Foundations of Economics

A Beginner's Companion

Yanis Varoufakis

• Publisher: Routledge
• Year: 2002
• ISBN:
  9781134682607
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Foundations of Economics breathes life into the discipline by linking key economic concepts with wider debates and issues. By bringing to light delightful mind-teasers, philosophical questions and intriguing politics in mainstream economics, it promises to enliven an otherwise dry course whilst inspiring students to do well.
The book covers all the main economic concepts and addresses in detail three main areas:
* consumption and choice
* production and markets
* government and the State.
Each is discussed in terms of what the conventional textbook says, how these ideas developed in historical and philosophical terms and whether or not they make sense. Assumptions about economics as a discipline are challenged, and several pertinent students' anxieties ('Should I be studying economics?') are discussed.

Book 1

Foundations

Chapter 1

Introduction

The textbook definition of economics

Economics studies the allocation of scarce productive resources (e.g. workers, machines, land) to different productive activities (e.g. factories, offices, farms, labour, machinery) whose purpose is to generate commodities that will satisfy consumers’ needs. In the economists’ own jargon, economics examines how scarce, or limited, ‘factors of production’ (usually defined as land, labour and capital) can be used wisely when there are many competing uses. In brief, economics is hailed as the science of rational choice under conditions of scarcity.

Yet, not everyone agrees…

Economics has been defined as the logic of choice…Economists have said that their subject is about reason…But almost none of them have said that their subject is concerned with imagination.

George Shackle, The Nature of Economic Thought, 1966

1.1 A world without economics

Let’s face it. Beginning a lecture with the textbook definition of economics (see box) is not the kind of opening line that is likely to send ripples of excitement through an audience. So allow me a different introduction: why are you interested in economics? If you are a university student, why have you not chosen to study something else? Your university offers a multitude of courses from astronomy to zoology. Why economics?

Ignoring the usual answer of the sort ‘er…because my friends/ parents suggested it’ or ‘because I want a job and economics is compulsory for a business degree’, the usual response to this question more often than not involves some general statement on the importance of the economy in social life. But then the question becomes: was economic life not important in the past, e.g. in the seventeenth century? Why were there no people thinking of themselves as students of economics? (Even Adam Smith, the founder of modern economics who wrote during the second half of the eighteenth century, was a moral philosopher.) And why did it take so long (i.e. not before the 1890s) for universities to offer degrees dedicated to economics?

Ancient economics

Economic questions have, of course, featured in the minds of intellectuals since the dawn of civilisation. The ancient Greeks, for example Aristotle, have written on matters which, today, we can identify as economic. Yet, unlike the first western economists (e.g. Adam Smith), none of those ancient writings were part of an overarching economic thesis (that is, an economic theory) on how society as a whole worked.

One may be tempted to think that our ancestors were less sophisticated and developed than we are in all the intellectual pursuits and economics, just like the other disciplines that make up today’s university curricula, took its time to evolve. To some extent this is true. The oldest European universities, dating back to the twelfth century, taught almost exclusively the classics, law and theology. The natural sciences—physics, astronomy, chemistry (all known as natural philosophy back then) —were introduced only gradually after the sixteenth century. But why did economics take two or three centuries longer? Moreover it is not true at all that our ancestors were intellectual slouches. The ancient Chinese, Egyptians and Greeks were responsible for admirable technological advances and built incredible monuments to them. The depth of their philosophical thinking still tortures and shapes the mind of our best thinkers today. As for the modern, post-Dark Ages era, at least since the fourteenth century physics, chemistry, botany and mathematics have been flourishing. Yet genuine economic thinking had barely taken off the ground four centuries later. Why?

I suggest that contemplating this question is the best introduction to economics. It helps us to realise that the current collection of economic concepts is puzzlingly recent. That it is not as if the contents of the textbook have always been there waiting for you to come along and digest them. No, economic models are recent concoctions which are impossible to understand properly without understanding how they came into being. Back to the question then: why was there no discipline of economics until so recently? Did the Romans not care about their economy? Were Elizabethans unaware of the importance of economic might? Was the aristocracy of the French so-called ancient régime (i.e. the pre-Revolution establishment) uninterested in matters economic? Surely they must have wanted more power and wealth. So, why did they not develop a systematic economic approach? My answer (and I say ‘my’ because not everyone agrees with it) is that earlier societies had no use for economics; that they could understand social power and wealth without a specifically economic analysis. By contrast, in our days it is unthinkable that we can say something sensible about the state of a society (e.g. the distribution of income, of opportunities and of power) without engaging with ideas which are specifically economic.

