Last update: 14 September 2018

Lecture 1
Objectives of lecture 1
 To provide an understanding of;
o What an economy is.
o How economists conceptualise an economy
o How economists approach the study of an economy
o How economists seen its functioning and the results of this functioning.

Introduction
 It is generally agreed by economists (i.e., those who study the economy) that an
economy is an integrated system of production, distribution and consumption.
 Economists take as their point of departure that we are material beings; that
consume products and services in order to sustain our lives.
 It is recognised that we need to produce the products and services we consume,
and that we typically do this in a cooperative fashion. That is to say, production
takes place in the context of “a division of labour”, meaning that the economy
should not be seen as comprising self-sustaining individuals.
 It is also recognised that what is produced needs to be distributed between those
doing the producing, and the society at large.
 The analysis of an economy is typically about how production, distribution and
consumption take place.
 Most economists are concerned to explicitly or implicitly analyse the dominant
form of economic organisation we live in today – the capitalist economy. It is the
analysis of this form of economy that is the focus of the present lecture series.
 It is agreed that a capitalist economy is one in which property is fundamentally
private, products are produced by firms to be sold for money, and there is
competition between entrepreneurs/capitalists seeking to maximise their earnings
from the sale of their products.
 Economists differ over how to conceive of such an economy, how it works, and
the results of its working. The two groupings considered in the present lecture
series are the Neoclassicals and the Heterodox approaches.
o Neoclassical economists can be seen as orthodox economists and including
most economists teaching in Universities and working in key government
organisations, while Heterodox economists can be seen as those occupying
the fringes of the system – mostly in academia.
 The approach of the lecture series is to first critically explain the Neoclassical
approach to understanding a capitalist economy and then use the criticisms of this
approach to construct the alternative Heterodox approach.

Approach to explaining the economy

Neoclassicals
 Neoclassicals begin their analysis of the capitalist economy by analysing the
markets for products and factors – the exchange of products and factors – in

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 terms of the utility maximising behaviour of individuals (and firms as owned by
individuals). This is referred to as the microeconomic foundations. They use this
basis to explain the functioning of the economy as a whole or the macroeconomy
– the growth of aggregate output, changes in the aggregate money price level, and
the balance of payments and the exchange rate.
 A distinction is drawn between real and monetary phenomena. Microeconomic
analyses are typically seen as pertaining to real phenomena, dealing with relative
prices, quantities of products produced, real factor incomes and quantities of
factors demanded and supplied. Macroeconomic analyses are seen as pertaining to
both real and monetary phenomena. The real phenomena include aggregate output
or economic growth, employment and unemployment and the distribution of
income. Monetary macroeconomic phenomena are seen as including inflation, the
balance of payments, and the exchange rate.
o Real phenomena are seen as explained by real factors (mostly the
preferences of individuals and the physical productivity of factor inputs), and
monetary phenomena by monetary factors (mostly the quantity and price of
money).
o It is argued that individuals take decisions with respect to quantities of
products and factors to be bought and sold on the basis of real factors
(relative prices, real factor rewards, etc).

Criticisms
 Seeing the utility maximising individual (or any other alleged behaviour of the
individual) as the basis for understanding capitalist economic phenomena leads to
a mistaken view of these phenomena. In fact the reason for doing so is largely an
ideological one – to sanitise and justify the workings of the system.
 An understanding of the capitalist system requires an understanding of capitalist
production and the process of the accumulation of wealth by capitalists, the basis
of which is profit.
 The distinction between real and monetary phenomena and factors determining
them is an artificial one which results from the necessity to oppose objective
explanations prices and economic phenomena in general.

Heterodox
 Begin their analysis of the capitalist economy by analysing the money prices of
goods produced and sold by producers needing to cover their money costs,
including wages paid to the direct producers. The aim of this starting point is to
focus on what is seen as the core foundations of the capitalist economy – the
process of production and reproduction of commodities.
 This core is then extended by conceiving of producers as capitalist producers
who produce goods for sale in the market in order to cover their money costs and
allow for a certain money rate of profit. It is this that is used as a basis for
explaining what is conceived of as macroeconomic phenomena, i.e., growth,
inflation, etc.
 Heterodox economists deny that there is an analytical separation of real from
monetary phenomena, or their explanations in terms of real and monetary factors.

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Conceptualising a capitalist economy
 The different approaches to the explanations of the capitalist economy are
accompanied by different conceptualisations of these economies, notwithstanding
general agreement that capitalist economies are characterised by private
property, markets and competition between capitalists.

