Marginal Productivity Theory

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This chapter describes the “marginal revolution” of neoclassical economics. The idea of marginal productivity and payments to “factors of production” was developed for ideological reasons to counter thinkers like Marx and George. The theoretical framework learned by generations of students is contradicted by the evidence. The ideas of capital and land in neoclassical economics are incoherent.

Economists tell us how consumers on the market, “voting” with their purchasing power got what they wanted and wealthy landowners got the economic theory that they wanted. It was economists like J.B. Clark that were necessary if your economics department was to become well-funded.Clark moved to Columbia University in 1895. The university was blessed by funding from Wall Street banker J. P. Morgan.

The key idea for theorists like Clark was that “factors of production” earned what they added to production “at the margin”. If adding an extra worker to the payroll adds more to production, sales and revenues, than that worker costs to hire, then it was in the interests of the employer to hire the extra worker. The same logic continued to apply as long as each additional worker enabled more money revenue to come in from extra production and sales than they cost. The process of adjustment by hiring more workers would stop at the point where the last worker (marginal worker) was adding as much to enterprise revenues as they were costing. Now what could be fairer than that? Employers would employ more workers until a point where each worker is being paid the same amount of money as the value they have added to production can be sold for.

The same logic is applied to explain the income being earned by the other “factors of production”, namely, an amount equal to the revenue from the sale of their marginal products. This idea was an ideological construction that suited business interests nicely.

Critics have pointed out the flaws in this reasoning. A technical argument about where a business person will no longer find it worthwhile, under tightly defined conditions, to add more and more labour to his capital, has been fudged as an ethical argument justifying the income distribution between that business person and his employees and ignoring the underlying social relationship between the wage labourer and the capitalist. In the words of Joan Robinson:

The very essence of the theory is bound up with a particular institution — wage labour. The central doctrine is that “wages tend to equal marginal product of labour”. Obviously this has no meaning for a peasant household where all share the work and the income of their holding according to the rules of family life; nor does it apply in a [co-operative] where, the workers” council has to decide what part of net proceeds to allot to investment, what part to a welfare fund and what part to distribute as wage.
Joan Robinson quoted in (What is Wrong With Economics, 2009)

Neoclassical economics thus, emerged, originating in an ideological imperative, namely, the justification of property incomes. This new approach concocted an elaborate fiction that was subsequently fed to each generation of students which purports to describe how companies decide how much they are going to produce.

If you ask most business people what determines how much they produce they will probably say that they are limited by how much they can sell or how much capital they can raise to expand production – which will also depend on them convincing a capital provider of how much they can sell. To the neoclassical economist, however, what limits what a firm will produce is not only that it may have to reduce its prices if it tries to sell more but that, as the firm increases, its production its costs will rise.

In the textbooks there is a picture of what happens in the production arrangements of companies which goes like this: If a company wants to expand its output “in the short run”, it will find itself unable to alter the availability of some “factors of production” like its premises and its capital equipment. However, it will be able to vary the input of other factors of production like its labour force. But adding more and more workers to the fixed quantity of capital equipment will eventually lead to “diminishing returns”. The neoclassicals want us to believe that output will increase but at a diminishing rate. The reason is that the ratio of workers to capital equipment becomes less than optimal after a certain point. Indeed at some point adding another worker would lead to no extra output at all. The last worker would simply get in the way and might even reduce total production.

The implication of “diminishing returns” from the variable factors of production (e.g. labour) is that if companies try to expand output they find that their costs will rise. Let us illustrate by imagining a company in which, in the early stages of an expansion process, there is little labour and much capital equipment. In this company, in order to expand production by 10 units a week it would require one extra worker costing an extra £100 a week to hire. An example of what “diminishing returns” would mean is that, to produce a further 10 units a week beyond this might require 2 extra workers costing £200 to hire. An extra 10 units a week again might cost 4 extra workers at £400. This being the case, if this imaginary company is to be induced to produce more and more, its owners will want to be able to sell the greater number of units at higher and higher prices so that they can cover the higher and higher costs. Since the company is unlikely to be able to get consumers to buy more at higher prices its expansion will be choked off by the diminishing returns which has led to rising costs.

Well, that is the textbook story anyway – but it is a conceptual house of cards which was dreamed up for ideological purposes in order to justify the distribution theory. The idea of diminishing returns is 164 important because, if you think about it, it implies that to employ more workers the labour force must take a wage cut. In the imaginary story an employer who employs more people is getting less and less additional product for each additional worker. To induce him to do this, he has to be able to pay them less to make it worth his while. It’s obvious then, isn’t it that, if there is unemployment in the economy, it is because wages are too high. Wouldn’t you know it – once again the poor have only themselves to blame.

