Originally, as we have just seen, economists presumed that all indices, including rents, were determined by the interplay of objective factors (facility of production, fertility of land, and so forth) as these are taken up into the rational calculations of profit-maximizing agents. The calculability of economic magnitudes -- the possibility, that is, of deducing the magnitude of changes in prices, rents, wages, or profits that would result from a change in a technique of production, say, -- depends completely on this assumption of rational self-interest. In order to determine the effect of an improvement in the technique for producing corn, for example, we must assume that corn producers will adopt the new technique unhesitatingly once they calculate that it is more profitable; that consumers will bid down the price of corn as soon as there is excess supply in the market; that producers in less profitable lines will shift their capital as soon as possible to the corn sector, where higher profits are being made; and that landlords will readily rent out their land for as much as or as little as they can get.
With these assumptions, some very nice theoretical deductions can be made. For example, with the aid of modern mathematical techniques, it can be shown that any technological innovation that it is profitable for the individual firm to introduce at current prices will, once the total system of prices has adjusted itself to the innovation, have the effect of raising the system-wide rate of profit. Or, to take a very much more elegant and powerful result due to the great mathematician John von Neumann, any economy engaged solely in the production of capital goods and wage goods has available to it a balanced growth path along which the growth rate of the economy exactly equals the profit rate. And so on and on.
Once we introduce Mill’s factor of custom, however, all such deductions become in principle impossible. If the rental for land depends in part upon custom and habit, what will be the effect on rents of an improvement in the techniques for producing corn? If custom is not a factor, the answer is simple: rents will rise. With a little modern algebra, one can even calculate exactly how much they will rise. But if custom is a factor, there is really no telling. The most we can possibly say is that if custom holds sway, rents may change not at all. If competition is the sole determinant, the full effect will be felt. Somewhere between the two lies the answer.
Now, growth depends on the disposition of the annual surplus, and according to the behavioral assumptions of the classical model, capitalists invest and landlords consume. So clearly the secondary effect of custom will be to alter the growth rate of the economy. The more custom operates to hold rents at the traditional levels in the face of technical advances in corn production, the more will the additional output resulting from those advances turn up as profit in the pockets of the capitalists, there to serve as additional capital for growth. The less custom operates, the more additional output will end up as increased rents, to be consumed unproductively by the profligate landlords.
How can we adjust our theory to take account of custom? The obvious maneuver, and the one which is essentially at the heart of modern econometrics, is to introduce into our equations a dummy variable standing for the influence of custom on rents. We can, for example, stipulate that when techniques of corn production change, the rents will change by a factor of k times the amount that would change if competition along were operative.
The value of k, obviously, cannot be calculated by the sort of a priori reasoning on which classical theory rests. In order to put a value to k, it would be necessary for us to collect large amounts of data from actual land-rentals over long periods of time. We would then have to make a number of simplifying assumptions, such as that all renters are affected by custom to the same degree, that the effect of custom is reasonably constant over time, and so on.
Now, it is very important to understand that this something called custom which is thereby introduced into our model has an ontological status if you will permit me some heavy philosophical artillery, fundamentally different from that of the rational self-interest underlying competition. “Custom” is not that name of a principle of rational choice, nor is it even the name of a stable, identifiable non-rational psychological element. “Custom” is simply a catch-all title for the sum-total of all the deviations from rational self-interest that might cause ground-rents to be something other than what the pure theory of competition dictates. Some landlords may fail to adjust rents because of laziness, others because of stubbornness, others for religious or family reasons, and others still because of bonds of baronial loyalty to the peasantry. Obviously, a wide variety of historical, social, economic, and cultural forces may manifest themselves under the heading of custom, with economic consequences of quite varied sorts.
With the marginalist revolution of the 1870’s, based on the substitution of subjective utility for objective technology as the fundamental determinant of price, all hope is given up of a theoretically a priori determination of economic magnitudes. Individual consumers are assumed to have consistent preferences among alternative bundles of commodities, but these preferences -- summarized under the heading “utility functions” -- are asvaried, as idiosyncratic, and as unfathomable as any subjective psychological phenomena can be. Economists have sought to overcome the anarchy of subjective preference by a number of heroic assumptions about the general mathematical shape of individual indices of satisfaction -- assumptions that bear no particular relation to reality. The result is an elegant structure of microeconomic theory -- what is now called the theory of consumer behavior -- whose principal virtue is its ability to support the ideological claim that capitalism is both efficient and fair. What has been lost, however, is the ability to relate the objective facts of technology and production in some direct way to the structure of prices, wages, profits, and rents through which the social product is distributed among the major classes of the society. It is in fact quite striking that the original theoretical model of equilibrium put forward by Leon Walras is actually a model of pure barter or exchange, in which production does not figure at all. Only after he has established his major theoretical propositions for the case of an exchange economy in which the goods being exchanged are simply posited, or given, at the outset, can Walras move on to extend his theory to the case of production.
