What is Wrong With Economic Theory

Author(s): Nicholas Kaldor

Source: The Quarterly Journal of Economics, Vol. 89, No. 3 (Aug., 1975), pp. 347-357
Published by: Oxford University Press
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 THE
QUARTERLYJOURNAL
OF ECONOMICS
Vol. LXXXIX August 1975 No. 3

WHAT IS WRONG WITH ECONOMICTHEORY *

NICHOLAS KALDOR

There is a widespread and growing dissatisfaction with prevail-

ing economic theory in numerous quarters in England. It has even
reached such respectable pillars of the economic establishment as
the President of the Royal Economic Society and the British Asso-
ciation, as shown by their recent (1971) Presidential addresses. I do
not believe that this wave has yet reached America in its proper di-
mensions - except perhaps at the graduate student level, and
among a few rather isolated critics or heretics -but I have little
'doubt that someday it will. For primarily because the logical system
of general equilibrium theory has been more thoroughly explored
by American economists of the mathematical school of the postwar
generation than anywhere else, clarifying in detail the number and
kind of postulates required to establish its conclusions and their
precise implications, they (or rather their pupils) should also be the
first to perceive that the result of that great exercise has ended in a
"cul-de-sac": it made the theory a less usable tool than it was
thought to have been in its early and crude state before the full
implications of general equilibrium have been so thoroughly ex-
plored.
My basic objection to the theory of general equilibrium is not
that it is abstract; all theory is abstract and must necessarily be so,
since there can be no analysis without abstraction; but that it starts
from the wrong kind of abstractions and therefore gives a misleading
"paradigm" (or scenario? -the now fashionable word in America)
of the world as it is: it gives a misleading impression of the nature
and the manner of operation of economic forces.
In this connection there is not, in my view, a single, over-
whelming objection to orthodox economic theory: there are a num-
*A Political Economy Lecture given at Harvard University, April 29,
1974.

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348 QUARTERLY JOURNAL OF ECONOMICS

ber of different points that are distinct though interrelated. Some of

my Cambridge colleagues are "monists" in this respect: they believe
that there is a single basic, logical objection to the theory of mar-
ginal productivity that is alone sufficient to pull the rug out from
under the neoclassical value theory. I am referring to the difficulty
of isolating or measuring the change in the quantity of capital when
the inventory of capital goods changes - which makes it impossible
to regard capital as a quantity, per se, irrespective of the actual
forms in which it is embodied at any one time, and makes it im-
possible to attribute to capital a marginal productivity of its own.
But there are other things to object to that in some ways are even
more misleading than the application of marginal productivity
theory to the division between wages and profits, which has been
the main subject of discussion.

The first of these is that economic theory regards the essence

of economic activities as an allocation problem - "the allocation of
scarce resources among alternative uses" - to use Lord Robbins'
famous definition of the subject matter of economics. This means
that attention is focused on what are subsidiary aspects, rather than
the major aspects, of the forces in operation. The principle of sub-
stitution (as Marshall called it) or the "law of variable proportions"
or of "limited substitutability" is elevated to the central principle
on the basis of which both the price system and the production
system are explained; and it is implied that the world is one where
elasticities of substitution are all important. This approach ignores
the essential complementarity between different factors of produc-
tion (such as capital and labor) or different types of activities (such
as that between primary, secondary, and tertiary sectors of the
economy), which is far more important for an understanding of the
laws of change and development of the economy than the substitu-
tion aspect. Indeed, it is, I think, the concentration on the substitu-
tion aspect, which makes "pure" equilibrium theory so lifeless and
motionless: it purports to "explain" a system of market-clearing
prices that are the resultant of various interactions: it cannot there-
fore deal with the problem of prices as signals or incentives to
change. Attempts have been made to graft growth and development
to equilibrium theory, but they have not succeeded in transforming
it into a sequence analysis in which the course of development is
dependent on the path of evolution.

