Quesnay and the physiocrats

The physiocratic school that prevailed in France during this period was a true school of thought,
with a doctrine to defend and propagate, a recognized master, Franc¸ois Quesnay, and a fervent
group of followers.

The physiocratic scientific contribution was outstanding. Four points in particular are worth
underlining:

(a) The notions of productive and unproductive labour, by means of which the real source
of wealth was found .

(b) The idea of interdependence among the various productive sectors and the related idea
of macroeconomic equilibrium;

(c) The representation of the economic exchanges as a circular flow of money and goods
among the various economic sectors;

(d) the displacement of scientific interest from the stock of wealth to the
flow of net product.

Quesnay assumed that the productive cycle lasted one year, and that the final product of each
year was partially consumed and partially re-utilized as a necessary input for the following year.

He focused on agricultural production, the only sector capable of producing a surplus over
replacement costs and the only real source of wealth.

The physiocrats considered the surplus as a kind of natural gift from land.
 The farmers, therefore, formed the ‘productive class’.
 The people employed in manufacturing industry, on the other hand, made up the ‘sterile
class’, not because they did not produce useful goods, but simply because the value of
their output was considered to be equal to the overall value of the inputs.
 Finally, there was the class of landlords, or ‘distributive class’, whose economic role was
to consume the surplus created by the productive class

Main role was expenditure of the rents, the circulation process of money and goods among the
various economic sectors.

 The physiocrats called this circulation process ‘distribution’.its function was to ensure an
effective ‘distribution’ of the income and goods among the various sectors.

Quesnay derived two important political consequences from this model.

 The first concerns the ‘natural’ ability of an economic system to reproduce Itself.
  The second political implication of the physiocratic model concerns the doctrine of the
impoˆt unique that the best that could be done by the central authorities to impose a single
tax on the only productive factor, land, which would be paid with the net product.

Galiani’s work:

Galiani’s most important contribution in the field of theoretical research concerns the theory of
utility value,
.
He borrowed the theory, according to which value depends on the utility and scarcity of goods.

First, he argued that value is not an intrinsic quality of goods but is a quality .

Second, it is necessary to start from individuals in order to define these choices. Both utility
and scarcity depend on the needs of individuals. Thus, the same good has different utilities
for an individual according to the quantity which follows DMU.

Third is value is an idea of proportion between the possession of one thing and that of
another in the mind of a man.

He also maintained that ‘the value of talents’ and a ‘real’ cost of production measured in terms of
labour and valued at a price that depends on the utility and scarcity of natural endowments.

Galiani tried to explain the interest rate by linking it to the price that must be paid to equate the
value of present to that of future money. The necessity of paying this price is fact that future
money is valued less than present money.

Finally, it is important to mention Galiani’s theory of equilibrium and the political consequences
he drew from it. He argued that industry offers advantages for exploitation by the political
authorities.

 In the first place, industrial production is not affected by changes in climate;

therefore, the prices of its products are more stable than those of agricultural
products.
 Secondly, agricultural production is restricted by the scarcity of land, Whereas
industrial production is potentially unlimited since it increases with the level of
employment.
 Third, industrial expansion is useful also to agriculture since it increases the
demand for its products.

The ‘mechanical clock’ and the ‘invisible hand’

Newton’s theory of universal gravitation contributed to the Natural phenomena,

God created the universe together with the laws that regulate it and then he stood aside. There is
no need for his continual intervention to hold the world together, as it is completely self-
regulating

In the eighteenth century The central problem of European political philosophy was the
accounting for social life without having to resort to metaphysical presuppositions. In the Middle
Ages, social consensus was maintained by two fundamental principles: authority and faith.

The problem of modern social thought was: how is social life possible if those two principles and
their metaphysical justification are left aside?

A first answer to this question was: the natural egoism of man makes free social life impossible
and the absolute State necessary. On the one hand, therefore, was the need for a political
philosophy by which the civil society could justify itself independently of the State. On the other
hand, it was necessary that such a justification take into account the real processes of wealth
formation.

