A Comparison of Modern and Classic Price Theories
The end of the 18th
and the middle of the 19th
century are known to serve as a historic period that gave rise to the most innovative economic theories in many countries where significant changes took place. They used to be associated with the vast advancement of the industrial production, a prerequisite for which was the industrial revolution. This event happens in all countries in this or that period of time. This phenomenon is thought to be marked by a significant process of the replacement of manual labor by the machine one. In addition, the transition from the factories to the plants can be noticed along with the development of market infrastructure.
A great number of qualitative changes in the economy led to the all-time high rates of economic development and later made a great contribution to the process of strengthening the faith of the economists which have appeared in the so-called post-manufacture, i.e. new era. The omnipotence of ideas of economic liberalism had been glorified by their founders whose names were Adam Smith and David Ricardo. Moreover, in England, the transition to the industrial system was accompanied by numerous 'victories' over the ideas and mercantilist protectionism, as well as the increasing liberalization of the economy. The modern price theory which has been elaborated by George Stigler and Milton Friedman is supposed to have originated from the teachings of Smith to a great extent.
Thus, this paper is aimed at analyzing the similar and opposite characteristics of the two types of price theories, the classical and the modern ones. The paper assumes that the classical theory created by Adam Smith and David Ricardo served as a firm basis for the appearance of the modern price theory.
Background of the Price Theories
The main result of the domination of the western economic science methods used by the neoclassical school was the loss of the ability of modern economic theory to analyze and evaluate the reality. Fundamental economic concepts of value and capital in the neoclassical school almost completely lost touch with the reality, becoming a theoretical abstraction that serves to make the logical unity of stylized theoretical construct, but not to solve practical problems of economic life (Elqadri, Priyono, Suci, & Chandra, 2015). Nowadays, it must be recognized that some of the reasons for this state of economic theory became the ideological motives associated with the opposition between liberal and socialist conceptions of the economic structure (Ciconne, Gehrke, & Mongiovi, 2011). This confrontation on both sides contributed to prejudice against theoretical arguments of opponents thus making a dialog between them unproductive. In terms of the theory, the result of this ideological confrontation was the rupture of tradition in economics and the emergence of an insurmountable contradiction between the classical political and neoclassical economies.
Among the followers of the teachings of Adam Smith who appeared in the post-manufacture period (the first half of the 19th
century) were David Ricardo, J. B. Say, T. Malthus, N. Senior, F. Bastiat and some other economists that have become part of the history of economic thought (Elqadri et al., 2015). Their works bear the imprint of the 'new' time, which showed that economic science ought to once again take up to the comprehension which had been achieved in the 'Wealth of Nations' period in many economic categories and theories. According to the research, some of them will continue, thus, being based on the classical political economy in the third stage of its development (Ciconne et al., 2011).
An important role in the development of the classical price theory was played by the laws which had been passed during that period. For instance, the British Parliament was known to adopt the so-called “Corn Laws” which had a tendency to sharply limit the import of foreign corn, and this helped to preserve the high price for bread and respond only if the interests of powerful landowners were the same. In his pamphlet, Ricardo tended to prove the negative value of the Corn Laws for the majority of the population of England. He saw the situation in the light of the unrestricted free trade of grain, including the imports of cheap grain from other countries (Elqadri et al., 2015).
The modern price theory is centered on the groups engaged in the processing work which according to the classical
theory is the main tool to determine the price. Large-scale industry has a tendency to be more well-organized than the small one, and the representatives of the modern price theory explain the phenomenon of concentration as follows (Ciconne et al., 2011). If a large industry consists mainly of a small number of large companies, it is actually a small group. At the same time, the relatively small industry that has dispersed in nature, i.e., made a significant number of small businesses, is a greater group in terms of political influence, with all the attendants; hence, the cost of self-organization can become very high.
Due to the self-defined approaches to exerting political influence, manufacturers are usually better organized than consumers. As politicians and political parties are interested in re-election, and organized producers can make a significant contribution to the necessary resources, the response of politicians to demand from industries under control is quite natural and economically rational (Elqadri et al., 2015). Consequently, the regulation of the economy is aimed not at the compensation of market failures but at ensuring the redistribution of income in favor of certain sectors in exchange for their financial and political support.
