Thursday, 9 July 2009

Reclaiming Economics Part 5

Comparative Advantage

A&A set up the following example: They use the same kind of graph as that I used in Part 3 to show the actual price a single producer/consumer has to pay in terms of the Labour-time they have to expend in order to produce/consume a given quantity of any good, or, what amounts to the same thing, the amount of production/consumption of some other good that has to be foregone. But, they then introduce a second producer/consumer who faces a different slope, demonstrating that their productivity for either or both goods is different.

It now becomes clear that if both producers specialise in producing that good for which they have a comparative advantage then the total amount produced, and which is then available for consumption will be increased. This is the concept of Division of Labour, first elaborated by Adam Smith. Of course, Marxists do not dispute this theory. In fact, it is the basis on which Socialism becomes possible, due to the massive increase in society’s productive potential.

However, the fact that a society CAN increase its production/consumption by doing so is only any use if it actually results in producers exchanging their products so that they can ACTUALLY enjoy the benefits of this increased production. The question is then, what is the mechanism by which the two producers will be encouraged to specialise and exchange.

They assume that both have different preferences for each good, which determines how much of each good they are prepared to give up in order to have an extra unit of the other. At the point at which this rate of exchange is equal to the actual cost of producing one good in terms of the other, this tells us the optimal position, the amount of carrots and potatoes they would produce, to go back to my original example, to maximise their utility.

A&A then jump from these assumptions to reach conclusions about the rate at which one producer will be prepared to give up the good they have specialised in, in return for quantities of the other good. Anticipating the argument, A&A then show that there will be a difference between the “cost” that at least one producer will face in producing their good, and the “price” that the other will be prepared to pay for it, and that this difference is the source of both a “consumer’s surplus” and of “profit”. I will show how this argument is a fraud.

The basis of this fraud is essentially the same as that in the previous example of meat suppliers. By presenting both parties to the exchange as monopolists, the factor of competition between suppliers, which necessarily forces prices down towards costs plus average profit is removed in order that each supplier is able to charge what the consumer is prepared to pay i.e. their “subjective” valuation – though it should be noted here that even A&A are forced to admit that this “subjective” valuation comes down to the objective reality of how much they have to give up of one good to produce the other! In fact, what it removes from the determination of that subjective valuation here is again that Exchange Value of the commodity, determined in the market, but now seen from the angle of what any individual would assess based not on what they could resell it for, but based on what other suppliers would be prepared to sell it to them for. Later, A&A do introduce other suppliers and competition to show that it would force prices down towards those costs, but it is notable that they do not begin from that position, and that even later having introduced competition, they do not have that competition completely erode the consumer surplus, or profit.

But, other orthodox economists do arrive at that conclusion. The Swiss economist Walras demonstrated that in a perfect market, competition would force all prices down to the point where they were equal to costs. That is no profit could arise. More recent adherents of orthodox economics such as William Baumol arrive at the same conclusion! But, how remote from reality is that conclusion that under Capitalism profit is impossible??? Even if we take the argument that the profit that exists is because perfect competition does NOT exist, then we would similarly have to conclude that there must be equivalent losses to balance these profits. We still end up with profit overall being zero. Yet, we see in every Capitalist economy huge amounts of profit. And, we don’t just see Monopolists making profits, but even small companies. So, we are drawn to the conclusion that if Capital overall is making these profits, it can only be, even under the assumptions of orthodox economics, because some other input is being paid less than the revenue it is creating. That is precisely the point that Marx made. Labour Power creates more Exchange Value than it is paid in wages.

So, let me deal with A&A’s example.

If we begin with the last graph we see the position from the viewpoint of society as a whole. Without specialisation the society COULD produce a total of 6Y OR 9X. Where the price of Y for Mr. A, shown in the first graph, is 2X, and for Mr. B, shown in the second graph is 1X, for society the price is 1.5X. It is the same as the graph I produced for potatoes and carrots, where I said that it could be viewed from the point of view of society as a whole taking its average level of productivity across all producers. This is what the Labour Theory of Value states. If, society wants 6Y, then both Mr. A. and Mr. B will have to both devote all of their labour time to producing it. The cost is the 6X that Mr. A would have produced, and the 3X that Mr. B would have produced. The Exchange Value is the AVERAGE socially necessary labour-time. Because, society wants all Y, the labour-time of both producers is socially necessary, and because both have different levels of productivity in producing Y compared to X, we have to take the average figure, hence 1.5X. If less than 6Y is required then not all the labour-time of both producers will be required. What is socially necessary then becomes only that minimum time required. In other words, it will be the time taken using the most efficient means to achieve the desired output.

However, what we are interested in is not what COULD be produced, but what IS produced if this economy specialises. In that case let us assume that Mr. A wants all of Mr. B’s production of Y, whilst Mr. B wants all of Mr. A’s production of X. In that case we meet the requirements set out by the Labour Theory of Value that the labour-time expended is both socially useful, and that it is calculated on the basis of the average required using the most efficient means. I have chosen this example, because it simplifies by making the average also the minimum. In Part 6 of this series I will show how it makes no significant difference to this argument if we introduce producers with different degrees of productivity for the same product.

