Political economy means different things even to informed scholars. Like a Rorschach ink blot, one’s favored definition reveals much about one’s background and interests. For some, it means Marxism, derived from Aristotle’s conceptions of the moral foundations of exchange and production. For others, it means neoclassical economics, with a focus on choice and efficiency, expanded to account for political outcomes that shape, and are shaped by, market processes. There is merit in each view.
Until the late nineteenth century, political economy was the joint study of politics and economics. John Stuart Mill and Karl Marx exemplify scholars who combined the study of politics and economics, but the study of politics and economics later became separated, both in focus and method. Recent developments in each field have moved toward new connections.
Any society, at any time, must come to grips with the central political economic questions: What activities will be collective, organized either through command or democratic choice, recognizing that individual incentives still matter? What activities and rights will be individual, focused on self-interested, private voluntary exchange, recognizing that collective consequences still matter? The theories of markets and market failure provide one framework for analysis and understanding, but political economy is much older than the theory of market failure.
The Origins Of Political Economy
Aristotle believed that in a just exchange, each party receives equal value. Yet, questions remain about what constitutes “value,” and how one might judge if it is equal. In Chapter 5 of Book 5 of Nichomachean Ethics, Aristotle claims that exchange establishes communication and social connection among citizens. Political relations are thus closely tied to exchange relations, which create a consciousness of cooperation in society.
Aristotle then raises a problem, however—one that still vexes modern scholars. Voluntary exchange may often yield unequal rewards, as one party benefits more than the other. Over time and across many exchanges, especially if some citizens come to specialize in trade, these differences create social and political distinctions that are powerful but morally arbitrary. Aristotle concludes that “nothing . . . can prevent the product of one of the parties being better than that of the other, and in that case therefore they have to be equalized” (143).
Unfortunately, this is logically incoherent. If exchange is voluntary, then what each party receives is strictly better than what is given up. One questions what essential value there is in transactions, other than the value parties subjectively attached to the commodities. Alternatively, if money is value, then the only way to ensure justice is to exchange equal monetary values. Yet, this is true only if money is exchanged for money. What about an exchange of money for bread? Are the values equal? Is the exchange just? Aristotle recognized the problem, but never solved it. Thomas Aquinas, in question 77 in Summa Theologica, inquires as to “whether it is lawful to sell a thing for more than its worth?” (1507–1508). But again, “worth” appears intrinsic, and objectively observable. Aquinas is unable to make a coherent claim for why value differs from whatever price a buyer is willing to pay and a seller is willing to accept.
This formulation of just price preserves the contradiction of whether price and monetary value, in the judgment of those trading, are or are not the true “worth of things.” The question was finally answered fully only by Karl Marx. In Capital, Marx argued that equal labor values could balance just transactions. However, exchange in capitalist wage labor systems is not balanced. The buyer of wage labor derives disproportionate benefits from the transaction, and is able to accumulate large quantities of capital. Further, just as Aristotle claimed, these disparities have social and political implications. Over time, profits for capital engender disparities in social and political class and constitute the basis for a system of domination of both the economy and the polity.
Further, Marx recognized the great power of capitalism to create wealth and amass capital—a key stage in the development of any nation. His unique contribution rests in his conception of the metastasis of disparities of economic power into political and social control of the nation. Vladimir Lenin extended this idea in powerful ways to account for what he saw as the international expansion of capitalism through colonialism and imperialism. The argument concludes that capitalist nations and the capitalist system will, over time, tend toward greater instability, and ultimately an eschaton where the internal contradictions of capitalism are resolved in favor of a more just and economically sustainable system of exchange and allocation.
Therefore, while many scholars conclude that view defining value as labor is unworkable as a purely economic theory, the core elements of the Marxist-Leninist theory of economic history remain important elements of modern political economy. Modern scholars have extended this synthesis, both correcting some problems in the framework and applying the framework to problems that Marx did not explicitly foresee, such as globalization and culture.