Classical Price Theory of Smith and Ricardo
The birth of the classical price theory is known to be determined not by the economic circumstances of the period Smith and Ricardo used to live in, but by the economic
traditions which had been created in the ancient times. The first human tools were roughly processed stone and stick. They were like an artificial continuation of the man’s body: his hands and fists. Among the first machines of our ancestors, converted and stored energy apparently can be considered a self-acting trap. Ancient people used the force of gravity of an animal or branches of the elastic forces, i.e. the bent trees (Ciconne et al., 2011). The most striking example of a lightweight version of this 'machine' with remote action is a bow and arrow. Great achievements in the development of primitive human nature included the discovery of fire. The discovery of fire and its application gave people an opportunity to dominate over certain forces of nature. Cooking on the fire helped expand the range of foods available to humans: roasted meat, fish, starchy roots and tubers, seeds, cereals, etc. The fire also played an important role in the manufacturing of the means of production, giving protection from the cold weather and wild animals.
In addition, the constant mental and physical development of people contributed to their ability to create more sophisticated tools. For hunting, there was used a stick with a pointed end, for instance. Then, the stick was replaced by a stone point. There were axes, spears tipped with stone and stone knives. These tools made it possible to hunt large animals and develop fisheries.
On the one hand, all these factors made a great contribution to the development of the labor tools, which simplified the process of work and brought numerous benefits. On the other hand, the appearance of the bigger financial benefits required the ability to control them and, as a consequence, made a contribution to the development of the economic theories (Ciconne et al., 2011).
The starting point in the work of Ricardo is known to be very similar to all the authors of classical political economy. The concept of commitment to economic liberalism does not allow any state intervention in to the subject matter of economy and implies free enterprise, free trade and other concepts which are generally united under the name of the economic freedom. This position has consistently been championed in his scientific writings. It was the main theme of his small pamphlet that was published in 1815 and entitled “The Experience of the Impact of Low Prices of Bread on Capital Gains.” It had a great success in the progressive social circles in Britain at the time.
While getting acquainted with the best work of David Ricardo which is known as “Principles of Political Economy and Taxation” it is necessary to pay attention to what is written in the preface to the book. More precisely, the author gave a detailed description of the ways he used to concisely express his own understanding of the two major issues of economic theory (Ciconne et al., 2011). First, in solidarity with Adam Smith, he also identifies three main social classes (landowners, owners of money and capital needed for its processing, the workers, whose labor is processed) and three types of income (rents, profits and wages). Second, he gave an interpretation of the main task of political economy and concluded that it is to determine the laws that govern the distribution of income (Elqadri et al., 2015).
Later on, in the denouement of the 19th
century, mainly for this reason the leader of the classical political economy of the US, G. Carey referred to the doctrine of Ricardo as a system of discord and enmity between classes. Ricardo’s class relations are the basis of the distribution of incomes in the society, as he was convinced that the growth of incomes of the capitalists (profit) necessarily reduced labor income (wages), and on the other hand, saw it as a tough law-governed feedback (Ciconne et al., 2011).
Similarly, the concept of the natural order of A. Smith for the enhancement of the country's wealth, was considered as the corresponding value of volume of production, and Ricardo perceived it as the main condition for free competition and other policy principles of economic liberalism. This is particularly evident from his unequivocal statement that only a fertile country, particularly if it allows free import of food, can accumulate capital in abundance without a significant reduction in the rate of profit, or a significant increase in land rent (Ciconne et al., 2011).
In general, the society in which Smith and Ricardo used to live followed certain rules from the economic point of view. These rules consisted in the assumption that the value of a commodity is determined by the amount of labor expended in the course of its production, and it seems that the lazier or clumsier the production is and the longer it takes them to manufacture the product, the greater the value of goods would be. But the work that forms the substance of value, suggests equal human labor, expenditure of one and the same human labor power (Wolff & Resnick, 2011). All the labor power of society is expressed in the value of the commodity world as one and the same human labor power, even though it is made up of countless individual labor forces. Each of the individual work force, like any other, has the same human labor power, since it has the nature of public labor and functions as such, therefore, it uses the production of a product as only required in the medium or socially necessary labor time. Socially necessary labor time is the working time required for the production of a use-value which manifests in cash, socially normal conditions of production and average level of skill and intensity of labor.
The classical price theory of Smith and Ricardo had a number of shortcomings which tended to negatively affect the theory (Ciconne et al., 2011). Its drawbacks were mainly determined by the conditions of the time. Primarily, the role of energy was rather underestimated from the point of view of a measure of value. The political savings used to rely firmly on the labor value and price theory created by Smith and Ricardo. The socially necessary time served as its measure (Wolff & Resnick, 2011). Time as a measure of value or price corresponds to the goal. This category was certainly seen as more natural than the category of energy, both in terms of accounting and their essence. The cost of living human labor became a measure in a society long before the formation of the category of energy in physics (Wolff & Resnick, 2011).