Neoclassicals
 Neoclassicals typically conceive of an economy in the first instance as
comprising individuals (as consumers) and enterprises or firms as producers of
products consumed by individuals. When expanding on the economic basics
Neoclassicals typically bring in to the analysis government and banks.
o Individuals, enterprises, and banks are referred to as “economic agents”.
 Enterprises are seen as producing products and selling these to individuals as
consumers of these products for money in markets for the products. Markets are
physical or virtual places where products are sold by enterprises and bought by
individuals for certain prices. Prices are seen as sums of money that need to be
paid by buyers of goods to enterprises in order to purchase the products being sold
by them. Enterprises are seen as setting whatever prices they wish, provided there
are buyers for the products, and individuals buying whatever products they wish,
provided they pay the required prices for these. Prices are seen as determined in
markets as a result of bargaining between individuals and firms as demanders and
suppliers of products.
 Individuals obtain the money required to buy the products by selling factor
services to the enterprise for a certain money income in markets, with the
magnitudes of incomes (or prices of factor services) seen as determined in
markets for factor services. The factor services sold are labour services, capital
services and land (or property) services. Individuals, as owners of these factor
services, are seen as free to sell or rent them to whomever they want for whatever
price they wish, providing there are buyers of these services at the required prices.
The money incomes these factors receive are wages, interest and rent. Some
Neoclassicals conceive of a fourth factor as entrepreneurship or entrepreneurial
services to which income in the form of profits accrues.
 At a later stage in their analyses, Neoclassicals extend this basic conceptualisation
to include government, financial markets, trade and international capital flows.

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Criticisms
 It is misleading to conceive of the capitalist economy as being understood as
comprising individuals governed by utility maximisation or any other behavioural
attribute.
o Firms are seen as owned by utility maximising individuals – entrepreneurs.
 Modern behavioural economics argues that all the problems with Neoclassical
economics stem from the assumption that the behaviour of the individual is that of
utility maximisation. They argue that experiments not only falsifies this
assumption but suggests other behaviour – which provides a more realistic
explanation of economic phenomena. Apart from the fact that this behaviour can
be anything the researcher wants it to be, it leaves in tact the general principle that
economic phenomena can be explained by the behaviour of individuals – the
aggregation of this behaviour.
 Although Neoclassicals formally conceive of goods being exchanged for money
and the prices being explained as money prices, in fact the exchange they are
conceiving of in the first instance is one commodity for another (i.e., barter) with
the price being explained as the relative price – the quantity of one commodity
commanded by another.
o The reason for this conceptualisation of the exchange process is that
Neoclassicals want to explain price in terms of the (relative) subjective
worth individuals attaches to products (see later). To be able to explain
relative prices as relative money prices Neoclassicals would have to first
explain money prices (i.e., the quantity of money commanded by different
commodities) in terms of the relative subjective preferences of individuals.
To do this, money would have to be seen as representing the subjective worth
(or preferences) of individuals per se. By definition, the subjective worth (or
preferences) of individuals for commodities is not quantifiable and therefore
cannot be added, even for the individual.
 Although Neoclassicals formally conceive of the exchange of products being
explained as between firms as producers and sellers of products and individuals as
buyers, in fact they conceive of the exchange process as in the first instance
between (utility maximising) individuals. It is argued that the owners of firms
are individuals that are motivated by utility maximisation – they produce and
acquire an income in order to enhance their consumption satisfaction.
o This conception of the exchange of products being essentially that between
utility maximising individuals is important if one is to be able to explain
relative prices in terms of relative expected satisfaction or preferences for
products. It is for this reason that early Neoclassicals argued that the
foundations of the economic system need to be analysed as a pure exchange
system – with exchange being between individuals naturally endowed with
commodities.
o Hence Neoclassicals often ignore the fact that buyers of products in product
markets are also firms buying inputs to produce goods – firms as producers of
the products. This is necessary in order to avoid having to argue that when
firms buy inputs they are doing so with a view to producing commodities (or
acquiring commodities in exchange for what is produced) which enhance the
consumption satisfaction of the owners of the firms.
o Of course when those exchanging products are seen as producers it is still
necessary for Neoclassicals to conceive of them as owned by individuals