The central theoretical claim of marginalism, of course, was that a capitalist economy, unfettered by state restrictions or legal distortions, would achieve and maintain an equilibrium position in which all markets, including the market for labour, would clear and in which no further improvement in subjective satisfaction could be achieved by mutually acceptable exchanges. To say that the labour market clears is to say that there is no long-term involuntary unemployment. Those who are out of work are either between jobs, as it were, or else prefer leisure to employment on the terms being offered.
The equilibrium thesis of marginalism was mortally wounded by the experience of the great depression. The presence of millions of unemployment workers, unable to find work year after year, constituted as much refutation as any scientist could want of the theses of the established economic theories. It was clear that the microeconomic foundations of economic theory were incapable of yielding plausible macroeconomic conclusions. There were two options open to the economist: the first was the reject the microeconomic foundations, and begin a search for a theoretical perspective capable of yielding conclusions more in keeping with reality. The second was to formulate a theory of the economy as a whole, and leave to one side, at least for the time, the relation of the large scale theory to the theory of individual economic units. As you all know, John Maynard Keynes’ GENERAL THEORY took the second tack.
I do not propose today to review Keynes’ theory. Rather, I wish to call attention to certain of its foundations which tend to be lost sight of in the complications and elaborations of macroeconomic model-building. Essentially what Keynes does is to extend and generalize Mill’s notion of custom by introducing into his analysis of the behavior of capitalists and workers the idea of subjective preference and subjective estimates of probability.
The most dramatic break with previous economic theory was the substitution of subjective expectation for objective probabilities or perfect knowledge. It is, on reflection, obvious that what actually determines a capitalist’s decisions is his subjective estimate of future prices, future sales, future costs, not the actual prices, sales, and costs that ensue. Keynes, who was methodologically quite sophisticated about matters of rational choice and probability, therefore constructs his entire model of investment and employment on the basis of such subjective estimates of probability, or, as he calls them, expectations.
At the same time, Keynes loosens up the classical behavioral assumptions by recognizing that capitalists are not perfect accumulators and workers are not perfect consumers. Instead, each individual is thought of as having a certain innate psychological inclination or propensity to consume some proportion of his or her available income. When it comes to disposing of the remainder of the income, the individual is conceived as having a second propensity or subjective preference, namely a preference for holding a certain proportion of the non-consumed income in the form of money, the remainder to be invested.
This positing of psychological propensities and preferences is in keeping with a long tradition of British empiricist thinking, which goes all the way back to the writings of David Hume, Lord Shaftesbury, and Frances Hutcheson. Like his distinguished predecessors, Keynes is essentially an armchair psychologist, offering quasi – a priori reasoning rather than experimental evidence in support of his claims about human motivation.
"The fundamental psychological law, upon which we are entitled to depend with great confidence both a priori from our knowledge of human nature and from the detailed facts of experience, is that men are disposed, as a rule and on average, to increase their consumption as their income increases, but not by as much as the increase in their income." (Keynes, p.96)
Keynes then offers a mathematical expression of this so-called “law” which makes it look quite impressive and objective, but obviously we have here nothing more than an ad hoc stipulation.
The central concept of Keynes’ analytical model is what he calls the “marginal efficiency of capital.” He defines this, in a manner familiar to those who have studied some economics as follows:
“the relation between the prospective yield of one more unit (of a certain type of capital) and the cost of producing that unit.”
The key word in this definition, though it may not seem so, is “prospective.” The cost of producing one more unit of machinery, is objectively determined by the current state of technology in the machinery-producing industry taken together with the current costs for steel, coal, labour, and so forth. In short, the cost of producing one more unit of machinery, or of any other sort of capital, is the sort of objective fact that classical economics dealt in. But the prospective yield of that additional unit is quite another matter. “Prospective yield” simply means “yield expected by the capitalist making the investment.” If his hopes are high, his animal spirits frisky, then he will evaluate the prospects for future yield quite favorably, and as a consequence the marginal efficiency of the capital will be high. If, with exactly the same technology available and the same current prices ruling in the market, he takes a gloomy view of the future, anticipating a downturn, dreading the turn of international affairs, fearing a resurgence of the Labour Party and a decline of the Tories, then the marginal efficiency of capital will decline.
These remarks are in no sense an exposé of the hidden and unacknowledged implications of Keynes’ theories. Quite to the contrary, he is insistant to the point of repetition on the subjective sources of economic indices. “It is evident,” he says at one point in his discussion of the incentives to liquidity, “that the rate of interest is a highly psychological phenomenon.” (p. 202). And when he comes to restate his general theory, he lists among his ultimate variables “the three fundamental psychological factors, namely, the psychological propensity to consume, the psychological attitude to liquidity and the psychological expectation of future yield from capital-assets,” which is to say, the propensity to consume, liquidity preference, and the marginal efficiency of capital.