Second, the magnitude of the value of goods was determined by the amount of human labor used. But the human living labor is only a part of the cost in terms of energy consumption in the process of production. Together with the formation of thermodynamics, it became clear that people actively use the natural energy flows in the form of labor tools in the process of production along with the living workforce.
Modern Price Theory of George Stigler and Milton Friedman
The basic work on which this area study of state regulation of the economy had been grounded was published by Stigler in 1971 (Wolff & Resnick, 2011). The initial theory bore the idea that the regulations developed had to be introduced, and used primarily for the benefit of the various industries (sectors) of economy (Wolff & Resnick, 2011). The benefits which were obtained by the introduction of industry regulations are believed to be quite obvious:
- The government may grant subsidies or
- prevent the entry of competitors into it,
- establish a single price level more easily than
- it would have made a cartel, or
- add the production of substitute products by
- encouraging the production of complementary products (such as subsidies) (Ciconne et al., 2011).
In accordance with the modern price theory, in the process of political decision-making, the groups which have been engaged into the working process do not have separate individuals and interest groups among them. Some individuals (who are not politicians) do not participate in this process, since the formation of its own representation about the specific policy areas involves supplies of the time and effort that is associated with certain costs. Meanwhile, the benefits of such costs measured in terms of political influence are insignificant (Wolff & Resnick, 2011). Therefore, the more representative the democracy is, the less clearly and 'loudly' the preferences of different groups regardless of their scale are expressed.
These differences are frequently related to costs of (self-) organization of influential political groups: for some types of the groups such transaction costs are higher, while for others they are lower (Wolff & Resnick, 2011). The small groups have the advantage in this case, because they are faced with below mentioned transaction costs and easier solvable free-rider problems. Furthermore, in case of success in providing political influence in small groups, an individual benefit of each participant would reinforce the incentive to self-organization.
Dominance in terms of the principles of economic efficiency approaches bears the nature of conservation and has resulted in the aggravation of environmental problems which are not possible to solve fully within the existing method of production (Ciconne et al., 2011). Part of the problem is intended to allow the economic mechanism of natural resources as an integral system of economic instruments, the use of which ensures the preservation of the natural environment. Its formation began only in the second half of the twentieth century. It happened largely as a consequence of the negative impact of the third technological revolution on the environment. Certain economic instruments include an economic mechanism of nature developed in the framework of counter-cyclical economic policy at the end of the first third of the twentieth century.
Winning the competition leads to the transfer of income from a less effective to a more effective group, but this transfer has its limits. The fact is that it is associated with losses in the value created, known as the deadening costs, which in this case are provided in the form of the fees imposed on less effective pressure groups and leading to higher costs (Wolff & Resnick, 2011). Consequently, the loss of the least effective groups may be greater than the benefits of the most effective groups, and when there is a total loss of the increasing political pressure, pressure groups can be more effectively reduced, because the benefits of it would be smaller (due to the worsening of emerging social welfare, i.e. of the value produced).
Contrast between The Classical and Modern Price Theory
Currently, the economic science faces the insufficient research in the area of the optimum distribution of income. The debate is first of all centered on the question of the allocation criteria. Thus, it is necessary to discuss the issue of recognition of interest social classes, including the degree of risk and responsibility, which members of society encounter in the process of social production.
The problem consists in the need to consider the interests of two opposing and at the same time connected with each other factors of production – labor and capital.
Political economy seeks to develop the most effective mechanism of the distribution of income. It is necessary to analyze the existing research on the subject and summarize them. Income includes cash and other tangible assets, which it facilitates as a result of the production of goods which carry the
surplus value. For example, income may be obtained from the sale of labor power, mining, or agricultural products as well as the rent for the demised property (Tisdell, 2014).
The classical price theory which had been elaborated by Adam Smith and his follower, David Ricardo, occupies a significant position in the classical economy. In general, both authors are convinced that the cost or price for a certain product or the amount of any other commodity for which it is exchanged has a vast tendency to depend on the relative amounts of labor required for its production, and not on the greater or lower compensation which is paid for this work (Ciconne et al., 2011).
Contrary to Adam Smith and David Recardo, Stigler and Friedman used to consider that it was extremely inefficient if the use did not affect the prices for the products within the industry. However, very often, the regulation is used for individual enterprises or professional groups, rather than the whole of society, for which it was originally intended. If the regulation does not reach the goals, it will question the justification of the existence of control.