Steve Keen quotes Galbraith:

Neoclassical economics can be summed up, as Galbraith once remarked, in the twin propositions that the poor don’t work hard enough because they are paid too much, and the rich don’t work hard enough because they are not paid enough. (Keen, 2011, p. 119)

What all of this has got nothing to do with, however, is the real world. This theory has been tested against empirical research over a hundred times and shown not to be true. If the theory were true it would be demonstrated by rising costs as companies try to expand, but these are not the findings. A few companies have cost structures like this but the vast majority don’t. The evidence is in cited in Keen’s book Debunking Economics.

For example, a study by Alan Blinder surveyed 200 medium to large US firms which collectively accounted for 7.6% of America’s GDP admitted that:

The overwhelmingly bad news here (for economic theory) is that, apparently, only 11% of GDP is produced under conditions of rising marginal cost… Firms report having very high fixed costs – roughly 40% of total costs on average. And many more companies state that they have falling, rather than rising marginal cost curves. While there are reasons to wonder whether respondents interpreted these questions about costs correctly, their answers paint an image of the cost structure of the typical firm that is very different from the one immortalised in the textbooks. Blinder 1998 quoted in (Keen, 2011, p. 126)

Blinder’s research is not alone. Steve Keen mentions 150 empirical studies. Every study found the majority of firms acting in a way that contradicts the textbook theory. (Keen, 2011, p. 125)

The reason is that the idea of “diminishing returns” is wrong. It is far more accurate to describe short term expansion (or contraction) in an industrial economy as involving “constant returns” as production is scaled up or scaled down. The “constant returns” occur at the same time as an increase or decrease in capital utilisation.

Here is another imaginary example that is a little more realistic. You wish to set up a business in the clothing trade employing (mainly) women who each work with a single sewing machine. You do it by acquiring premises and putting a number of sewing machines in the factory. The price of the premises, the sewing machines and other equipment are your fixed costs. As you start up you may use only half of the sewing machines and half of the production space of the factory, depending on the size of the market but if your product becomes more popular you hire extra women to sew using the otherwise unused sewing machines and the previously unused factory space. The sewing machines and space brought into use do not cost any more. These are fixed costs that were already being paid for and are now being spread across a larger volume of production. Nor are there any “diminishing returns” to the increased labour input, because, just as before, each worker works with one sewing machine and in the same amount of space, specifically for their work.

Fact is that production in an industrial economy requires an often tightly defined specialisation of labour functions and/or a specific relationship of workers to production equipment. There is no point in varying the worker to sewing machine ratio. Two or more workers per sewing machine at any one time makes no sense at all. Likewise, at any one time, just one lathe will be used by just one worker. A blast furnace has just so many workers with specific functions. The technical ratios between specialist workers in teams and between the workers and machines cannot be varied. To have flexibility one must have spare capacity – and then employ that capacity in the appropriate ratios that make for team work and relate workers with specific trade skills to specific kinds of equipment. The capacity, unused and used, represents a fixed cost that, when spread over increasing production, brings unit costs down. Because expansion is an expansion of all factors of production in a technically defined and fixed ratio, no such thing as diminishing returns occurs. What occurs is that capital utilisation rises or falls spreading the fixed costs over a varying output.

All this was largely worked out by a critic of the neoclassical school, Piero Sraffa in a paper written in 1926 that was published in the Economic Journal (Sraffa, 1926 ). It forms the basis for the chapters in Steve Keen’s book from which I have taken this very brief account. Keen quotes Sraffa:

Business men, who regard themselves as being subject to competitive conditions, would consider absurd the assertion that the limit to their production is to be found in the internal conditions in their firm, which do not permit of the production of a greater quantity without an increase in cost. The chief obstacle against which they have to contend when they want to gradually to increase their production does not lie in the cost of production – which, indeed, generally favours them in that direction – but in the difficulty of selling the larger quantities of goods without reducing the price, or without having to face increased marketing expenses. (Keen, 2011, pp. 116-117)

This way of explaining things helps to explain the rise and rise of the marketing industry. If, as neoclassical economists claim, it is diminishing returns and rising internal costs that prevent companies selling more and more then why would they bother to advertise? If the adverts worked they would be pushing themselves into a zone where rising internal costs would choke off further production anyway. On the other hand, if unit costs fall as production expands, then as long as the price is greater than that unit cost the company will make more the more that it sells. What limits the company then is the ability to sell its product. If the company reaches full capital utilisation then what limits it is the ability to raise 166 new capital to expand – and that partly depends on being able to convince an investor of increased sales in the future.

