous demand-driven output trend, which is really why they do better explaining the real world, including the Great Recession.

On the question of expectations Gennaro was clear, as a Post-Keynesian (PK) he is not particularly interested in expectations. He, however, suggested the possibility of using what Tom Palley refers to as model consistent expectations. That is, agents use expectations that are consistent with model (in this case the PK model, and, hence Lucas's problem is not that agents use all the available information, but that he has the incorrect model). Mind you the introduction of this expectational framework does little to improve the ability of the modeler to understand reality.

Finally, I want to note that while I do think that it is essential that these models, which are an alternative to applied DSGE models used around the world in Central Banks, international organizations, think tanks, and other institutions that managed to miss every single sign of the crisis, are developed and used more by economists, they should not be seen as the only modeling strategy available to heterodox economists.

In my view, the stock-flow and the demand driven (and I should say, the fact that price dynamics is orthogonal to the income flow determination structure)** is the essential characteristic of this approach. But the empirical, macroeconometric models that Gennaro and Wynne build have, more importantly, the full set of accounts, something that is essential for the empirical models, but sometimes too cumbersome for making a theoretical point. Hence, sometimes models that present the stock-flow dynamics (in a classical Keynesian perspective), without the full accounts (see here, for example), are necessary, useful and more directly relevant for the task of providing theoretical insight into a specific problem.

* This means that these are supermultiplier models in the Kaldorian tradition, which should not be a surprise since Wynne was a disciple of Kaldor. In fact, Kaldor was responsible for bringing Wynne to head the Department of Applied Economics at Cambridge in the late 1960s.

** Wynne was a student in Oxford of Andrews, one of the main authors of the Full Cost Pricing School.

Gravitation, Full Cost Pricing and Prices of Production

Franklin Serrano (Guest blogger)

Most Sraffians understand that gravitation of market prices to normal prices is much quicker than the slower, but inevitable, adaptation of capacity to demand. But other eminent Sraffians have made some confusion by wrongly identifying classical prices of production with full cost pricing.

Classical prices of production are the centre of gravitation for market prices and are determined by the costs of the dominant techniques (at the level of normal utilization of fixed capital) and the state of distribution. It is a general theory of the structural determinants and limits for the trend of market prices in all types of markets. In spite of the similar name it has little or nothing to do with “normal cost” or full cost pricing which is a generalization of the descriptions given by some firms as to how they actually calculate their own prices based on a markup over their own costs (not those of the dominant technique).

First of all, there is obvious fact that the theory of prices of production was developed in a historical period in which such these pricing rules simply did not exist (see Hicks’ Market Theory of Money, 1989). And prices of production can still explain, in my view, the structural or trend element even in markets with highly flexible prices subject to wild short run fluctuations and rampant speculation, as in the so-called “commodity” markets (in Garegnani’s comment on Asimakopulos he explicitly mentions the importance of explaining the trend of the relative price of copper even though “at any one time copper prices are 50% or more above or below trend”)

Second, even in the so called fix price markets, were firms set the prices of their products directly, the full or "normal cost" that particular firms use to calculate their own price is the actual cost of these particular firms and the markup these particular firms think they can add to prices without trouble. These calculations generate actual market prices or (if stylized enough to have some generality short run theoretical prices) that are not unique even for a single market as the full cost prices can be different for different firms. These prices differ from prices of production because they refer to the actual costs of some firms and not the costs of the dominant technique available. For that particular product that determines a single price of production for that market.

The way prices of production may regulate the full cost prices of firms is by getting them in trouble whenever their actual costs plus their desired markups are too high relative to the costs (including normal profits) of the dominant technique, thereby attracting new entrants or cause some rival firms inside that market not to follow price rises that are due to increase in costs particular to that firm or “excessive” desired markups of these firms.

Professors Fred Lee and Marc Lavoie are both absolutely right and some Sraffians wrong in saying that full cost pricing is NOT the same thing as the classical theory of prices of production. Where I think they are definitely wrong is in thinking that classical prices of production are thus irrelevant for market forms in which firms follow such rules. For, through the power of actual or potential competition, the classical prices of production are the centers of gravitation that regulate even the trend of the prices of firms that practice full cost pricing. The closest analogy between classical prices of production and the industrial organization literature is thus the concept that Sylos-Labini called “limit” prices.

So market prices in both fix and flex price markets gravitate, towards or around classical prices of production. Any theory of full cost pricing can at best be a particular theory of short run price behavior of some firms in particular types of markets. There are old papers by James Clifton that started this confusion many years ago in Contributions to Political Economy and the Cambridge Journal of Economics. It is about time we stop confusing ourselves and our post Keynesian friends on this issue.

References:

Lavoie, M. (2003), “Kaleckian Effective Demand and Sraffian Normal Prices: Towards a reconciliation,” Review of Political Economy, 15(1) available here.

Lee, F. and T-H. Jo (2011) “Social Surplus Approach and Heterodox Economics,” Journal of Economic Issues, 45(4) available here.

Garegnani, P. (1988), “Actual and Normal Magnitudes: A Comment on Asimakopulos,” Political Economy, republished in Essays on Piero Sraffa: Critical Perspectives on the Revival of Classical Theory, Routledge, 1990.