Politica Economy of Italy prof. Magliulo

LECTURE 1- WHAT IS POLITICAL ECONOMY?

1- FROM POLITICAL ECONOMY TO ECONOMICS AND BACK AGAIN

What’s the main issue of our time? How to run the world. How to run Europe, that is to say what is

the single role of every nation.

We can manage the globalization in order to improve not only the output of goods and services, but

also social justice.

This is the subject of several disciplines including economics (international economy and

international political economy). Economics was born as political economy. The wealth of nations by

Adam Smith (67), then we have The principle of political economy and taxation by Ricardo and finally

John Stuart Nell (Principle of political economy), whose original title was Political economy is the

sign of wealth.

CLASSICAL ECONOMICS (1776-1874)

The content of the discipline: political economy is the science of wealth of nations, so it is an

enquiry into production, distribution and consumption of goods and services.

Wealth is a key issue for classical economists. They used a particular classical approach:

1- Methodological holism: society divided into 3 groups, social classes rather than individuals.

Society composed by 3 main social classes: landlords, workers and entrepreneurs.

2- Labour theory of value: interested in studying and explaining the market economy. At the

centre of the market economy there was the phenomenon of exchange. Again, the importance

of exchange value, market value. Value of goods and services. One good is valuable because

it requires a cost of production. Value of objects determined by the cost of production, that is

given by the labour to produce the things. Everybody specializes in some objects. Value of

exchange determined by the cost of production: the higher the cost, the higher the final price.

In particular, the work force, the human force to produce.

3- Ricardian discovery: Principle of comparative advantage. Idea: the entire world become

richer thanks to a division of labour, principle of specialization. It is not necessary to be more

efficient in everything.

For more than one century (1776-1874): golden age of classical economy.

The main message: in a world characterized with imperfect international mobility of goods and

services, it is sufficient to guarantee free trade in order to maximize and reconcile national interests.

Main message of classical economics.

In the domestic market everything can circulate, on the contrary in the international market there is

an imperfect international mobility of K and L.

Then something occurred: the decline of classical economics. 1

THE DECLINE OF CLASSICAL ECONOMICS

Reasons:

1- Limits of the labour theory of value: it was false that the value of good depended on labour. It

was not the cost, the time of L in particular, to determine the exchange. There was something

else. Also Smith recognized that utility was an important criteria of value, but he said that it is a

prerequisite of value, but it is not the cause of value. The classics understood that utility was

playing a role (the water is the most important thing, and it is free). Distinctions between use

value and exchange value: the classics did not have the concept of marginal utility, that is, the

utility that provides the last available dose of goods. In the desert, a bottle of water has a different

value than it would have in Rome.

2- The lack of distinction between absolute and relative gains of international trade. Ricardo

and the other classical economists stated that there is a trade gain. International trade is a win-win

activity, but someone said: we distinguish between absolute and relative gains, some countries

become richer compared to others. Some gain more than others: phenomenon of globalization,

where some took the best benefits, leading then to an increased inequality.

3- The class struggle and the fear of Marxism. Marxism learned economics studying Ricardo.

Many people thought that the classical economics was a dangerous discipline. For several reasons,

the decline of classical economics curved after the end of the century and the 2 paradigm

appeared: neoclassical economics.

NEOCLASSICAL ECONOMICS (1870-1935)

• Alfred Marshall (1890), Principles of Economics: “political economy or economics is a study

of mankind in the ordinary business of life”. First time that appeared “principle of

economics”: paradox because Marshall was a political economist. He was very expert in

Marx, but he believed in a social science rather than in a pure economy. He uses the 2

expressions as synonyms. But the 1 book that has the title of Principle of economics is that

st

of Marshall, but Marshall remain a political economist, so advocate of an economy that can

talk to the society, that can interpret the society, not only a “mathematical” science. He

formalized the theories in the appendix, where he put the mathematic formulas. His ambition

was to be understood by everyone.

• Economics as the science of rational choices under conditions of scarcity. Choice of

rational choices. People face every day the phenomenon of scarcity, so they have to make

rational choices. Lionel Robbins (1932): “the science which studies human behaviour as a

relationship between ends and scarce means which have alternative uses”.

o Economy not anymore as science of wealth, but science of the rational choice.

o Margaret Thatcher “society does not exist”: there are all individuals. Marginalist

economists, marginal revolution: first of all they said they had to study the behaviour

of the single individual, but there is an economic problem, because Robinson Crusoe

must face some decisions concerning the way of satisfying his basic needs.

o So there was a change in the approach: starting from the behaviour of the individual

behaviour of Robinson Crusoe: how to formulate the economic problem of the

consumer. Approach that from the bottom starting from individual choices went up to

the point of explaining the entire economic system. Copernican revolution: for the

marginalists at the centre there are individuals, with their needs, limit of resources,

possibility of making rational choices.