Capital in neoclassical theory

The fact that the theory does not match reality does not stop marginal productivity theory and diminishing returns being reproduced in the textbooks because it is useful ideologically as an “explanation” of income distribution. “Land”, “labour” and “capital” “get what they contribute at the margin” according to the theory when things are presented in this way. It is not within the scope of this book to go into these ideas in depth because I am trying to review the foundational issues that underpin economics in a simple way. Unfortunately, it is not possible to ignore them either and, in fact, there is a whole set of questions about “capital theory” where Ricardian economists in Cambridge in the UK and neoclassical economists in Cambridge in the USA (at the Massachusetts Institute of Technology) clashed about how to understand the “returns to capital”. These are described in Steve Keen’s book Debunking Economics where he does a good job in describing a very complex debate in which neo-classicals like Samuelson eventually acknowledged that the Cambridge economists in the UK had established their point. In effect, the UK economists challenged the idea that profit is the reward for capital’s contribution to production.

For neoclassical theory to be a complete picture of income distribution in society it has to scale up from how individual firms operate. This meant that economists needed to assume that units of labour and “capital” were identical or homogenous entities that move between economic sectors and firms as they adjusted continually to try to achieve their optimal outputs. Now, that idea is understandable when it comes to labour moving from one company or economic sector to another. But a loom cannot “flow” into work as a lathe. A lorry is a piece of capital equipment that cannot flow into use as a computer. Land cannot flow either. It is stuck where it is.

Economists have had lots of fun over the years dreaming up metaphors to try to get around this problem. Much effort has been devoted to creating “models” where “capital” as a physical entity is thought of in malleable terms in order to rescue neoclassical distribution theory. Capital in a “putty” form, or models using capital that could be reconstituted in a different form like Meccano, have been put forward. This was all in order to have “capital” that could move from sector to sector.

J B Clark started the process with what was called the “jelly theory of capital”. Naturally, Clark recognised that capital goods differ from industry to industry and from time to time. To cope with this conceptual problem, he regarded capital goods as being specific and transient embodiments of a general and permanent “essence of capital”. This is the fund accumulated by the economy’s savings up to any point in time and ploughed into specific capital goods.

Mason Gaffney describes this way of thinking as “endowing capital with a Platonic essence”. The ancient Greek philosopher Plato thought that what we experience in the physical world is an imperfect reflection of eternal perfect “forms” that exist somewhere. Ideal objects that capture the “real essence” of the things dimly reflected in our imperfect everyday physical existence. Thus, particular machines – lathes, looms, tractors – were an imperfect reflection of the “essence of capital”. The rationale of thinking in this way is something like this: capitalists use their resources in processes that “turns over” capital. Assuming they are involved in production they start with money, go on to buy machines, buildings, materials and hire workers, organise a production process and then sell the products to make a “return” which brings their money back with, as they hope, more money than they started. In this process, and over time, they will hold back some of the money returned to replace and buy new machinery. (Gaffney, 1994)

However, the only thing that looms, lathes and lorries, as items of capital equipment have in common is the fact that they have a money value. Neoclassical economists ignore the differences and just count the money value of the different kinds of machines as the common element making for comparability and measurability. But there is a problem of using price as a common way of counting different kinds of capital goods. The price of capital goods depends on the rate of profit and the rate of profit is the very thing that you are trying to explain. What one can do, however, is think of “capital goods” as commodities which enter into the production of other commodities. With this idea, Piero Sraffa at Cambridge UK succeeded in showing that you could make calculations based, not on money prices, but from calculating commodity inputs into the economic process as “dated labour inputs”. Ultimately, any lathe, loom or lorry is made with labour and with other inputs. These other inputs were made from labour and even earlier inputs. The earlier inputs were made from labour and other inputs made even further in the past and so on. If you go back far enough, you only have labour inputs – but you have to adjust your calculations to allow, at each stage, for a profit rate which has been taken out; and for the fact that different kinds of commodities enter into the production of other kinds of commodities in variable ratios.

What this exercise establishes is that, rather than the rate of profit depending on the amount of capital used as neoclassical economists would like us to believe, the measured amount of capital depends upon the rate of profit.

This, in turn, grounded the idea that the distribution of income is not the result of impersonal market forces but reflects the power relationships between different social classes as well as the technical capabilities of factories.

In later chapters I will explore ideas about production not developed by either Cambridge, England or Cambridge, USA – to explore the idea that the production of society depends on one input in addition to labour that enters into absolutely all economic activity – energy. Since energy is a commodity that enters into the production of all commodities, it is absolutely crucial and, as we will see, if the amount of energy needed to produce energy rises, and if the amount of energy needed to produce other raw materials rises too, then society will be in deep trouble.

J B Clark was not just interested in providing ideological cover for the property income to capitalists. He was concerned about landed income too. Perhaps conscious of the need to counter the arguments of Henry, George Clark described “land” as just another purchased input, another form of capital. Adding land to the picture of capital as Clark did was, as Tobin pointed out, a step that destroyed the equation of the capital stock being equal to the society’s accumulated savings. One may save resources (hold back from consuming them) in order to create machinery instead, but no one saves up to create land. Leaving aside polders and other reclaimed land, land is already there.