Ricardo first demonstrated his commitment to the labor theory of value, because it was published two years before the problem appeared. The bias and cost of such a principle of interpretation of the value of goods mentioned above are frequently fairly perceived as the general characteristics of the classical political economy. It is very significant and remarkable that Ricardo made a reservation here and added comments, for example, that the exchange value was to be determined along with the quantity and quality of labor scarce commodity and that the relative prices of goods ought to be considered only along with the number of products. It can be increased by human labor in the production of which the effect of competition is not subject to any restrictions.
Contrary to Adam Smith and David Recardo, in his work “The theory of Economic Regulation” Stigler answered plenty of questions which had been based on the assumption on the maximization of wealth through political means. George Stigler is known not only as an expert in microeconomics, but also as a historian of economic thought. In his field of vision there were the works of a variety of scientists – from Ricardo and the Fabians to Galbraith. His historical research was universally accepted.
Ricardo and Smith argue that different types of labor are the basis of all costs and that it determines the relative amount or (almost exclusively) the relative value of commodities. It means that the differences that appeared when labor had been lost and consequently, the difficulty of comparison between one-day or one-pile industry hardly had the same duration as the other. Evaluation of the labor of different qualities on the market was soon established and is known to be largely dependent on the relative strength and art of the workers who performed their labor (Ciconne et al., 2011).
Contrary to Adam Smith and David Recardo, Stigler and Friedman found that in addition to the direct impact of the expected regulation of economic processes, there is always a side effect that sometimes negates all efforts to reach a certain purpose. As an example, Friedman and Stigler had led a legislative regulation of electricity tariffs, which virtually had no useful effect. The reason for such a phenomenon was seen in a lack of understanding of real conditions, difficulties in the practical implementation of regulatory measures, as well as neutralizing of the impact of external factors. After Stigler, there were conducted similar studies on the legislative regulation of the impetus in many other countries.
Meanwhile, in the presentation of textbooks by David Ricardo and Adam Smith, in contrast to the works of Marx, the categories of 'value' and 'price' are virtually synonymous. In particular, speaking about the 'natural' and 'market prices,' Ricardo was convinced that the work serves as a basis for the cost of goods, so it does not means that there are casual and temporary deviations of the actual or market price of commodities from their primary and natural price (Gibbons & Roberts, 2012).
In his later works, oppositely to the representatives of the classical price theory, Stigler and Friedman showed that the legislation was not an 'exogenous' factor affecting economy externally, and therefore it was an inherent part of the economic system. In addition to this, Stigler argued that this process would continue as long as the costs of the duration or intensity of such searches would not exceed the size of the expected savings from buying products at a lower price (Ciconne et al., 2011).
In regard to the Ricardo’s viewpoint that the level of chains of goods along with expended living labor affects materialized labor, i.e. the money flows are spent on weapons, tools and buildings, contributing to this work, it is certainly cannot be agreed with. However, his thesis is worth arguing about, since the relative cost of goods is not believed to depend on changes in the level of wages, and consequently can hardly be called reasonable. Thus, such a thesis of David Ricardo and Adam Smith contributed to the increase in the cost of labor (i.e. what is generally referred to as wages) which was not possible without a decrease of profits.
Contrary to Smith and Ricardo, the method which had been applied in the Stigler and Friedman's model for the study of economic problems facilitated a new approach to the theory of market behavior. What is more, according to Stigler, the uncertainty should not be seen as something given, as well as the degree of ignorance, which could be reduced as a result of certain costs and acquisition of information (Ciconne et al., 2011). This approach had a great impact on the economic analysis, both theoretical and empirical, and was used in various fields, including the study of consumer behavior and the distribution of prices in advertising (Gibbons & Roberts, 2012).
Among the provisions made by David Ricardo in relation to the characteristics of the category of “value,” two of them belong to the “golden fund” of classical political economy. Their essence is the following. First, the price for the goods necessitated the growth of wages, which in turn is invariably accompanied by an increase in the prices of commodities. And, secondly, the money as a universal medium of exchange among all civilized nations are distributed among them in proportions that vary with every improvement in commerce and machinery as well as with the difficulties of obtaining food and other necessaries for a growing population.
The total opposition of the Stigler and Friedman's points of view towards the classical school of the price theory was manifested even when the interests Stigler possessed gradually moved from the sphere of pure theory to the area of economic regulation. He was particularly interested in the issues of state intervention in the economy and the market place in the modern economy (Gibbons & Roberts, 2012). Dissatisfied with the prevailing notion that agencies regulated the public interest, he put forward the so-called 'capture theory' applied to the regulation.