Neoclassical Economics And Subjective Marginalism
Neoclassical economics, beginning with William Stanley Jevons, Carl Menger, and Leon Walras, solved the defining-value problem very differently. As Menger frames it in Principles of Economics: “Value is thus nothing inherent in goods, no property of them, nor an independent thing existing by itself. . . . Hence value does not exist outside the consciousness of men” (120–121).
Subjectivism unshackles price from intrinsic value, and allows both production cost and product demand to be accounted for in the calculus of price determination. Even in the subjectivist world of modern microeconomics, the cost of production is still the core concept because, under perfect competition, the price will always be driven to the cost of production. Jevons, Menger, and Walras were the first to argue specifically that a subjective concept called utility, not objective physical or moral goals, drove economic actors. Indeed, they went further, and claimed that the economics of consumer choice was properly the study of utility at the margin.
Alfred Marshall formalized the intuitions of subjectivism and marginal utility and combined them with the optimization conditions now learned in basic economics classes. Marshall’s unique combination of talents allowed him to describe the foundations of economic theory clearly and precisely. It is difficult to imagine modern economics without Marshall’s contributions, which, for individual actors, parallel the mathematical achievements of Walras at the level of an aggregate economy of many actors. In fact, Marshall was either the last political economist of the normative school or the first true economist of the mathematical and positivist tradition now found in university economics departments all over the world. Not until the innovations in mechanism design at the end of the twentieth century were the ancient interests in political institutions and the economy reconnected.
In Marshall’s benchmark world of perfect competition, the stylized invisible hand of Adam Smith reconciles competing goals and directs resources to their highest valued use. Every exchange makes both traders better-off, and in equilibrium, there is no feasible additional trade that could make anyone better-off. The first and second welfare theorems capture the normative properties of this mathematical world.
Such proofs illustrating the welfare consequences of operating perfect markets represent important contributions by Walras, Kenneth Arrow, and others. The static and dynamic forms of the theory of competitive equilibrium have an important place in the pantheon of scientific political economy, and they continue to play a role in many areas. While this is not a world that many observable markets resemble, it is the basis for a strong presumption in favor of markets by many economists and citizens.
However, for decades, a parallel school—including Austrian economists such as Ludwig von Mises and Friedrich Hayek— argued that the focus on equilibrium, with abstract assumptions invoked simply as a means to prove equilibrium results, were a distraction from real-world market processes. In fact, beginning with Adam Smith’s simple pin factory example, assumptions like perfect competition and decreasing returns appear suspect. Smith’s division of labor, with its resultant specialization and economies of scale, is the motor that creates wealth and improves the human condition.
The title of Book 1, Chapter 3 of the Wealth of Nations contains a dynamic challenge to the same static competitive equilibrium theory for which Smith himself was the inspiration. The chapter title is “That the Division of Labor is Limited by the Extent of the Market.” Smith envisioned that the use of production lines and specialization creates a surplus of trade goods. To transform this surplus into wealth, distant people who had no previous connections now began to trade those surpluses and to become more interdependent. Still, there are downsides to this increase in prosperity. Real markets—driven to expand by division of labor and returns to scale in production, innovation in transportation technology, and improvements in product packaging and durability—have proved to be enormously corrosive of local customs and traditional exchange relations.
Joseph Schumpeter identifies and analyzes the role of the entrepreneur. Though driven by profit, the entrepreneur is also an innovator, the force that animates the story that Adam Smith told about division of labor, expansion of markets, and increases in wealth. Schumpeter describes the process of creative destruction, where new products and cheaper production processes expand consumers’ menu of choice and society’s prosperity. Schumpeter’s Capitalism, Socialism and Democracy reflects an instinct that the study of economics implies a study of politics, but he does not take it very far.
There are signs, however, that the integration of these two fields is accelerating. Douglass North, John Wallis, and Barry Weingast point out that developed societies always have developed economies and developed polities, and that this suggests that the connection between politics and economics must be a fundamental part of the development process.