No matter – for Clark capital could “transmigrate” into land – a metaphor that made land and capital the same kind of stuff. This theoretical sleight of hand had the useful function of getting rid of the Ricardian theory of rent and provided the appearance of an answer to Henry George in the process.

Henceforth, most economists just focused on “labour” and “capital” as concepts to explain production. Land, with its distinctive features – spatial, temporal and environmental, largely disappeared from economic theory.

Thirty years after Clark, John Maynard Keynes wrote his General Theory of Employment, Interest and Money and declared that the influence of land was restricted to an agricultural age. It was capital and particularly, financial capital, which was the important influence in the modern age (cited in Harrison, 2005, p. 142)

Trying their best to be helpful to the elite, the idea of rent was also muddled by creating a new definition for it. “Economic rent” is now said to be the difference between what each factor of production is paid and how much it would need to be paid to remain in its current use – a definition of rent that rests upon the idea of opportunity cost.

Taking land out of economic theory meant that economic theory was “dis-located” or “dis-placed”. The conceptual category of “land”, and the linked concept of “rent”, represented real influences in the world that the system of ideas called “economics” was struggling to represent. Making these categories disappear from the constellation of ideas that made up economic theory had serious implications. The theory lost dimensions of inclusiveness and clarity. It was impoverished. More events could now happen in reality than the concept system had terms to explain. What was disappearing from theory when the concept of land was fudged into the concept of capital was the likelihood of further investigations into the distinctive features of land – spatial, temporal, environmental and ecological – all those things that I have tried to put back into this book. Even considered in narrowly economic terms, land is a very distinctive kind of asset because it is one of the main forms of collateral for the banking and finance system.

Discussions of production as the relationship between capital and labour were no longer “grounded”. The embodiment of economic activity in the physical world disappeared. The sense that it entails natural fertility; specific production locations; the extraction of matter and energy sources from out of the planetary crust and, consequently, putting wastes back into the earth; into the rivers and the atmosphere. All these kind of things were effectively out of sight of the theory and out of the mind of the theoreticians. Out of sight and out of mind was exactly how the landed elite liked it – particularly in Britain where the power and inequality involved in landed property has been deliberately hidden by an aristocracy anxious to avoid the threat of a land value tax and to enjoy their privileges undisturbed.

Kevin Cahill’s book Who Owns Britain sets out the figures starkly: the UK is 60m acres in extent, and two-thirds of it is owned by 0.36% of the population, or 158,000 families. In Scotland it is even worse – 432 individuals own half the private rural land. In contrast 24 million families live on the 3m acres of the Britain’s “urban plot” – and then buy into the idea that Britain is a severely overcrowded country in which land is extremely scarce. (Adams, Tim 2011 ).

“Much of this can be traced back to 1066. The first act of William the Conqueror, in 1067, was to declare that every acre of land in England now belonged to the monarch. This was unprecedented: Anglo- Saxon England had been a mosaic of landowners. Now there was just one. William then proceeded to parcel much of that land out to those who had fought with him at Hastings. This was the beginning of feudalism; it was also the beginning of the landowning culture that has plagued England – and Britain – ever since.” (Kingsnorth, Paul 2012.)

However, in the last few years a large amount of landed property in the UK has been purchased by the moneyed members of the global elite from the descendants of early medieval gangsters. The astronomic house prices and rents in London as well as in some of Britain’s country estates is because the property magnates of the world are buying up the place. (Adams 2011)

Concluding remark – different meanings of “diminishing returns”

It was Ricardo who first utilised the concept of “diminishing returns”. He realised that different areas of land as a resource had different fertility and different degrees of desirability in other senses too e.g. distance to markets. He used this idea of differences in desirability in his theory of rent. Ownership of the most fertile land nearest to market meant the ability to charge more rent than in less fertile and more out of the way places. What happened was that the neoclassicals tried to adapt Ricardo’s explanation for rent for other factors of production by claiming diminishing returns in different circumstances – where factors of production were used in differing ratios with each other. As we have seen, this was not an appropriate thing to do in most industrial production processes but the idea of diminishing returns is useful in some contexts. As we will see, it is useful in office work and service contexts and it is, above all, useful in describing the relationship between the economic system and the ecological system. As the size of the economic system expands in relation to the fixed size of the ecological system, there are indeed diminishing returns. When the best sources of fuels, minerals and soils are used first, depletion means that the cost of extracting increasing amounts for economic use increases. More resources have to extract resources. Furthermore, if wastes and pollution from production increase then more resources have to go to deal with the consequences. This is diminishing returns. Those problems are the limits to economic growth. Ironically neoclassical economists seem unable to acknowledge these diminishing returns as a problem.