Key points:

• Methodological individualism

• Marginal utility theory of value: value depends on marginal utility 2

• Economic equilibrium: the classical were interested in the long run issues, basically they

formulated an economic growth theory. Neoclassical economists focus their attention of

short run: the main issue was economics equilibrium, best allocation of scarce results.

Main result: economic freedom remains the way to reconcile national interests and to ensure the best

allocation of scarce resources. Support of a “do nothing policy”, best way is the economic freedom.

Main result was also freedom, ensure a convergence of all economic system to a full employment

equilibrium. Without obstacles economies converge, tend towards a balance of full employment, all

available resources are allocated in the best way. Free market economy ensures a balance of full

employment. Main political message of neoclassical mainstream economics until J.M Keynes.

KEYNESIAN REVOLUTION (1936)

• “The general theory of employment, interest and money” (1936)

• The founder of macroeconomics was Keynes

• The hidden disease of capitalism: not only business cycles but underemployment equilibrium

too

• The role of aggregate demand and expectations (uncertainty)

• How to manage the economy? With a demand management policy, rather than freedom.

• For Keynes economy is governed from the top of the demand. We need a government that acts

on the level (sum C, I, G, T etc.) and aggregate demand. Before then there was the myth of the

equilibrium of the balance. The deficit was not allowed. Keynes justified aggregate demand

management policies. If investments, private consumption, and spending cannot move, the

system plummets. The state must replace private individuals when they fall.

• Main idea: free markets converge towards an under employment equilibrium. The hidden of the

capitalists is not just the business idle (way of prosperity and depression), but also the tendency

towards underemployment. Idea derived by the crisis of 1929.

• Keynes introduces the revolutionary idea according to which freedom leads to

underemployment equilibrium. Why? Basically, because of uncertainty. Key word. Everything

is ok until negative expectations, uncertainties, fears, psychological factors prevail. Families

who can spend do not spend, those who can make investments postpone them. Aggregate

demand decline.

• According to Keynes all depends on the aggregate demand. Main idea: due to uncertainty we

can observe a drop in private investments.

NEOCLASSICAL SYNTHESIS

• One year later J.R Jick, “Mr Keynes and the “classics”. A suggested interpretation” (1937).

Review of book by Keynes.

It was a revolution in economics introducing the neoclassical synthesis: try to reconcile

Keynes and the classics.

• IS- LM model core of macroeconomics: investments saving, liquidity money. The message

was: Keynes is right, but the Keynesian theory is just a special case within the “general”

neoclassical theory”. The special case refers to great depressions. Message: in the normality

of economic affairs the neoclassical theory holds. There are, however, extraordinary events

due to fear, uncertainty, animal spirits, which can lead to a major crisis where Keynesian-

type intervention is needed.

• The Keynesian theory as a “special case” within the “general” neoclassical theory. The

special case refers to great depressions 3

THE RISE OF MAINSTREAM ECONOMICS (AFTER WWII)

After the end of World War II the rise of mainstream economics was characterised by:

1- High theory and popularized economics. Lot of formulas etc but approach basically

neoclassical. On the other hand standard economics, in the newspaper, radios etc used for

interpreting the main ordinary events of Italy, Europe and so on.

2- Both focused on rational behaviour and economic equilibrium: they share a common

approach, the

3- Progressive separation from history and politics

4- Economics as a self-sufficient discipline

PRINCIPLE OF ECONOMICS

Nowadays the basic principle of economics:

• The twofold meaning of the Italian word economia translates into English with 2 words:

economy (real world) and economics (social science investigates the economy). Tourism

economy: tourism market activities, and tourists economics. Italian economics: Italian

economy developed by Italian economists.

In real world we ca see several economics problems:

• Consumers choices

• Firm decisions

• Functioning of markets

• Growth

• Unemployment

• Inflation

• Debt…

ECONOMIC ACTORS

• 3 main actor on decision-makers:

1- consumers,

2- producers,

3- governments (public authorities)

• Consumers households would like to buy/have a lot of things

• Entrepreneurs would like to earn a lot of money

• Workers would like to have both high wages and high employment

• Governments would like to have everything (high growth, low inflation..)

• Essence of all economics problems? Scarcity.

THE ESSENCE OF ALL ECONOMIC PROBLEMS

• The consumer would like to have everything, same for the produces.

• Unfortunately the available resource are insufficient to satisfy all need to achieve all ends.

• The essence of all economic problems is scarcity.

• Therefore we have to choose how to use the scarce resources in order to achieve the main

desirable ends. 4

ECONOMICS

• Economics is today the science of rational choice under conditions of scarcity.

• It focuses on the relationships between multiple ends and scarce means

o Ends refers to human wants

o Means refers to economic goods

TEN BASIC PRINCIPLES

Watch and read Mankiw chapter 1.