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 WHAT IS WRONG WITH ECONOMIC THEORY 349

Perhaps the best way I can illustrate this point is by asking the
question: Is Say's Law valid, and if not, just what is wrong with
it? This is a very old question, hotly debated already in the early
nineteenth century, if not earlier, and ever since then (until Keynes
came along) it was the hallmark of all true economists to have
understood the reasons why competitive markets necessarily bring
about a situation in which all scarce resources are fully utilized.
The reason, in essence, is a very simple one. The laws of supply
and demand state that in any competitive market, say, for the jth
commodity, there is a "market clearing" price, characterized by
dj= sj,
where dj and sj, respectively, are the maximum quantities that buy-
ers are willing to buy or sellers to sell, at those prices (not just sales
purchases).

dj

Pjd
Si di~~~~S

XS

FIGURE I

At pj buyers are ready to buy and sellers to sell xj or any

quantity less than xj.
If this is true of any one market, it must be true for all, j=
1, . . ., n, (O<n< oo), in the markets for resources, as well as
commodities. Hence if all markets are in equilibrium, all resources
must be utilized, and production in total must be supply-constrained,
or resource-constrained; it cannot be demand-constrained.
Or, put in other words, since taking all markets together, we
see that it is commodities that are exchanged against commodities,
there is no sense in saying that the production of commodities can
be limited by demand. As Ricardo said, "there is no amount of
capital which may not be employed in a country, because demand
is only limited by production."' Or, John Stuart Mill made the
1. Ricardo, Principles, P. Sraffa, ed. (Cambridge: Cambridge University
Press, 1951), p. 290.

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350 QUARTERLY JOURNAL OF ECONOMICS

point more forcibly: "All sellers are inevitably and ex vi termini

buyers. Could we suddenly double the productive powers of the
country, we should double the supply of commodities in every mar-
ket, but we should, by the same stroke, double the purchasing
power." Hence, "production can be ill-assorted, but it can not be
excessive." 2
Keynes thought he found the answer to this compelling bit of
logic by postulating, in effect, that in one particular market, the
market for savings, the price is not, or need not be, "market clearing"
(owing to liquidity preference), and if it is not, there is another
mechanism, that of the multiplier, to bring about equality in that
market- equality between savings and investment (or the supply
and demand for savings). But that mechanism operates by varying
the amount of production in general. It leads to a situation that is
not resource-constrained.
However, there is a more basic reason why Say's Law is wrong:
a reason that might apply equally in a barter economy, and not
just a money economy, or in an economy where there is no capital
market because people save directly in "real terms" by accumlating
stocks of their own produce, e.g., the farmer who accumulates corn
so as to increase further corn output, or the steel producer who saves
by ploughing back steel into the business so as to increase steel
capacity. All we need to assume is the absence of constant returns
to scale in terms of transferable resources as a general or universal
rule (applicable to all productive activity).
Suppose that we take a simple two-sector model, consisting of
A and B sectors, agriculture and industry. And let us assume that
land exists as a specific factor in agriculture, i.e., land is required
for agricultural production but not (or not in significant amounts)
for industrial production. Industrial production consists of the
processing of basic materials produced by agriculture, for example,
transforming raw cotton or wool into finished textiles, shirts or suits
(or for that matter, iron ore extracted from the soil into steel and
machinery) with the aid of labor, which also requires food, which is
the wage good par excellence. Hence, agriculture (and mining pro-
duces both direct and indirect inputs for industry -basic materials
and food.
If agriculture is subject to the Law of Diminishing Returns, ag-
ricultural output may be constrained by land and the available tech-

2. J. S. Mill, Principles of Political Economy (London, 1849), Vol. II,

Book III, Ch. XIV, ?2-?4.