How come there was no such need in past societies? Consider one example. In medieval times the success of the Spanish merchants in Latin American markets could be explained adequately by pointing out the military presence and power of the Spanish conquistadores on that continent. Similarly the success of English and Dutch traders made sense in terms of the domination of important sea routes by the English and Dutch navies. Contrast this type of extra-economic explanation to what is needed today in order to explain why it is that Japanese firms are successful at selling cars in the USA. Unlike medieval successes, modern commercial triumphs or disasters have to be narrated in terms of purely economic concepts such as price competitiveness, costs of production, quality control in factories, innovation, etc.

Let me now make an even more controversial claim: not only was there no use for economics in earlier societies but, in addition, those societies could not possibly develop the kind of economics that you will find in any modern textbook. To see this point, consider the textbook definition of economics in the box on p. 3: the economics textbook tells a story about the creation of goods for the purpose of selling or exchanging them. Such goods are called commodities. And what are those commodities made of? The ingredients necessary to produce them are known as factors of production and they fall under three main categories: Land, Labour and Capital (by the way, the latter refers not to money as such but to the tools and machinery necessary in the production process; that is, ‘means of production’, which were produced earlier—I shall be returning to this shortly). To produce commodities, the modern textbook continues, a firm needs to mix some land (and the minerals, oil, etc. found under its surface) with some human labour and, preferably, with some machinery other humans produced earlier (i.e. capital). But where does the firm get these factors from? In later chapters the standard economics textbook explains: it gets them at the same place that one buys all things, the market-place. Indeed this makes much sense today given our experience of such markets, e.g. estate agents selling or renting land, the local employment bureau (or the newspaper’s job pages) in which labour is traded and the well-developed market for machinery, computers, etc. (that is, the market for so-called capital goods).

So, production generates commodities required by consumers by utilising other commodities which are needed by the firms (that is, the factors of production). Both the output (i.e. goods and services) of and the input (i.e. factors of production) to the process of production are commodities which are traded in various markets (e.g. the market for bananas, the market for land, the market for labour, etc.). Then economics is defined as the science of how markets, as a result of competition between many buyers and sellers, allocate rationally all these commodities in a society which always wants more of them. In short, economics is defined by the textbook as the science of how commodities are distributed under conditions of scarcity.

What we call today the discipline of economics (as opposed to some disconnected thoughts about prices, etc.) tries to disentangle the above process; to explain the workings of societies in which both its material products and the raw materials (human and non-human) used to produce them are commodities; that is, goods freely traded in markets. This is precisely why it was irrelevant a few centuries ago! If this conclusion seems too sudden, consider this. The description so far of what economics tries to achieve would have been out of place in ancient Greece, imperial Rome or feudal France. Granted that production and exchange are as old as Homo sapiens, it is easy to forget how different pre-industrial societies were from ours. Take the three factors of production mentioned in the previous paragraph: land, labour and capital. They always existed. Yet not in the way they do today, not as fully-fledged commodities.

Start with land. Of course there was land. Recalling that a commodity exists only to the extent that its very function is to be traded, a commodity called land has not always existed. That is, until a few centuries ago there was no established market for land deciding who owned which plot of land and how much someone had to pay to get it. In ancient times when the powerful wanted more land, they did not contact an estate agent; instead they formed an army made up of hapless subjects, often slaves, and started a war of conquest. Under those circumstances no one had an urgent need for an economic analysis of land-ownership. Things changed under feudalism. In the feudal era, the lords owned whole estates (including the peasants living in them) and usually considered the sale of inherited land shameful. Indeed property rights to land were passed on to the lords by kings and queens as reward for political services and even though land prices were quoted extensively in medieval archives, their function was not what it is today (that is, to regulate the demand for and supply of real estate). Instead they played the role of reflecting the power and political status of the landlords. In short, land was not a commodity with a price determined by the level of demand by prospective owners whose eagerness to buy the land was, in turn, its capacity to generate profit in some market (e.g. the market for agricultural commodities or indeed in the market for land). A handle on war history and political machination would have proved much more useful than economics in explaining land transfers and prices.

A glimpse of the pre-industrial world

AD 1305 Europe

The total amount of goods which came into France in a year over the Saint Gothard pass (on the first suspension bridge in history) would not fill a modern freight train; the total amount of merchandise carried in the great Venetian fleet would not fill a modern steel freighter.