• How people make decisions: To get one thing that

1- People face trade-offs: to get one thing, you have to give up another thing.

we like, we usually have to give up another thing that we like. Making decisions requires trading

one goal for another. Examples include how students spend their time, how a family decides to

spend its income, how the government spends revenue, and how regulations may protect the

environment at a cost to firm owners.

A special example of a trade-off is the trade-off between efficiency (the property of society

getting the maximum benefits from its scarce resources) and equality (the property of

distributing economic prosperity fairly among the members of society). For example, tax paid

by wealthy people and then distributed to poor may improve equality but lower the incentive for

hard work and therefore reduce the level of output produced by our resources. This implies that

the cost of this increased equality is a reduction in the efficient use of our resources.

2- The cost of something is what you give up to get it (it includes both implicit and explicit cost).

It is the value of the best alternative. Opportunity Cost also includes the implied cost. In

Because people face tradeoffs,

economics, the cost includes both implicit and explicit costs.

making decisions requires comparing the costs and benefits of alternative courses of action.

The cost of going to college for a year is not just the tuition, books, and fees, but also the foregone

wages.

3- People think at the margin (marginalism idea) comparing marginal costs and marginal

benefits. The rational individual when choosing makes every instant decisions by comparing the

Consumers want to purchase the bundle of goods and services that allow them

marginal benefit.

the greatest level of satisfaction given their incomes and the prices they face.

Firms want to produce the level of output that maximizes the profits.

4- People respond to incentive: the government can influence individual choices with incentives.

Incentive is something that induces a person to act [by offering rewards to people who change

their behavior].

Because rational people make decisions by comparing costs and benefits, they respond to

incentives. Incentives may possess a negative or a positive intention: for example, by offering a

raise in the salary of whosoever works harder can induce people to work hard which is a positive

incentive. Whereas putting a tax on a good, say fuel, can induce people to consume it less which

is a negative incentive. 5

• How people interact:

5- Trade can make everyone better off: it means that trade is a win-win activity. Voluntary

exchange make everyone better off. Comparative advantage principle.

6- Markets are usually a good way to organize economic activity: theory and experience show

us that the best way for organizing economy activity is free markets rather than planned economy

(centralized, programmed). Market are where buyers and sellers can meet to get goods and

Market prices reflect both the value of a product to consumers and the cost of

exchange items.

the resources used to produce it. Centrally planned economies have failed because they did not

allow the market to work.

7- Governments can sometimes improve market outcomes. In real world very often we

experience the so called “market failings” (situation where a market left on its own fails to allocate

resources efficiently): markets aren’t the best mechanism to allocate the resources, they don’t

guarantee the efficiency. So governments can sometimes improve market outcomes.

• How the economy as a whole works:

8- An economy’s standard of living depends on its ability to produce goods and services (that

is to say, productivity): the key variable in the LR is productivity. In the SR Keynes is right, but

in the LR the main variable is productivity. Italy since 1995 is suffering of a fall in the productivity

in the standard of living from one country to another are quite large.

of labour. Differences

Changes in living standards over time are also quite large. The explanation for differences in

living standards lies in differences in productivity (the quantity of goods and services produced

from each hour of a worker’s time). High productivity implies a high standard of living. Thus,

policymakers must understand the impact of any policy on our ability to produce goods and

services. To boost living standards the policy makers need to raise productivity by ensuring that

workers are well educated, have the tools needed to produce goods and services, and have access

to the best available technology.

9- Prices rise when the government prints too much money: according to this theory, inflation is

When

a monetary phenomenon. Milton Friedman said that inflation is always a monetary issue.

the government creates a large amount of money, the value of money falls.

Examples: Germany after World War I (in the early 1920s), the United States in the 1970s and

Zimbabwe in the 2000s. Most economists

10- Society faces a short run trade-off between inflation and unemployment.

believe that the short-run effect of a monetary injection (injecting/adding money into the

economy) is lower unemployment and higher prices. An increase in the amount of money in the

economy stimulates spending and increases the demand of goods and services in the economy.

Higher demand may over time cause firms to raise their prices but in the meantime, it also

encourages them to increase the quantity of goods and services they produce and to hire more

workers to produce those goods and services. More hiring means lower unemployment. Some

economists question whether this relationship still exists. 6

THE METHOD OF ECONOMICS

• In order to investigate the economy, real world, economists use models: abstract

representation of reality

• All economics models have one or more critical assumptions.

FUNDAMENTAL ASSUMPTIONS

1- Every economic decision maker tries to achieve a particular goal (profit, employment).

2- Every economic decision maker faces constraints

Maximization subject to constraints: the economic approach to understanding a problem is to

identify the decision makers and then determine what they are maximizing and the constraints they

face.

THE RATIONAL CHOICE

• People must choose something and give up other. People