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 WHAT IS WRONG WITH ECONOMIC THEORY 351
nology that limit the number of workers who may be effectively em-
ployed in agriculture. The rest could only be effectively employed
in industry.
Supposing that the employment of all the available labor in
industry (and assuming adequate capital for their employment in
the form of physical equipment at the prevailing technology) would
lead to a relative "overproduction" of industrial goods (and services)
relative to the available supply of agricultural goods. Mill would
have said that this is a case of production becoming, or threatening
to become, "ill-assorted." But the movement of prices that would
accompany this event would bring its own remedy. Agricultural
prices would rise in terms of industrial prices, and this process will
go on until the excess supply of industrial goods, which is the same as
the excess demand for agricultural goods, is eliminated. Even if
agricultural output were wholly inelastic owing to the shortage of
land, the very rise in prices would be sufficient: for it would trans-
fer purchasing power from industry to agriculture, and this transfer
will go on until the agriculturists are willing and able to buy all
the goods that industry is capable of producing (in excess of in-
dustry's own requirements for investment and consumption).
There must be some price, therefore, at which the excess supply
of B (or excess demand for A) disappears: to suppose otherwise is
to assume that industrial goods would remain in excess supply even
at a zero price. And this formal conclusion (as I already said) is
not dependent on the supply of agricultural products being elastic,
which would be the case if the land shortage did not impose a con-
straint on output.
Now the error in this reasoning is that it ignores the peculiar
character of labor as a commodity or resource, the price of which
cannot be regarded as being determined by supply and demand in
the same way as the price of other resources, such as land, for ex-
ample.
Whatever the supply of labor (or the potential supply of labor)

3. Though the classical economists (and of course, the neoclassical econ-

omists) reasoned as if agricultural production were simultaneously constrained
by the supply of both land and labor, it is in fact unlikely that in any given
situation (i.e., in a given state of technology) the land-labor ratio will be such
as to permit effective "full employment" for both labor and land. Since there
is only a limited range within which these two factors are substitutes for one
another at the margin, the likelihood is that either the land constraint or the
labor constraint will be operative, i.e., that there will be too much labor
(relative to land) or too much land (relative to labor) though for reasons
given below it would be vain to look for evidence for this by asking which
of these two resources has a zero price.

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352 QUARTERLY JOURNAL OF ECONOMICS

in relation to demand, the price of labor in terms of food cannot

fall below a certain minimum determined by the cost of subsistence,
whether that cost is determined by custom or convention or by sheer
biological needs. (The food-value of wages tend to be very rigid
downward in all communities at some attained level.) Ricardo and
Mill (just as Adam Smith and Marx) were fully aware of this point,
but they had not thought out its consequences in terms of Say's
Law.4
If wages (or minimum wages) can be taken as given in terms of
food, the prices of manufactured goods (or rather the "value added"
by manufacturing activities) are equally constrained, and this con-
straint may prevent both markets from being in equilibrium simul-
taneously.
The supply price of industrial goods is given by the equation,

p = (1 + 7) W"1,
where
p = prices of industrial goods per unit, in terms of agricul-
tural prices
w" =wages per man, ditto
l=labor required per unit of output (inverse of produc-
tivity)
7r=profits as a share of output,

and this will not be a "market-clearing" price, so long as the supply

of labor exceeds the demand; or so long as there is a low-earnings
"subsistence" sector of the economy, which enables people to survive

4. Or rather they assumed that the dependence of population on capital

(through a Malthusian process) will ensure that the labor supply in existence
will be no greater than can be employed at a positive profit. Mill in par-
ticular argued that, as capital accumulates and population grows in conse-
quence of it, profits would fall on account of the operation of the Law of
Diminishing Returns in agriculture and this would cause "all further accumula-
tion of capital to cease" -implying (without putting the point explicitly)
that this itself will limit the size of the labor force to the number that can be
effectively employed in the given natural and technological environment. It
was for this reason, I presume, that Mill made the statement that "low profits,
however, are a different thing from deficiency of demand; and the production
and accumulation which merely reduce profits, cannot be called excess of
supply or of production." But what if the absorption of the unemployed in-
volved a negative profit? This latter possibility as far as I know was never
considered. Yet there is no reason why the density of population resulting
from the Malthusian Law (and which operates so as to keep income per head
at a bare subsistence level) should coincide with the highest population
density at which the whole of the labor force can still be effectively employed,
i.e., which is consistent with a positive marginal product of labor in agricul-
ture. (See Mill, op. cit., Book III, Ch. XIV, ?4; and Book IV, Ch. IV, pas-
sim.)

