The Value of Everything (UK)

by Mariana Mazzucato

  THE RISE OF THE ‘NEOCLASSICALS’

  Prices, then, reflect the utility that buyers get from things. The scarcer they are – the higher their marginal utility – the more consumers will be willing to pay for them. These changes in the marginal utility of a product came to be known as consumer ‘preference’. The same principle applies to producers. ‘Marginal productivity’ is the effect that an extra unit of produced goods would have on the costs of production. The marginal cost of each extra Mars Bar that rolls off the production line is lower than the cost of the previous one.

  This concept of marginalism lies at the heart of what is known today as ‘neoclassical’ theory – the set of ideas that followed the classical theory developed by Smith and Ricardo and was extended by Marx. The term neoclassical reflected how the new theorists stood on the shoulders of giants but then took the theory in new directions. Microeconomic theory, the theory of how firms, workers and consumers make choices, is based on the neoclassical theory of production and consumption which rests on the maximization of profits (firms), and utility (consumers and workers).

  As a mathematician, Marshall used mathematical calculus, borrowed from Newtonian physics, to develop his theory of how an economy worked. In his model, the point at which a consumer’s money is worth more to him or her than the additional (marginal) unit of a commodity (that next Mars Bar) that their money would purchase, is where the system is in ‘equilibrium’, an idea reminiscent of Newton’s description of how gravity held the universe together. The smooth, continuous curves of these equilibrating and evolutionary forces depict a system that is peaceful and potentially ‘optimal’. The inclusion of concepts like equilibria in the neoclassical model had the effect of portraying capitalism as a peaceful system driven by self-equilibrating competitive mechanisms – a stark contrast to the ways in which the system was depicted by Marx, as a battle between classes, full of disequilibria and far from optimal, whose resulting revolutions would have been better described by Erwin Schrödinger’s concept of quantum leaps and wave mechanics.

  So keen was Marshall to emphasize the equilibrating and evolutionary forces in economics, with their smooth, continuous curves that could be described by mathematical calculus, that the epigraph of his 1890 Principles of Economics was the Latin tag Natura non facit saltum, a nod to its use by Darwin in his 1859 On the Origin of Species to make the point that Nature, rather than progressing in leaps and bounds, evolves in incremental steps, building on previous changes.

  The equilibrium concept had a lot of appeal at the start of the twentieth century, when the rise of socialism and trade unions in Europe threatened the old, often autocratic, order and the conventional wisdom was that capitalism was largely self-regulating and government involvement was unnecessary or even dangerous.

  Equilibrium was predicated on the notion of scarcity, and the effect of scarcity on diminishing returns: the more you consume, the less you enjoy each unit of consumption after a certain amount (the maximum enjoyment); and the more you produce, the less you profit from each marginal unit produced (the maximum profit). It is this concept of diminishing returns that allows economists today to draw smooth curves in diagrams, using mathematical calculus, so that maxima and minima points (e.g., the bottom of a U-shaped curve showing how costs change with increased production) provide the equilibrium targets and utility maximization.

  Nineteenth-century economists liked to illustrate the importance of scarcity to value by using the water and diamond paradox. Why is water cheap, even though it is necessary for human life, and diamonds are expensive and therefore of high value, even though humans can quite easily get by without them? Marx’s labour theory of value – naïvely applied – would argue that diamonds simply take a lot more time and effort to produce. But the new utility theory of value, as the marginalists defined it, explained the difference in price through the scarcity of diamonds. Where there is an abundance of water, it is cheap. Where there is a scarcity (as in a desert), its value can become very high. For the marginalists, this scarcity theory of value became the rationale for the price of everything, from diamonds, to water, to workers’ wages.

  The idea of scarcity became so important to economists that in the early 1930s it prompted one influential British economist, Lionel Robbins (1898–1984), Professor of Economics at the London School of Economics, to define the study of economics itself in terms of scarcity; his description of it as ‘the study of the allocation of resources, under conditions of scarcity’ is still widely used.8 The emergence of marginalism was a pivotal moment in the history of economic thought, one that laid the foundations for today’s dominant economic theory.

  The Marginal Revolution

  The ‘marginal revolutionaries’, as they have been called, used marginal utility and scarcity to determine prices and the size of the market. In their view, the supply and demand of scarce resources regulates value expressed in money. Because things exchanged in a monetary market economy have prices, price is ultimately the measure of value. This powerful new theory explained how prices were arrived at and how much of a particular thing was produced.9 Competition ensures that the ‘marginal utility’ of the last item sold determines the price of that commodity. The size of the market in a particular commodity – that is, the number of items that need to be sold before marginal utility no longer covers the costs of production – is explained by the scarcity, and hence price, of the inputs into production. Price is a direct measure of value.10 We are, then, a long way from the labour theory of value.

  But what this model gains in versatility – the notion that the preferences of millions of individuals determine prices, and hence value – it loses in its ability, or, rather, lack of ability, to measure what Smith called ‘the wealth of nations’, the total production of an economy in terms of value. As value is now merely a relative concept – we can compare the value of two things through their prices and how the prices may change – we can no longer measure the labour that produced the goods in the economy and by this means assess how much wealth was created.