A different path was attempted by the English and Scottish empiricists and ‘moral-sense’
philosophers. Their approach was based on the assumption of the existence of a natural
‘benevolence’, or ‘moral sentiment’, which man experiences towards his fellows.

Accumulation and the distribution of income

The work immediately identified as the main condition for the growth of real wealth.
 The division of labour is a process by which a particular productive operation is
subdivided into a certain number of separate operations, each of which is carried out by a
different person.
 With the division of labour the worker’s skill increases, the idle time in transferring a
worker from one activity to another is reduced and, above all, technical progress is
stimulated.
 However, the division of labour is limited by the size of the market, is only possible when
the economy can produce for a sufficiently large market, and can be intensified only if
the market is expanding.
 In turn, the market will be larger the more the transport and communications
systems are developed, the more credit and monetary instruments are diffused, and the faster the
growth in the volume of production.

Smith subdivided capital into fixed capital, consisting of machinery, plant, buildings, etc., and
circulating capital, which is used to buy raw materials and pay for labour and energy.

The theory of income distribution among the social classes plays a fundamental role in Smith’s
theory of growth. In fact, the three basic classes, capitalist, workers, and landlords, are
distinguished both by the productive resources they hold capital, labour, and land and by the way
in which they spend profits, wages, and rents, their respective incomes.

The relationships among the types of productive resource, constitute the essential part of Smith’s
theory of capital accumulation.
The landowners, who do not own productive capital, are not interested in its enlargement and
have no inducement to save and accumulate capital.Their propensity to save is zero, and they
make no contribution to the growth of the wealth of the nation.

On the other hand, the workers only possess their labour. Both the ability of the capitalists’
coalitions to influence the government and parliament and the competitive forces on the labour
market push real wages down to subsistence levels. But with a subsistence wage the propensity
to save must be zero. Therefore, not even the workers make a positive contribution to the growth
in a nation’s wealth, although they make an essential one to its production.

Finally, the capitalists possess the productive capital and aim to increase it. This means they have
a very high propensity to save. It follows that the higher the proportion of the national income
going to profits, the higher the growth in the wealth of the nation.

The general interest of the nation, therefore, coincides with that of the bourgeois class. Smith
also made an important distinction between productive and unproductive labour. The former is
employed in the production of goods, the latter in the supply of personal services or in similar
activities.

This means that a growing economy must reduce to a minimum the percentage of workers
engaged in unproductive labour.

Market and competition

The natural price is determined by the production costs, The fluctuations of the market price
depend on the forces of demand, but are regulated by the production conditions.

The adjustment process needs A large number of operators, a certain knowledge of the price
conditions on the part of buyers and sellers, the mobility of capital, and the absence of entry
barriers are all conditions that limit the ability of each single agent to influence the prices to his
own advantage. Under such conditions, the market conditions ensure that exactly those goods in
exactly those quantities are produced which best satisfy the final demand.

In an equilibrium situation, the forces of demand provide for the distribution of capital among
the various industries. While the conditions of supply determine the relative prices, the
conditions of demand determine the relative quantities of goods produced. In this view, the
market is its own guardian and is capable of complete self regulation. So that, while everybody is
free to follow his personal interests, everybody is, in fact, controlled by an impersonal force.

Each person is induced by an ‘invisible hand’ to contribute to the achievement of an economic

end which was no part of his intentions: this is Smith’s theorem of the invisible hand. It states
that, in conditions of competitive equilibrium:

(a) the productive system will produce those goods the consumers demand;
(b) the chosen production methods are the most efficient, that is, those which do not waste any
resource;

(c) the goods are sold at the lowest price possible, which is the production cost inclusive of a
normal profit.
The main weakness of this grand construction is that it has remained unproved.

Smith’s three souls

Smith’s encyclopedism are three different components in Smith’s economic theory;

 macroeconomic,
 microeconomic and
 institutionalist components.

They are tightly intertwined and it is difficult to separate them, but it is possible and useful to do
so.
The core of the first two components consists of the theory of surplus and the theory of the
individualist competitive equilibrium.