Sixteenth century

German traders had to stop every 10 km to pay customs tolls which were decided after intense bargaining. Most villages had their own currencies and in an area the size of London there were 112 different measures of length. Moreover, from France to Russia, from the Ottoman Empire to Scotland, there was nothing that we would recognise today as markets for labour or for land.

Historical points borrowed from Robert Heilbroner, The Worldly Philosophers, 1953

The same applies to factor of production labour. Of course there was labour and plenty of it. The pyramids could not have been built without the rivers of sweat and blood of countless Egyptian workers. And while Plato was leisurely exploring the distinction between a perceived and an ideal reality, surrounded by adoring disciples and intellectual antagonists in his Academe, slaves and Athenian women were doing all the work. Under feudalism, and excepting the idle classes, the European peasants worked much harder than any of us will ever do. Nevertheless the immense toil of slaves, peasants and women was not a commodity. Its product was, of course, greatly enjoyed by those who benefited from it (e.g. the philosophers, the rulers, the men). Yet all this effort was not something that was bought by some employer at a price (i.e. a wage) determined in accordance to its productivity and to the demand for its output. In feudal Europe, for example, those unfortunate enough to have been born peasants did a lot of work in the footsteps of their mothers and fathers. They cultivated the same land generation after generation producing harvests in the hope that the landlord would allow them to keep a portion which would see them through the next winter. To understand how much of their harvest they were allowed to keep, modern economic thinking would have been irrelevant. Why? Because the distribution of the harvest between lord and peasant was a political matter depending on the lord’s cruelty as well as on his fear of a peasant revolt, the role of the sheriff, the degree of solidarity between landlords (and between peasants), the relations between the political centre (i.e. the king or queen) and the regional powers (i.e. the estates and the lords and even the bishops), the threat of invasion by foreign armies and so on. By contrast, if we want to explain today the wages of farm labour in the United States, Germany or Indonesia we cannot rely on purely political notions. Instead we need to ask questions about the market value of agricultural products, the productivity of the farm labourers, their alternative employment prospects, etc. In brief, we need an economic approach that would have been impossible to conceive in a feudal world in which the lord simply collected a portion of the harvest from the peasantry.

Two definitions of capital: a means of production or a property right

Students of economics may be confused by the fact that the term ‘capital’ is used by economists in two seemingly very different ways: (1) machines, tools or any produced means of production; (2) a right to own the revenue that is left after land (i.e. rent) and labour (i.e. wages) have been paid for. The two definitions are brought closer together if it is assumed that those who own the ‘tools’ also own the right to appropriate the surplus (i.e. revenue minus cost) that they produce.

The third factor of production mentioned in economics textbooks, capital, was in its infancy. First, a reminder of the fact that, unlike accountants, when economists speak of capital, they do not mean money (see box). Instead they are referring to a commodity (e.g. a tractor) that was produced at an earlier stage in order to be used in some productive process (e.g. in ploughing a field). With this definition out of the way, let us agree that, just like land and labour, capital also existed since palaeolithic times in the form of tools, ploughs, etc., even if its presence in production was minuscule by comparison to how crucial it is today (think of industrial robots, computers, production lines, etc.). However, what is crucial is that capital did not really exist as a commodity. In ancient times it was produced mostly by slaves for their masters. In feudal estates tools were produced locally, often at the estates themselves, by artisans who found a niche in between the aristocracy and the peasantry. Even when they were sold at the town’s market, it was never under competitive conditions as competition was ruled out either by the fact that there was a single producer in each municipality or because, when there were more than one, they were part of a guild which expressly banned competition amongst them. Thus, it is impossible to think of the utilisation of capital in a modern economist’s terms: that is, as a scarce commodity which the competitive market was allocating to its best possible use. Again we find that the economics textbook’s conception of capital would have been irrelevant back then.

Lastly, markets and trade were not what they are now. When merchants arrived in a medieval town, they brought with them some spices, some fancy clothing, a few luxury items. Their volume was microscopic as a proportion of all the goods consumed in the area. (Let us not forget that, back then, when the peasants and villagers wanted something they did not shoot off to the shops to get it; they made it themselves instead.) Moreover there was no competition since it was unlikely that there would be more than one merchant selling the same type of good in the same village. And when they were, the authorities (including the priest and the local lord) ensured that there ...

Table of contents

• Cover
• Half Title
• Title
• Copyright
• Dedication
• Preface
• Contents
• List of figures
• List of tables
• BOOK 1 FOUNDATIONS
• BOOK 2 ANXIETIES
• Further reading
• References