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 trying to increase their consumption satisfaction, rather than simply to
accumulate wealth in the form of money as capital in order to facilitate the
continuing expansion of wealth.
 Conceiving of the exchange of products in the first instance as between
individuals as buyers of products and firms as producers raises the question of
whether prices can be seen as determined in markets as such (i.e., bargaining
between buyers of the product and firms as producers and sellers). If production is
to continue, it is accepted that prices need to be such that they cover the costs of
producing (or reproducing) the product. This suggests that producers need to be
seen as setting a certain minimum price for the products prior to them being
brought to market. If they are set by firms then it is difficult to avoid the
conclusion that in a normal situation (i.e., one where the firm is not operating at
full capacity) it should be unit costs that determine the prices they set.
 Neoclassicals have good reason to exclude entrepreneurship as a factor input.
This is because entrepreneurs are the owners of enterprises and it is enterprises or
firms that are seen as employing factor inputs. To avoid entrepreneurs being seen
as employing themselves, they need to be seen as a special kind of factor input –
one that employs other inputs, and is not bought and sold in a market. Another
reason for excluding entrepreneurship as a factor is that it is difficult to conceive
of it and explaining profit as given by its contribution to the production of
commodities. Specifically, Neoclassicals want to explain profits in terms of the
productivity of entrepreneurship, but, obviously, cannot it in a way that allows its
quantification and permits an explanation of the income accruing to it as a certain
rate of profit on entrepreneurship.
o Neoclassical get around this by arguing that entrepreneurs too own capital
and obtain a rate of profit on this capital, but one that is different to the rate of
interest. This is theoretically confusing and messy.
 Neoclassicals also find the conceptualisation of capital very difficult, one
compounded by the fact that money is necessarily excluded from the analysis in
the first instance – the analysis being the explanation of relative and not money
prices. In order to conceive of capital in a way that precludes the necessity for the
explanation of the interest on capital as explained by surplus labour time,
Neoclassicals conceive of capital as an array of physical inputs into production,
and this array of inputs as one homogeneous entity that can be referred to as
capital, with the rate of interest on capital being the physical income (physical
products) accruing to owners of this capital (so-called “capitalists”) that is loaned
to entrepreneurs. One problem is how to conceive of aggregate the physical
inputs into production in a way that allows them to be referred to as capital and
conceive of the interest accruing to the owners as a certain rate. A second is how
to conceive of a market for physical inputs as capital which is separate from a
market for these inputs as simply a product market. A third problem is why the
inputs into production exclude the wage goods needed to keep the workers alive
and happy.
o Most textbooks avoid discussion of this problem and simply conceive of
capital as the sum of money lent by individuals (via banks) to entrepreneurs
to buy physical inputs into production. There is no indication how money is
supposed to reduce physical inputs to equivalence, and why expenditure on
wages is excluded from the capital advanced.
 It is difficult to conceive of the demand for, and supply of, loan capital as
determined by the relative strength of demand and supply for these funds when

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 the central bank in most capitalist countries not only sets the base interest rate,
but appears to influence the movement of the whole structure of rates.
 There is also no recognition of the coercive nature of the economic structure that
requires one part of the population, the largest part, to sell their labour services
in order to maintain their living standard.
o In modern advanced economies these structures include consumerism and
debt (starting with debts incurred when studying), with periodic periods of
unemployment (and reduced levels of support for unemployed, single parents,
etc).
o In developing countries these structures are long-term unemployment and
poverty for large parts of the population.
 It is unclear that wages can be meaningfully conceived of as being determined in a
market for labour rather than in the production process involving labour. This is
because the wage offered to workers wanting to join an enterprise is typically that
negociated by the firm with those already in employment. It would be
inconceivable that new employees added to the work force would be able to
negociate different wages for the same job as those in employment, or that the
firm would change the wages already negociated with those in employment in line
with wages promised to new employees.

Heterodox
 Heterodox economists also see the basic economic system as one comprising
private property, markets and competition between producers of products, but
deny that;
o The prices of products to be explained are relative prices,
o The incomes of services to be explained are real incomes,
o The prices and incomes (as alleged prices of factor services) are determined
in markets for products and factor services, and explained by the activities of
utility maximising individuals.
 Prices are seen as money prices mostly set by producers in order to recover
costs and appropriate a certain commensurate rate of profit.
o Prices are not seen as determined in markets – as a result of the interaction of
buyers and sellers
o Producers are seen as producing as much as possible to maximise their
profits.
 Heterodox economists see producers as those seeking to accumulate wealth in
the form of capital – a sum of money that is expanded on the basis of the
production and reproduction of commodities for prices that exceed their costs.
 The purchase of goods is seen as for two different purposes; for the satisfaction
of consumption needs and as inputs into a production process the aim of which is
to make a profit. The motivations for the two types of purchases are very different.
 Producers of commodities make us of factor inputs in the production of goods, but
these inputs are not all bought in markets, and the magnitudes of incomes accruing
to them are not determined in markets for them.
 The producers of commodities are seen as capitalist enterprises owned by
entrepreneurs or capitalists. These producers advance capital to undertake
production, with some of this capital being borrowed in financial markets. They
obtain a profit in relation to the capital advanced after covering all costs (material