According to this theory, regulation was of great importance. This was regardless of the fact that the intention of the relevant state departments engaged in regulatory policy, rather than protected the interests of the consumers and industrial enterprises themselves from the new competition (Scarth & Mankiw, 2014). As an example of Stigler, there were the attempts of the Interstate Trade Commission to restrict the movement of trucks between the states that served as a benefit not for the population, but for the railway companies (Ciconne et al., 2011). The theory of regulation by Stigler connects the right and the economy, and represents the pioneering work of an interdisciplinary nature. It showed that only the analysis of the political and economic organization of the state as a whole can explain how and why the regulation can be introduced within the industry.
In addition, in the contrast to the classical point of view on the price theory, and according to Friedman, the quantity theory of money in the first approximation was a theory of demand for money (Gibbons & Roberts, 2012). Monetarists based their model on findings and suggestions on the monetary policy of the state as an important tool for regulation of social reproduction. In terms of the impact of market changes in the money supply, monetarists distinguish a long-term and short-term model (Scarth & Mankiw, 2014). In the short term model, increase in the monetary fund causes a drop in interest rates, expanding demand and reducing the rate of unemployment. In the long term, the growth of the money supply triggers investment, which leads to an increase in the production, income and demand for money raising interest rates. Furthermore, Friedman and Stigler believe that the law system which used to exist at that time harmed people, increasing the rate of unemployment (Scarth & Mankiw, 2014). The logic of his argument consisted in the fact that the law on minimum salaries that increased labor costs makes them non-beneficial for many low-paying firms to keep adrift as a result of those who might in other circumstances remain at work or be fired (Gibbons & Roberts, 2012).
In this case, it is obviously impossible to describe the process of co-production in terms of direct and indirect labor costs, but along with labor costs there should be taken into account direct and indirect costs of resources (Scarth & Mankiw, 2014). These direct costs of resources in the production of products are generally called the costs of the product in its own production (Scarth & Mankiw, 2014). For example, in order to grow wheat, it is necessary to keep part of the harvest for future sowing or to produce steel, there must be expended the same steel in the form of depreciation of machinery, equipment and tools used for its production. Indirect costs of resources in the production of products which are called the costs in the manufacture of products are related to the resources in other industries (Scarth & Mankiw, 2014). For example, wheat production requires the use of steel in the form of machinery, equipment and tools used for the cultivation and harvesting.
As a consequence, analytical apparatus of the classical theory of price takes into account certain adjustments and allows building a complete model of reproduction and, therefore, is not inferior to the neoclassical theory (Gibbons & Roberts, 2012). Moreover, the classical approach can be compared to the neoclassical one with a significant advantage consisting in the fact that they are considered as the parameters of reproduction, the relative costs of resources and labor. In contrast, the modern price theory can be directly measured by observing the actual production and therefore on the basis of this approach, mathematical models of reproduction can be used for a detailed analysis and forecasting of real processes in the economy, while the neoclassical general equilibrium model is not practical because of its extreme complexity.
The community development is inextricably linked with the mastery of society scientifically sound economic theory. In the course of socio-historical development of the theory, reflecting the objective laws, it becomes an effective means of transforming the society. In the field of economic theory achieved certain results. It is enough to read the following works to assess the level of modern scientific analysis of the theory of value.
The paper proved the fact that the modern price theory has originated and is mainly based on the classical theory which has been elaborated by Smith and Ricardo. It was found that they admitted variability factor proportions in the chapter on 'machines,' but the concession was never flowed into the mainstream of what is frequently referred to as the classical theory. The community donated to the special case of agricultural products, where the marginal cost of production is in fact deviated from the average one. Classical economics is, therefore, forced to operate the two theories of value: the price of industrial products depends entirely on the conditions of the offer, while the price of agricultural products varies with the scale of production and therefore depends on the nature of demand.
The stumbling block for the classical theory of value was the fact that surplus value resulting from production was not proportional to the direct labor costs for manufacturing
resources so that in reality the equation of the conditions of information production costs for labor costs were not met. The reason for this is that the actual work is not the only force in the productive economy, i.e. single source of value. In addition to the labor force of production, in the economy there are the forces of nature. It is the use of natural forces in the production which
allows creating a surplus product, so that it makes the specialization of labor implemented. However, the forces of nature act according to their own laws and are not directly related to the division and distribution of labor. As a result, the cumulative value of the product is not proportional to the value of the labor spent in manufacturing.