Draft notes for Bob Wayland’s Economics of Business Class 1 Notes, Part 1: Economics: The Delightful Science1 Objectives: Part I of these notes sets out a framework of four economic concepts found in Adam Smith’s work and introduces the class readings within that context. The readings are noted in bold face as they are introduced. There really is a story line to the course beginning with what is a firm and ending with the origins of new firms through entrepreneurialism. After the story line is set out there follows a very short history of business to convey its scale, ancient origins, and the often under-appreciated sophistication of early markets, especially in finance. The second set of notes sets the stage for our discussion of Ronald Coase’s seminal contribution to the study of firms that describes how entrepreneurs choose to organize and conduct complex activities by combining resources from either the market or through firms. I. Economics: the Delightful Science2 Adam Smith’s monumental 1776 book, The Wealth of Nations is the foundation work of modern economics. Smith changed the way people thought about markets and the creation of economic value. His ideas also changed the intellectual environment within which political and economic theory and policy were debated. Smith, a Scottish professor of moral philosophy, created a coherent discipline based in part on four notions: (a) The beneficial power of self-interest 1 My friend and colleague Jim Mulcahy, also a business economist, has served as a sounding board and contributor to these notes. He has suggested many improvements and corrected my errors. Jim is therefore responsible for all remaining errors. 2 Economics is frequently referred to as the “dismal science” a slander that would be less common if the critic realized that the term is actually a badge of honor bestowed on economics by the racist2 Economics is frequently referred to as the “dismal science” a slander that would be less common if the critic English historian realized that the term is actually a badge of honor bestowed on economics by the racist English historian Thomas Carlyle, originally in a particularly offensive 1849 article “Occasional Discourse on The Nigger Question” in Fraser’s Magazine (reprinted in Miscellaneous Essays, London, Chapman and Hall, 1888 Vol. 7, pp79-110). Carlyle’s notorious article mocked the political economists such as Smith, McCulloch, and particularly J.S. Mill, who argued that slavery was both immoral and in general inefficient. It prompted J.S. Mills’ famous January, 1850 rejoinder, “The Negro Question,” in Fraser’s Magazine 41, The exchange ended their already eroding friendship. Understanding the origins of the slur should encourage critics of economics to seek more savory authorities. The more frequent but erroneous citation is to Carlyle’s criticism of Malthusianism as “dreary, stolid and dismal” in an earlier 1839 essay, “Chartism,” also reprinted in Miscellaneous Essays. An interesting and accessible discussion of the 19th century economic debates over slavery is Peter Groenwegen, ”Thomas Carlyle, ‘The Dismal Science,’ and the Contemporary Political Economy of Slavery,” History of Economics Review (Canberra, Australian National University) 34 (Summer 2001), 74—94. Surprisingly, David Warsh, an economic journalist and author of the Knowledge and the Wealth of Nations, 2006, W.W. Norton, New York, devotes his Chapter 5, “How the Dismal Science Got Its Name, (pp. 48-60), to an exposition of Malthus’ and Ricardo’s pessimistic outlook without mentioning Carlyle, the slavery issue, or Mill’s rejoinder. Paul Krugman, who plays a role in Warsh’s discussion of increasing returns, praised it here: http://www.nytimes.com/2006/05/07/books/review/07krugman.html?pagewanted=all&_r=3& 1 Draft notes for Bob Wayland’s Economics of Business (b) The division of labor, or specialization, as a primary basis of a nation’s wealth3 (c) The importance of freedom to trade, among people, businesses, and nations (d) The market as a self-directed, autonomous system There is far, far more to Smith’s work but these four concepts form an effective foundation and framework for an examination of the economics of business. The course is designed to explore these ideas through the work of eminent economists. The next sections introduce the ideas and the related readings. 3 We are simplifying here a bit to focus on the factors most relevant to the economics of business. Smith writing on the forces of national economic growth stated, “The annual produce of the land and labour of any nation can be increased in its value by no other means, but by increasing either the number of its productive labourers, or the productive powers of the labourers who had before been employed. The number of its productive labourers, it is evident, can never be much increased, but in consequence of an increase of capital or of funds destined for maintaining them. The productive powers of the same numbers of labourers cannot be increased but in consequence either of some addition and improvement to those machines and instruments which facilitate and abridge labour; or of a more proper division and distribution of employment. In either case an additional capital is almost always required.” (Adam Smith, An Inquiry Into The Nature And Causes Of The Wealth of Nations, originally published in 1776. The edition quoted from here is the Modern Library Edition, 1937, 1965, page 326) 2 Draft notes for Bob Wayland’s Economics of Business I. A. The Beneficial Power of Self-Interest Private enterprise is driven by private initiative and prospects for gain. Smith noted that for the most part men acted rationally and in their self-interest, famously pointing out that: “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.”4 Smith explains later that the aggregate effect of many people seeking to find the best use of their capital and exhorting the industries that they invest in to produce value will tend to increase the annual revenue of a society. …As every individual, therefore, endeavors as much as he can, both to employ his capital in support of the domestic industry, and so direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it.5 The outcomes of market operations are sensitive to the initial distribution of resources and the rules of the society. However, most economists argue that people are generally best able to discern their own interest and to allow them freedom to do so, with only a few compelling restraints, is in the general interest of society. Given an initial distribution of resources or wealth voluntary free market interactions among people will produce the highest valued total output and social wealth. Students sometimes equate the pursuit of self-interest with Gordon Gekko’s signature line in the 1987 film Wall Street, "Greed, for lack of a better word, is good." Adam Smith was a moral philosopher and certainly did not endorse unbridled avarice, the corruption of trust and relationships, or the exploitation of privileged information for self- enrichment. Self-interest is not the same as selfish. Acting selfishly (in the sense that game theorists call “defecting”) can be against one’s interests. Self-interest need not be a strictly monetary or self-centered objective.6 Smith and his followers knew well that people gained utility or satisfaction from many things.7 In fact Smith would have been a 4 Adam Smith, An Inquiry Into The Nature And Causes Of The Wealth of Nations, originally published in 1776. The edition quoted from here is the Modern Library Edition, 1937, 1965, page 14. 5 Page 264 of 570 of electronic Kindle edition 6 Selfless behavior provides satisfaction to some people but it is not evidence either of acting irrationally or against their self-interest. Apparent altruism is common among humans and some other animals such as bats. In most cases it can be explained by game theory as a form of tit-for-tat strategy in which repayment is expected. In other cases, we simply admit that some people find utility in being noble and selfless. 7 Today there is a branch of psychology called hedonic psychology that was founded by Daniel Kahneman, (see Well-being: The Foundations of Hedonic Psychology. New York: Russell Sage Foundation. Kahneman, D., & Tversky, A. 2000) a psychologist who became interested in what made people happy based on his exposure to the economic concept of utility. Kahneman, who never took a course in economics, was awarded the 2002 Nobel Prize in Economics, largely for his work on prospect theory and his founding work, with Amos Tversky, on 3 Draft notes for Bob Wayland’s Economics of Business notable scholar based only on his earlier work, The Theory of Moral Sentiments. But his point was that whatever those things were that provided satisfaction, a person pursued them and made decisions in light of their value to him. Until relatively recently, the concept of self-interest employed in the theory of production was almost entirely confined to the pursuit of profit maximization by the entrepreneur. In contrast, self-interest in the theory of consumer choice was expressed in the concept of a utility function and guided by the consumer’s desire to maximize his utility – a measure of the personal value placed on a good or service. Now we realize that production decisions are not solely based on profit maximization (if such a thing were possible).