It is possible to trace back most of the successive Smithian orthodoxies to those two theoretical
components: the macroeconomic, based on the theory of the surplus, and the microeconomic,
based on the theory of competitive equilibrium.

The conceptions of the social classes, the analysis of their different types of income and
expenditure behaviour, the distinction between productive and unproductive labour, the
explanation of value in terms of embodied and commanded labour and, finally, the theory of
profit as a residual income, are all elements of the first component.

The second component, provides the foundation to the theorem of the invisible hand, to the idea
of a competitive capitalist economy as a natural economic order, explanation of profit as
remuneration for risk, and to the theory of wage differentials. The economic subjects which
appear in this second component are no longer collective agents such as social classes.
In order to understand how these two components of Smith’s theory are really different, yet
strictly interrelated, we will consider them at work on a specific problem: that of the explanation
of the nature of labour and the level of its remuneration.

Smith as an institutionalist
The institutionalist foundations of Smith’s thought can be traced in The Theory of Moral
Sentiments Institutionalism was eclipsed by the discovery of the ‘invisible hand’. In reality
Smith never abandoned the basic convictions.

The theories attributed to Smith by the various free trade orthodoxies, from classical to
neoclassical, should be reconsidered in the light of an institutionalist interpretation.

Market mechanism is necessary and sufficient for the constitution of social cohesion which fails
to capture the full wealth of Smith’s thought.
First, Smith conceives the market as a set of institutions: private ownership, ban on monopolistic
practices, in Smith’s opinion, another two spheres of human action play a fundamental role in
constructing social harmony: those of moral and legal rules.

One distorted interpretation sees Smith as a theoretician of Homo oeconomicus, a philosopher

who defines the social agent as an autonomous, rational, and self-interested individual. In reality,
Smith had a concept of man as a subject blessed with multiple selves, whose soul was
characterized by different and contrasting sentiments, there are selfish and altruistic sentiments.

The first category includes:

 the desire to improve one’s life;
 the desire for social esteem
 vanity; the desire to accumulate property and wealth,
 the desire for power and domination;
 the desire to lead an easy life and avoid all effort. down to utilitarian egoism,

‘opportunism’ lead to the build up of monopolistic situations which causes inefficiency The
tendency to avoid effort, as emerges apprenticeship, may give rise to productive inefficiency, by
inducing idleness at work.

an apprentice is not paid on the basis of his productivity; he therefore tends to provide second-
rate work and little effort generates inefficiency in accumulation of wealth. Wealthy people lose
interest in economic activity dedicate much of their life to lavish consumption and not worrying
about putting by the income necessary to increase their wealth, they do not even take the trouble
to manage efficiently the production activities from which their wellbeing derives.

Fortunately, human nature is also endowed with altruistic sentiments, which prompts the
individual to please his fellow men and directly generates co-operative behaviour like sympathy
and practises sympathy in order to gain his fellow’s approbation and avoid his disapprobation.
They build up in each individual’s mind a sort of social conscience which Smith called ‘an
impartial spectator’. Social control on individual behaviour operates through the judgements and
orders of this spectator.

‘invisible hand theorem’ is in the market , economic agents do not exchange goods only, but also
messages of approbation or disapprobation. In this way opportunism is kept at bay and co-
operative behavior is stimulated.

In his logic, individuals who rank higher on the social ladder of wealth and prestige. In this way,
not only are moral rules socially established, but also those very sentiments that determine
human choices.

The legal rules are no less important than the moral rules Thus the harmony that society would
naturally generate in markets, would not be altered by the legal rules, nor would the latter
contribute in any decisive way to forming this harmony. Smith’s enlightment was different
  First, he was perfectly aware of the fact that, in the exchange sphere, the economic agents
enter into a nonco- operative type of relationship with each other which can impair public
interest rather than foster it.

 Second, he observed that, in the endeavour to pursue their objectives, individuals

organize themselves into social groups directed at increasing their members’ power.