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 inputs used up in production and wages) and paying interest to those banks and
financial institutions they borrow money from.
o Heterodox economists define capital in the first instance as the money
advanced by entrepreneurs to purchase all material and labour inputs into
production. Some of this money is borrowed, but most comes from profits of
the producer.
 Producers do not borrow from financial institutions to fund their long-term
investment outlays – to expand the level of output. This comes from profits.
 Interest accrues to banks and other money lenders – not producers – in payment
for the money they lend to firms and individuals. The rate of interest is determined
in financial markets, with the base interest rate being heavily dependent on the
policy adopted by central banks.
 Producers pay wages to workers for their labour, but these wages are not
determined in labour markets. They are determined in the process of
production. New recruits get what others in the company get in terms of pay.

Functioning of an economy
Neoclassicals
 Neoclassicals see the driving force of all economies as the utility maximising
choices of individuals (with modern behavioural economics providing other
explanations of the behaviour of individuals).
 Neoclassicals see the utility maximisation of individuals in the context of private
property (including intellectual property), “free” markets, perfect competition,
free trade, and free international capital flows leading to;
o Balance (or equilibrium) in individual markets – between suppliers and
demanders of products,
o The best allocation of productive resources in the sense of maximisation of
welfare and minimisation of costs of production (referred to as economic
efficiency),
o A just distribution of income – one reflecting productivity of factors and
choices of individuals supplying them,
o A tendency towards stable economic growth, full employment, no inflation
and no balance of payments and/or currency problems.

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 Any instability in the system is attributed to either market failure or government
intervention. The only role for government is seen as setting and maintaining
laws and regulations designed to protect private property, ensure the smooth
functioning of markets, and prevent monopolies forming.
 Neoclassicals see government interference in the economy as damaging price
signals and optimum resource allocation.

Criticisms
 One important ideological purpose of Neoclassical economics has been to deny
the driving force of the capitalist system to be the accumulation of wealth on the
basis of profits arising from the exploitation of labour – the Classical view of
the economic system.
o To provide an alternative explanation of profit Neoclassicals required an
alternative explanation of prices (“theory of value”) to that of the Classical
economists – an alternative to the labour theory of price. This alternative is
the subjective theory of price – that the behaviour of individuals, as utility
maximisers, provides the basis for explaining prices.
o Modern behavioural economics is yet another attempt to rescue
Neoclassical economics in the context of a growing awareness of its serious
limitations, by trying to distract attention from the real source of its failings.
 Neoclassical economics does not see that the capitalist system requires (relative)
inequality and economic insecurity of the majority of the population. It is this
that drives individuals to offer their labour services at wages dictated by firms.
That is, inequality, unemployment, consumerism and debt, poverty, etc are all
necessary bases for profits and the accumulation of wealth by a few in the
capitalist economic system.
 Neoclassicals fail to see that the tendency of capitalist production is one of
periodic overproduction – in the drive of capitalists to accumulate wealth on the
basis of profits.
 They also do not see that the capitalist system is necessarily unstable, with
economic growth, inflation, interest rates, etc., all moving in cycles over time.
 Finally, Neoclassicals do not see that the state is a capitalist state (largely doing
the bidding of the wealthy and powerful), and is always interfering in the
economy at the behest of the rich and powerful.

Heterodox economists
 Heterodox economists see profits and not individual behaviour as the driver of the
economic system.
 It is denied markets tend towards balance in supply of and demand for products.
In fact, they are seen as constantly moving towards and away from balance as a
result of the drive of capitalists to make profits.
 Heterodox economists see inequality, periodic high levels of unemployment,
poverty (especially in some parts of the world), consumerism, and indebtedness
of ordinary people, as necessary features of the capitalist economic system.
 Heterodox economists the capitalist economy is necessarily unstable and subject
to periodic ruptures, episodes of high inflation, high unemployment, balance of
payments problems, etc. These tend to be accompanied by conflicts in defence of
basic living standards.

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 For Heterodox economists the state is a capitalist state – mostly influenced by
the rich and powerful. It has an important role to play in developing and
regulating capitalist societies and markets, and developing capitalism in less
advanced economies.