The Market Failure Paradigm
The so-called market failure paradigm brings government back into markets in a focused way. It takes the competitive equilibrium model as a starting point, assuming that markets and private allocation of scarce resources organize activity efficiently. Government action is justified when markets fail to produce efficient outcomes. Where Marxists see markets as inherently exploitative, market failure theorists view markets as the engine of prosperity, though in need of direction when the assumptions are not met.
Along with an unstated underpinning of law, property, and order, competitive equilibrium theory makes the following four assumptions: (1) all goods are private; (2) there are no negative externalities; (3) there are so many buyers and sellers that no one can influence a price; and (4) information is free and universal.
Violations of these explicit assumptions are the market failures. Taking these in turn, many goods are not private, but are collective goods in that they are jointly supplied and those who do not pay cannot be excluded from their enjoyment. National defense is the canonical example. Because of the temptation to free ride on the contributions of others, less than optimal amounts of collective goods will be supplied. One solution to this market failure is to have the government provide national defense.
Negative externalities are the costs over and above the price paid by a buyer to the seller, and suffered by people who are not party to the transaction, such as air pollution. Possible government solutions include regulation of the process producing the pollution, taxing emissions, or a cap and trade system that creates tradable rights to emit, but imposes the full social cost on polluters.
In regard to the many buyers and sellers, violations of the condition that no single actor can influence a price are not easy to resolve. The efficiency of markets rests on active competition in both the static and dynamic senses. In the static sense, competition implies that products are priced at their cost of production, satisfying Marshall’s marginality conditions and Aquinas’s intuition about just price. The difference is that economists have demonstrated that there are costs, termed deadweight loss, associated with monopoly and market power on the producer side. In the dynamic sense, competition requires new investment and innovation, and it is not clear how firms in a classical competitive environment with zero profits can take on the implied research and development.
Once the need for innovation is recognized, the problem of competition policy is harder to solve. In the presence of sharply increasing returns to scale, competition may result in a winnowing out of firms with only a few survivors, each possessing the power to raise price above marginal cost. There are two implied government actions to prevent this trend toward concentration from becoming too extreme. First, antitrust policy may seek to prevent the extreme concentration of economic power when it can be avoided, as in the case of trusts. The second implied government action is regulation in cases when a few producers is the most efficient result, as in the case of long-run economies of scale, such as utility companies.
The last category of market failure is information asymmetry. It may be difficult or expensive for consumers to learn whether a product or service is safe or effective. Further, the harmful consequences may be large enough to make ex ante, rather than ex post, sanctions necessary. Free market advocates tend to favor ex post sanctions, such as personal injury lawsuits, for fraudulent claims or harmful products. Liberal consumer advocates, on the other hand, gravitate toward ex ante regulations, including licensing of providers, health inspections, and lengthy clinical trials before a product can legally be offered for sale.
In all four cases of market failures, there are questions of what, how much and where. How much national defense is enough? When are negative externalities big enough problems to merit government intervention? When should government deal with the competition problem with antitrust, when with regulation, and when should it just leave well enough alone? When should government protect consumers from real risks to life and health, and when should it allow markets and the reputations of businesses to work in resolving information asymmetries? There are no right answers because these questions are matters of political belief, ideology, and partisan competition. However, while there may be no identifiable best practice, there is no assurance that government will make the best decisions, even in the absence of overt corruption.
The Possibility Of Government Failure
Arthur Pigou, one of the high priests of market failures, noted in 1920:
It is not sufficient to contrast the imperfect adjustments of unfettered enterprise with the best adjustment that economists in their studies can imagine. For we cannot expect that any State authority will attain, or even wholeheartedly seek, that ideal. Such authorities are liable alike to ignorance, to sectional pressure, and to personal corruption by private interest. (296)
Typically, market failure was a basis for government intervention to correct the failure, but there was an inconsistency between the selfish motivations assumed in markets and the benevolent and public-spirited motivations assumed for government. The public choice movement resolved this inconsistency by assuming that government officials are, like economic agents, selfish utility maximizers. Putting the institutions on an equal footing with respect to the assumed motivation of key actors led to considering the possibility that government may not solve market failures, and may even make them worse. There are thus three components to the public choice response. The first is the information problem; the second is the incoherence of majority rule; the third is the problem of limits.