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 WHAT IS WRONG WITH ECONOMIC THEORY 353

without being effectively employed or effectively contributing to

output.
This has important consequences.
1. First, the level of w" cannot be less than earnings in the
subsistence sector; but otherwise it is by no means tied to it; the
optimal wage to a capitalist employer may be a great deal higher
owing to the dependence of the efficiency of work performance on
food intake. (The poorer the country, the higher w" is in relation
to earnings in the subsistence sector.) (A. Smith, Ricardo, Mill,
and all classical economists assume a constant food wage, i.e., an
infinitely elastic supply curve of labor to industry.) Hence, one
cannot say that the relative price of industrial and agricultural
goods is determined by marginal rates of substitution between the
two sectors. There is no such thing as a "production frontier" show-
ing output combinations, a maximum A for any given B, or vice
versa, reflecting the allocation of resources between sectors. For
each sector accumulates its own capital as it expands its own output;
and labor, which is common to both, has a positive marginal product
only in industry, not in agriculture.5
2. Second, the fact that the price of "value-added" by manu-
facture cannot be reduced or compressed in terms of basic products
(if basic products rise in money prices, as they do now, it results in
general inflation rather than in a fall in industrial prices in terms of
primary products) is the equivalent of a "fixed price" situation (as
Hicks called it) ,6 where production is determined by demand, or
rather by the exogenous components of demand, which in turn de-
termine, through the usual multiplier and accelerator effects, the
endogenous components of demand. (Hicks called the relationship
of endogenous to exogenous demand the "super multiplier" -to
allow for induced investment as well as induced consumption).7
Hence it is the income of the agricultural sector, (given the "terms

5. It will be readily seen that this conclusion is critically dependent on the

existence of diminishing returns (in terms of capital and labor) in agriculture.
For assuming that agriculture were subject to constant returns to scale, the
excess supply of industrial goods at a given price relationship would cause a
transfer of labor and capital into agriculture until the excess demand for
agricultural goods is eliminated and "full-employment output" would cease to
be "ill-assorted." Hence the postulate of constant returns to scale (in terms
of transferable resources) as a universal rule applicable to all "processes" or
"activities" (which is a common axiom of general equilibrium theory) is suffi-
cient to ensure a Walrasian equilibrium that is truly resource-constrained.
6. Capital and Growth (Oxford: Oxford University Press. 1965), Chs.
VII-XI, pp. 76-127.
7. A Contribution to the Theory of the Trade Cycle (Oxford: Oxford
University Press, 1950), p. 62.

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354 QUARTERLY JOURNAL OF ECONOMICS

of trade") that really determines the level and the rate of growth of
industrial production, according to the formula,
1
0 1=
m
where
0= industrial output
DA= demand for industrial products coming from agricul-
ture
m = share of expenditure on agricultural products in total
industrial income.
This is really the doctrine of the foreign trade multiplier, as
against the Keynesian savings-investment multiplier. In both cases
multipliers arise on account of a "fixed-price" situation: the liquidity
preference rate of interest in the one case, and the fixed real wage
giving a cost-determined supply price for industrial products in the
other case. In some ways I think it may have been unfortunate that
the very success of Keynes's ideas in explaining unemployment in a
depression - essentially a short-period analysis - diverted atten-
tion from the "foreign trade multiplier," which over longer periods
is a far more important principle for explaining the growth and
rhythm of industrial development. For over longer periods Ricardo's
presumption that manufacturers and traders only save in order to
invest, so that the amount or the proportion of savings or both
would adapt to changes in the opportunities for, or profitability of,
investment, seems to me more relevant than the Keynesian assump-
tion for explaining the true constraints on the growth of production
and employment in the "capitalist" industrial sector.

II
3. Added to this is the second major point I want to make in
this lecture, albeit only briefly, and this concerns the existence of
increasing returns to scale or falling long-run costs in industry.
This was first emphasized by Adam Smith in the first three chapters
of the Wealth of Nations and subsequently emphasized by English
economists of the Ricardian school and by Marshall; while in the
United States (in a more isolated way) by a single great economist,
Allyn Young.
Marshall's falling long-run supply curve, unlike the ordinary
supply curve, is a schedule of minimum quantities, not maximum
quantities.