  Marginal utility and scarcity need a couple of additional assumptions for price determination to work as intended. First, all humans have to be one-dimensional utility calculators who know what’s best for themselves, what price to pay for what commodity and how to make an economically ‘rational’ choice.11 Second, there must be no interference, for example by monopolies, in price-setting. ‘Equilibrium’ with ‘perfect competition’ – in which supply and demand are exactly balanced, an idea Jean-Baptiste Say developed back in the early nineteenth century – became a necessary and central concept in economics. These assumptions, as we will see, bear heavily on today’s discussion of value creation.

  The Production Boundary Becomes Malleable

  The consequences of marginal thinking for the production boundary are dramatic. As we have seen, classical thinkers differed in their definition of who was and was not productive. For Quesnay only farmers were productive; Smith put services in the ‘unproductive’ bracket; and even Marx defined productive workers as those who were working in capitalist production. In marginal thinking, however, such classification was swept aside. What replaced it was the notion that it is only whatever fetches a price in the market (legally) that can be termed productive activity. Moreover, productivity will fluctuate with prices, because prices determine value, not vice versa. The utility theory therefore completely changes the concept of productive and unproductive labour. In fact, the distinction effectively falls away, since every sector that produces for the market exchanges its products – which means there are now few definitively unproductive sectors. The only part of the economy which clearly lies outside the production boundary and is unproductive, as in Figure 7, consists of those who receive income not earned in the market: the government by collecting taxes and the beneficiaries of government subsidies such as social security payments, and state entities like the armed forces.

  In Marshall’s state of ‘equilibrium’, wher
e prices are not distorted, everyone gets paid what they are worth – which may change if consumers alter their tastes or if technology advances. This has important consequences for how incomes are assessed and justified. What workers earn is reflected in their marginal productivity and their revealed preferences (marginal utility) for leisure versus work. There is no longer any room for the analytical distinctions that Ricardo or Marx made about a worker’s contribution to production, let alone the exploitation of that worker. You are valuable because what you provide is scarce. Because we are rational utility calculators in the face of scarcity, we don’t let things go to waste. Workers might choose unemployment because that gives them more marginal utility than working for that or a given wage. The corollary of this logic is that unemployment is voluntary. Voluntary unemployment arises from viewing economic agents as rationally choosing between work and leisure (i.e. ‘intertemporal maximization’ in modern theory). In other words, Marx’s concept of the ‘reserve army of labour’ disappears into thin air.

  Figure 7. The marginalist revolution

  As Lionel Robbins neatly put it,

  In the first place, isolated man wants both real income and leisure. Secondly, he has not enough of either fully to satisfy his want of each. Thirdly, he can spend his time in augmenting his real income or he can spend it in taking more leisure. Fourthly, it may be presumed that, save in most exceptional cases, his want for the different constituents of real income and leisure will be different. Therefore he has to choose. He has to economize.12

  Inherent in equilibrium is the idea that everything is in everyone’s interest. In the 1940s the Russian-born British economist Abba Lerner (1903–82) formulated what he called the ‘first fundamental welfare theorem’,13 which basically states that competitive markets lead to ‘optimal’ outcomes for all. Once market exchange at equilibrium prices has taken place, no one can be made better off, or, in economic parlance, have their ‘welfare’ increased (for example, by accepting more work) without making someone else worse off.

  Today, competitive markets where no one can be made better off without someone being made worse off are known as ‘Pareto-optimal’ – named after Walras’s successor in Lausanne, Vilfredo Pareto (1848–1923), who was the first to introduce the term ‘welfare maximization’. In his Manual of Political Economy (1906), Pareto studied economic equilibrium in terms of solutions to individual problems of ‘objectives and constraints’, and was the first economist to argue that utility maximization did not need to be cardinal (i.e., the exact amount that someone wanted something) just the ordinal amount (how much they wanted it more than something else – X versus Y). This made mathematical calculus even easier to use, and many welfare properties in economics today bear his name. He used his theories to argue for free trade in Italy, which did not make him popular with the Fascist government of the time, which was more protectionist.

  But to get to these ‘optimal’ outcomes, we must ensure that equilibrium holds: all obstacles to equilibrium, such as an interfering government, monopolies, other rents arising from scarcity and so on, must be obliterated. Our problems, marginalism holds, derive solely from imperfections in, and inhibitions on, the smooth working of the capitalist machine. Rent is no longer seen as ‘unearned income’, as it was by the classical economists, but as an imperfection that can be competed away. Left to itself, capitalism can thus create maximal value for everyone, which is conveniently what everyone ‘deserves’ based on their marginal product. The contrast with the classical economists is glaring. For Marx, capitalists appropriate surplus value by paying a wage less than the value of labour. Smith and Ricardo held that value was created by effort that directly added up to the wealth of nations. But with marginal utility there are no longer classes, only individuals, and there is no objective measurement of value.

  This approach has a very important consequence. It suggests that government should never intervene in the economy unless there are market failures. Market failure theory uses the first fundamental theorem (FFT) of welfare economics as its starting point. The FFT holds that markets are the most efficient allocators of resources under three specific conditions: first, that there exists a complete set of markets, so that all goods and services which are demanded and supplied are traded at publicly known prices; that all consumers and producers behave competitively; and that an equilibrium exists.