 Third, he studied the state as an apparatus which is continually crossed by economic

conflict and an instrument with which coalitions pursue their particular interests. One
field in which the powers of State are exercised in a strongly nonneutral way is the
regulation of the labour market and determination of wages. Smith, unlike the
mercantilists, argued that a subsistence wage was a fact rather than a normative principle.
According to him there is no valid ethical reason why a wage should be fixed at
subsistence level. Nevertheless, historical observation showed that its ‘natural’ value
tended to stabilize precisely at that level.

All this induces us to consider the predominant liberal interpretation of Smith as unsatisfactory.

The Theory of Moral Sentiments: does not necessarily reduce some principles in his nature
which interest him in the fortune of others and render their happiness necessary to him though he
derives nothing from it . Smith’s ‘schizophrenia’ has given rise to much debate.

The Smithian Orthodoxy

Malthus theory …

Bentham and utilitarianism

 First of all, utilitarianism provided a new way of conceptualizing human
motivation towards action. The increasing specialization of labour and,
more generally, the nature of capitalist production had led to the consideration
of individuals, not as integrated parts of an interdependent whole,
but as social atoms fighting with impersonal and unchangeable market
forces.
Its canonical expression is assertion according to which every human
motivation, at every place and time, can be traced back to a single principle:
the desire to maximize utility .
 Another pillar of Bentham’s theory was the idea that human beings,are also self-
interested.
 Lastly, the third pillar of Utilitarian ethics is consequentialism, the theory
which affirms that the moral judgement of an action refers to the consequences
it produces and not to the intentions of those who promote it. If
the consequences are good, the action will be judged as morally good. On the
other hand, a consequence is considered good when it increases the utility of
at least one individual.
All the three ideas were to be assimilated into successive theories of utility value.
The Smithian economists and Say

Say combined in an unusual way the two basic arguments of the Smithian theory of value,
 one concerning the dependence of the variations of market prices on the forces of supply
and demand
 other relating to the dependence of natural prices on the conditions of production.

He thus formulated a theory which was rather more similar to that of Galiani,

The value of goods depends on the forces of demand and the costs of production. The utility of
goods acts on the former, whereas the difficulties met in supplying them underlies the latter.
It internalizes theories of production and a theory of value.

The production of goods requires theutilization of three types of ‘productive service’: those of
labour, capital, and land.

As the value of goods depends on the demand and the efforts sustained to satisfy it, and as such
efforts require the utilization of all three of the productive services, value cannot be entirely
reduced to labour: All three services contribute to its formation. Furthermore, each productive
service receives an income that is determined by the demand for the goods it contributes to
produce.

The intermediary between the product markets and the productive service markets is the
entrepreneur. He compares the price with the costs of the productive services. In this way the
demand for consumer goods is transformed into the demand for productive services, and the
prices of the latter turn out to depend on their indirect contribution to the satisfaction of
consumer needs.

The concept of the dependence of the values of goods on the prices of all the productive services,
a vague rationalization of Smith’s additive theory of prices, led Say almost naturally, although in
a confused way, to a strange theory of distribution—strange with respect to its Smithian origin:
each productive service receives a price which is equal to its productive contribution.

Thus, the capitalist economy is not only efficient in the allocation of the resources, as stated by
the theorem of the invisible hand, but also equitable in the distribution of income. There is an
undoubted link between Say and Smith,

Smith restricted himself to lead a competitive economy to allocate the resources in such a way as
to satisfy the demand for the goods on the various markets, he pointed out that the adjustment
process would have to pass through the continual appearance and disappearance of sectoral
disequilibria which would never be completely eliminated. The problem remained as to whether
such disequilibrium situations would compensate for each other, which has two consequences:

1. Macroeconomic malfunctioning.
2. Fall in rate of profit.
On the contrary, Say tried to demonstrate the impossibility of a generalized excess supply. This
is the famous Say’s Law, according to which supply always creates its own demand. Say first
restricted himself to observing that the value of the aggregate production is necessarily equal to
the aggregate value of the distributed incomes.

As incomes are purchasing power, it is also possible to say that the produced goods always
create the purchasing power corresponding to their value. From here to say that the production
always creates its own demand may seem a small step. In fact it is enormous. One must add that
incomes are entirely and immediately spent.