Now, in this society we have 3 units of Y produced by Mr. B, and 6 units or X, produced by Mr. A. So, for this society, the price of Y = 2X. Without specialisation the price of Y was only 1.5X. Does this higher price of Y in terms of X mean that this society has become poorer? No, its swings and roundabouts. Y is more expensive in terms of X, solely due to the fact that specialisation has reduced the price of X. Moreover, this society now produced 3 units of Y, AND 6 units of X. Without specialisation had both producers spent half their time producing both X and Y, the most that could have been produced is 3Y, and 4.5X.

If this society exchanged its products at their exchange values, Mr. A’s 3Y, would exchange for Mr. B’s 6 units of X. Both producers would have expended an equal amount of labour-time. In reality what they exchange is only formally X and Y, what they have really exchanged is the amount of labour-time they have expended. However, A&A suggest that because of the differences in efficiency between Mr. A and Mr. B – that is the cost of 1 unit of Y for A is 1X, whereas for B it is 2X – then in order to know what the actual rate of Exchange is, we have to refer to the individual preferences for X and Y, between Mr. A and Mr. B. At first glance given the above it would seem that Mr. A should only be prepared to give up 1 unit of X to obtain a unit of Y – because that is what it costs him in terms of his own lost production – whereas, Mr. B would be prepared to give anything up to 2X for a unit of Y. At any price of Y less than 2X, Mr. B becomes better off than he was before, because at this exchange rate, he obtains more Y than he could have produced himself by reducing his production of X by that amount. Similarly, at any price higher than 1X = 1Y, Mr. A benefits because the price he receives is more than his cost of 1X to produce the 1Y. A&A argue that this difference constitutes “profit”, and consumer’s surplus.

But, again there are a number of things wrong with this argument. To take this last statement first. Technically, even within the terms of orthodox economics, the term profit here is wrong. If B’s higher production of X is due to feature of the land or such like where it is produced, then it is more correctly termed “rent”. The same could be said if it is in relation to Mr. B’s labour as opposed to Mr. A’s. So, this argument cannot be used to provide an answer to the question orthodox economics still has not been able to answer – “What is the source of Capitalist Profit?”

But, the main criticism is with the example, and the conclusions from it itself. Let me first finish detailing those conclusions. A&A then bring in the preferences of A&B to tell us what the actual exchange rate will be – so far we have established that it will be somewhere between 1x = 1Y, and 2X = 1Y. A&A conclude that it will depend on how much of each is demanded depending upon the preferences of Mr. A and Mr. B, and this will also determine how much of each CAN be produced, and the relative cost of production.

We know that Mr. A can produce 3Y and no X. Whereas, Mr B. can produce 6X and no Y. Total demand cannot exceed these limits. If A and B want more than 3Y, then in addition to Mr. A’s production, Mr. B will have to produce some Y too, giving up some production of X and vice versa.

So we get a new graph.

This demonstrates the optimum position above where 6 units of X and 3 units of Y are produced.

So, A&A say,

“If Mr. A is producing a mixture such that he personally (subjectively) values one more X as equal to 1Y, he will note that he can produce one more X if he only forsakes .5Y. Therefore, he will shift his production toward more X and away from Y, for he is willing to forego (in consumption) as much as 1Y to obtain one more X., whereas he must (in production) sacrifice only .5Y. He will continue to shift toward more X until he values one more X as equivalent to only .5Y.”

But, again we can see what is wrong with this analysis. The world is not made up of producers making these kinds of assessments. Henry Ford did not price the last Model T coming off his production line according to the criteria of how much he subjectively valued it for his own consumption! Had he done so, he’d have been giving them away! He only produced them because they had exchange Value, not because they had Use Value for his own consumption, or because as an alternative to selling them he would have wanted to line them up to admire them. Their only Use Value to him was precisely that they had exchange Value, could be sold, and could be sold at a profit.

So, to pose things in terms of Capitalist Producer A, subjectively values X at Y, to begin with, but reduces its value to only .5Y as he produces/consumes more X is to completely misrepresent the basis of why Capitalist production takes place. Every producer decides what to produce, and how much to produce, determines the “subjective” value of that product not on the basis of their own preferences, but on the basis of market prices.

A&A set a price of .71Y for X, as an equilibrium price.

We then have:

A produces 4X and 1Y. He sells 1.75X, and no Y.

B produces 0X and 3Y. He sells no X and 1.25Y.

The prices are then X=.71Y; and Y = 1.4X.

The relative costs are

For A. Y= 2X; X = .5Y
For B. Y= 1X; X=1Y

So, A sells 1.75X (cost .875Y), and gets back 1.25Y = profit of .375.
B sells, 1.25 Y (cost 1.25X) and gets back 1.75X = profit of .5X.

Which all seems very nice until we look at this more closely. As I said earlier, what we have here is not profit but rent. The difference between the two is essentially that the latter arises out of the existence of some monopoly; that is wherever an advantage gives rise to a lower cost of production of a particular producer and is not available to other producers. A particularly fertile piece of land enables a farmer to be able to produce a given output for lower cost than others. If he is able to charge the market price for that output, his profit will be higher, and the owner of the land will be able to charge a rent equal to this difference, for its use.