  Violations of any of these three assumptions leads to the inefficient allocation of resources by markets, or what marginalists term ‘market failures’. Market failures might arise when there are ‘positive externalities’, benefits to society such as basic science research from which it is hard for individual firms to profit; or ‘negative externalities’, bad things like pollution, which harm society but are not included in firms’ costs. If markets are not ‘Pareto-optimal’, then everyone could be better off as a result of public policies that correct the market failure in question.14 However, as we will see in Chapter 8, a body of economics referred to as Public Choice theory, advocated by Nobel Prize winner James Buchanan (1919–2013), later argued that as government failures are even worse than market failures (due to corruption and capture), so the correction of market failures by bureaucrats might make things even worse.

  From the Class Struggle to Profits and Wages in ‘Equilibrium’

  Defining everything that commands a price as valuable led to the marginalists’ conclusion that what you get is what you are worth. Profits are not determined by exploitation but by technology and the ‘marginal product of capital’. Capital and labour are seen as the two main inputs into production, and so just as labour earns wages for its productive contribution (marginal product of labour), capital earns a profit (marginal product of capital). John Bates Clark (1847–1938), a former critic of capitalism who converted to become one of the most ardent contributors to the marginalist revolution, argued strongly against the idea that labour was exploited. Capital could not exploit labour, he reasoned, because labour and capital were simply earning their ‘just rewards’ – their marginal products. In Clark’s view, capital goods themselves were the rewards for capitalist self-restraint. Instead of consuming their profits, they had saved them – saving that would eventually result in higher investment in more capital goods (we will come back to this in Chapter 8).

  The equilibrium view diverted attention from the tensions between capital and labour, and ultimately from alternative theories on the sources and distribution of value – which almost faded into oblivion from the late nineteenth century onwards, except in expressly Marxist circles and in the thinking of economists such as Joan Robinson (1903–1983), Professor of Economics at Cambridge, and Piero Sraffa (1898–1983), an Italian who also studied and worked in Cambridge. Both were dedicated critics of the neoclassical view of production, believing that the concept of the ‘marginal’ product of labour and capital was ideologically based, and was also subject to a ‘fallacy of composition’: the neoclassical theory of production could not apply to the entire system. They engaged actively in what was later called the Cambridge Capital Critique – a debate between the Cambridge, UK-based Robinson and Sraffa, and Solow and Samuelson, who were at MIT in Cambridge, Massachusetts.

  Sraffa and Robinson argued that ‘capital’ is heterogeneous and so cannot be used as an aggregate concept. That is, it cannot be aggregated since it would be like adding apples to oranges. In 1952 Robinson, influenced by the writings of Sraffa, argued that the idea of profits as the value measurement of capital is a tautology: there is no way to know the value of capital without knowledge of equilibrium prices, and these require an equilibrium rate of profit that cannot be obtained unless we have estimated the value of capital. Furthermore, following the ideas of Marx, Robinson and Sraffa argued that the rate of profit was not the reward for productive contribution of ‘capital’; it derived from social relations, that’s to say, who owned the means of production and who was forced to work for them. The circularity of the logic of neoclassical theory was partly accept
ed by Samuelson in a well-known 1966 article in the prestigious Quarterly Journal of Economics, where he admitted the logical validity of the points being made by Robinson and Sraffa. Solow, on the other hand, claimed that neoclassical economics should not be distracted by such critiques; and indeed, the debate between the ‘classicals’ and the ‘neoclassicals’ would later disappear, so that most students of economics today don’t even know it happened.

  Remarkably, the neoclassical theory of value has not changed much in the last hundred years. The maximization of utility has been extended beyond the economic sphere to explain human behaviour, including crime, drug addiction and, infamously, models of divorce. This particular idea originated with Gary Becker (1930–2014), an American who was Professor of Economics and Sociology at the University of Chicago and won the Nobel Prize in Economics in 1992. In essence, Becker postulated that two individuals marry when there is a positive surplus from their union in contrast to remaining single. These gains may come from, for example, economies of scale, provision of insurance and general risk-sharing. Becker’s ideas encouraged many others to pursue similar investigations.

  Attempts have also been made to forge stronger links between macroeconomic patterns (the whole economy, for instance inflation, unemployment and business cycles) and microeconomic decisions made by people and firms. And, as we will see, other work has looked at the need to include non-priced goods (such as care) into GDP.

  But despite the critiques, marginal utility theory prevails and is highly influential. The narrow equilibrium view that we will all benefit from perfect competition has influenced – and continues to influence – government policies and those of powerful multilateral bodies such as the International Monetary Fund and the World Bank: how, with perfect competition, individuals will supposedly maximize their preferences and companies their profits so we will all benefit. On the basis of contemporary economic assumptions, we can no longer reliably say who creates value and who extracts it and therefore how the proceeds of production – income – should reasonably be distributed. In the next chapter we will see how this subjective approach to value has also had a strong impact on the ways we measure national wealth and income through the concept of GDP.