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 WHAT IS WRONG WITH ECONOMIC THEORY 355

Neither Marshall, nor anyone else, has ever succeeded in recon-

ciling this assumption with neoclassical value theory, which is the
reason perhaps why, according to Hahn and Matthews.8 that it has
received so little consideration in recent economic literature.

Di

pi
D Si

xi
FIGURE II

At pj manufacturers are willing to supply x; or any amount larger than

xi but not less than xi.

There are three important consequences that I would like to

emphasize here. The first, which was emphasized by Allyn Young,
is that with increasing returns "change becomes progressive and
propagates itself in a cumulative way." 9 There can be no such
thing as an equilibrium state with optimum resource allocation,
where no further advantageous reorganization is possible, since every
such reorganization may create a fresh opportunity for a further
reorganization. There can never be full employment in the sense of
"efficient" or Pareto-optimal full employment, and the very dis-
tinction between changes in the quantity of resources, and changes
in the efficiency with which they are used, becomes a questionable
one.
Second, the accumulation of capital becomes a by-product,
rather than a cause, of the expansion of production; indeed it is only
one aspect of it. Again, as Young emphasized, it is the increase in the
scale of activities that makes it profitable to increase the capital-

8. "The Theory of Economic Growth: A Survey," Economic Journal,

LXXIV (Dec. 1964), 833.
9. Allyn A. Young, "Increasing Returns and Economic Progress," Eco-
nomic Journal, XXXVIII (Dec. 1928), 533.

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356 QUARTERLY JOURNAL OF ECONOMICS

labor ratio: the larger the scale of operations, the more varied and
more specialized the machinery that can be profitably used to aid
labor. As Young said, "It would be wasteful to make a hammer just
to drive a single nail; it would be better to use whatever awkward
implement lies conveniently at hand." 10 The form that increasing
returns normally takes is that the productivity of labor rises with
the scale of production, while that of capital remains constant. The
best proof of this resides in the fact that, while the capital-labor
ratio increases dramatically in the course of progress (and varies
equally dramatically at any given time between rich and poor
countries), these differences arise without corresponding changes in
the capital-output ratio. (For example comparing the United States
with India, we see that the capital-labor ratio is of the order of 30:1,
while the capital-output ratio is around 1:1). Paul Samuelson em-
phasized as the central proposition of neoclassical value theory
(placed in italics in his well-known textbook) "Capital-labor up:
interest or profit rate down: wage rate up: capital-output up." 11
These propositions are only true in a world of homogeneous and
linear production functions, where an increase in capital relative to
labor increases output less than proportionately. In reality this is
not so: higher wage rates in terms of products are associated with
higher capital-labor ratios but are not associated with higher capital-
output ratios. (This is to my mind an even more important "pull on
the rug" than the discovery of the possibility of "double-switching"
of techniques.)
Third, for the same kind of reason for which increasing returns
lead to a monopoly in terms of microeconomics, industrial develop-
ment tends to get polarized in certain "growth points" or in "success
areas," which become areas of vast immigration from surrounding
centers or from more distant areas, unless this is prevented by politi-
cal obstacles. As the postwar experience of European countries (e.g.,
Germany, France, Switzerland) has shown, the emergence of a
labor shortage need not hold up the further fast development of a
successful industrial area, since such political obstacles tend to be
removed when it becomes profitable to import foreign labor.
But this process of polarization - what Myrdal called "circular
and cumulative causation" -is largely responsible for the growing
division of the world between rich and poor areas, which, in per
capita terms at any rate, still appears to be widening. It would be
10. Ibid., p. 530.
11. P. A. Samuelson, Economics -An Introductory Analysis, Seventh
ed. (New York: McGraw-Hill 1967), p. 715.

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 WHAT IS WRONG WITH ECONOMIC THEORY 357

foolish to pretend that we understand all the causative influences

that make the industrialization of some parts of the world so much
more successful than that of others. But I am sure that a better
understanding of the nature and mode of operation of market forces
making for change and development will increase our powers of con-
trol for counteracting inherent trends toward greater inequality as
between the different regions of the globe.

UNIVERSITY OF CAMBRIDGE

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