By presenting us with just two producers and consumers here, what we have is essentially such a situation of monopoly. If we make a slight adjustment to A&A’s example, to bring it more into line with reality, we can see the consequences for the conclusions arrived at. Suppose we assume that A and B are not individual producers, but actually represent hundreds of producers of these goods. If we then assume that all of A’s production is sold to B and all of B’s to A, to avoid the problem of calculating the average productivity, we actually see something completely different from the conclusion A&A arrive at.

All of the producers of X, having produced, now want to get rid of it in order to be able to purchase Y. They do not know what the demand for X is and so they are keen to sell before that demand is satisfied. Suppose one of them offers to sell their X for 1Y, rather than the .5Y it costs to produce. Then another producer will undercut that price offering to sell for just .9Y. Another still will jump in to offer to sell at .8Y, and so on. At any price above .5Y, any producer makes a profit, and so competition will drive the price down to that level. No producer will want to sell below that price, because it means making a loss. And, in fact, provided Supply does not exceed Demand, no producer will need to. Any producer who sold below that price would see their Supply quickly taken up. The unsatisfied demand would then go to other suppliers, and with unused resources available to buy that demand prices would be bid up by consumers with those resources, so that prices then rose above costs. The losses of the suppliers who sold below cost would be cancelled out by the gains of those who sold above. The average price would equal costs.

But, in our example, here provided by A&A, costs are nothing more than the cost of the other product whose output has to be foregone, or in other words the labour-time expended. What the example actually proves when considered under the conditions of the real world – or at least a world in which competition exists – is precisely what the Labour Theory of Value states. The Exchange Value of a commodity is equal to the average, socially necessary labour-time required for its production. A&A are only able to create a situation where price diverges from that by removing competition between producers from the picture of reality. Of course, Marxists are the first to recognise the existence of Monopoly under Capitalism, but no Marxist would suggest the existence of the extreme monopoly implied by the example provided by A&A, at least not in the context set out here. Where Marxists WOULD agree with this picture of Monopoly and the consequences that flow from it as set out, is in relation to the Monopoly ownership of Capital by a Capitalist Class, and the consequent exchange relations that determines then with a class of non-Capital owners, i.e. workers.

But, an obvious problem appears in the example as it now stands. We now have the cost of production of X = .5Y. Meanwhile using the same approach we see the suppliers of Y prepared to sell it for its cost of 1X, whilst its price as a corollary of the price of X is 2X! In that case Y would now be selling at twice its cost of production. In reality this is an illusion similar to that referred to earlier when looking at the role of exchange in creating value. It arises by looking at things from the point of view of the two sides separately rather than looking at the process as a whole.

The cost of production for society as a whole of producing the 6X is 3Y, because given the capability of this society this is the minimum required (as we have assumed that all the producers of X produce at the average level of productivity, the average and minimum required are the same). So, does the fact that the cost of production of each Y is 1X for the producers of Y mean that they are making a profit of 3X? No, because the reality is that the price of X itself has fallen in this society in terms of the amount of labour-time required for its production. In effect, the 3X that COULD have been produced by the producers of Y has the same value as the 6X produced by the producers of X. (It is the difference between Value - meaning the labour-time required for production by a particular producer – and Exchange Value, meaning the labour-time required by society as a whole to produce that good, the socialised version of Value.) That is because both have the same cost of production in terms of the amount of labour-time embodied within them.

It’s true that the producers of Y are the beneficiaries of this process. They now are able to consume 6X as opposed to just 3X previously, whereas the producers of X are able to consume the same 3Y that they were able to consume previously. But, both work the same number of hours as previously. In fact, we see this all the time as new processes are introduced, productivity rises and the prices of those goods fall relative to other goods. The beneficiaries are those who consume those goods. Similarly, we see it in international trade. If producers of say sugar increase the output of sugar, its supply increases on the world market, and consequently the price falls. If no change in the production of say tractors has taken place, then the producers of sugar have to sell more sugar to buy one tractor!

Of course, there are aspects of A&A’s example that are relevant. Capitalism does contain monopolies; there are differences in the degrees of productivity between producers similar to that between Mr.A and Mr. B. Moreover, I have simplified by assuming all of the production of each is exchanged for that of the other in order to avoid for now dealing with that situation. I will deal with these in the next part of this series.


1. The diagram showing, total output as 9 units of X or 6 units of Y implies price is 1.5 not 2. This is if society wanted 9 not 6 units of X. That is the average socially necessary labour time is calculated on the basis of the labour-time actually needed for production of these 9 units. To produce just 6 units only the more productive labour is required so the average is less.

2. On the cost of production in terms of X. To, perhaps, make this clearer assume that X is an actual input in the production of Y, e.g. coal. If B can only produce 3 tons of coal in 10 hours, whereas A can produce 6, would you calculate the cost of production based on what it WOULD have cost him had he used his own labour, or what it actually cost him?

Back To Part 4

Forward To Part 6

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