As Hayek pointed out, markets depend on very widely distributed information about demand and willingness to pay. No central planner or government can possibly have as much information as is aggregated in the millions of choices made daily in consumer, labor, and financial markets.
Since Condorcet, it has been known that under many conditions, majority rule is cyclical. Arrow, who helped identify the conditions under which competitive markets fulfill the theorems of welfare economics, proved there is no voting method that satisfies some innocuous conditions, such as universal admissibility of preference orderings and nondictatorship. This means that any complex social-decision rule must have elements that are incoherent or arbitrary.
The third problem of government intervention is that majority rule is not self-limiting. James Buchanan and Gordon Tullock point out that once public decisions are rooted in the will of the people, whether expressed directly or through their representatives, constitutions are needed to protect individual rights and to limit the arbitrary scope of majority rule.
Bringing Politics And Economics Back Together
In December 20 07, three economists, Leonid Hurwicz, Eric Maskin, and Roger Myerson, gave separate acceptance speeches, acknowledging the Nobel Prize for mechanism design as an innovation in economic theory. Each recognized, in different ways, that the reintegration of political institutions with market institutions was largely accomplished. A mechanism is a process for determining outcomes—whether it is a game, a set of rules, or some social convention. Pure markets are a mechanism and so are utopian collective farms.
Myerson gives an explicit account of why a focus on economics is necessary, but incomplete in isolation. He argues that mechanism design expands the scope of analysis beyond technical and resource constraints into the realm of incentive constraints. Any social institution is a mix of incentives and a mix of political and economic considerations. Good social institutions foster communication and coordinated collective action in the face of adverse selection and moral hazard problems.
The bifurcation of economics and politics, in the public mind and in academic research, has been fruitful because generations of scholars working independently have constructed and tested separate analytical frameworks. Yet, the separation has never made sense from a practical perspective because neither politics nor economics exists separate from the other. The road toward a full reunification, toward the creation of a comprehensive theory that deals seamlessly with incentives and constraints in both politics and markets, has now been opened. It will likely be well-traveled in both directions.
Bibliography:
- Aristotle. Nichomachean Ethics. Translated and edited by Lesley Brown and David Ross. Oxford: Oxford University Press, 2009.
- Arrow, Kenneth. Social Choice and Individual Values. 2nd ed. New York:Wiley, 1962.
- Buchanan, James M., and Gordon Tullock. The Calculus of Consent. Ann Arbor: University of Michigan Press, 1962.
- Hayek, Friedrich A. “The Use of Knowledge in Society.” American Economic Review 35, no. 4 (1945): 519–530.
- Marx, Karl. Capital: A Critique of Political Economy. New York: Penguin Books, 1993.
- Menger, Carl. Principles of Economics, Auburn, Ala.: Ludwig von Mises Institute, 2007.
- Myerson, Roger. “Perspectives on Mechanism Design in Economic Theory.” American Economic Review 98, no. 3 (2008): 586–603.
- North, Douglass C., John J.Wallis, and Barry R.Weingast. Violence and Social Orders: A Conceptual Framework for Interpreting Recorded Human History. New York: Cambridge University Press, 2009.
- Pigou, Arthur Cecil. The Economics of Welfare. 3rd ed. New Brunswick, N.J.: Transaction, 2008.
- Smith, Adam. An Inquiry into the Nature and Causes of the Wealth of Nations. Chicago: University of Chicago Press, 1976.
- Thomas Aquinas. Summa Theologica. Vol. 3. New York: Cosimo Classics, 2007.
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