Marx and modern microeconomics
Few economists doubt that Marx flunked economics, a judgement mostly predicated on his labour theory of value. But this column argues that Marx’s representation of the energy relationship between capital and labour in the firm can be an essential insight for understanding and improving modern capitalism. Indeed, this insight is incorporated into standard principal-agent types of labour and credit markets.
Economists, looking back, have not found much to admire in Karl Marx, the economist, the bicentennial of whose birth we commemorate the following month. John Maynard Keynes described Capital as “an obsolete economic textbook [that is] not merely scientifically erroneous but without interest or application to today’s world” (Keynes 1925). Paul Samuelson’s judgement – "From the viewpoint of pure economic theory, Karl Marx could be seen as a minor post-Ricardian” – was equally harsh, especially as he thought Ricardo was "the most overrated of economists”(Samuelson 1962).
These assessments are based largely on our current – and correct in my own view – knowledge of Marx’s labour theory of value as a pioneering, but inconsistent and outdated, attempt at an over-all equilibrium style of pricing and distribution. But there is another facet of his work that is strongly vindicated by theoretical advances in recent decades: the theory that the exercise of power can be an important aspect of the working of the capitalist economy, even in its idealised, perfectly competitive, state.
Domination in liberal society
Marx used the labour theory of value to show that the exploitation of workers is a required condition for profits (Yoshihara 2017). The normative term ‘exploitation’ is justified by the declare that profit arises from something of domination where the wealthy, as owners of capital goods, direct the actions and limit the options of employees (Vrousalis 2013). Domination in this sense could possibly be sustained by an autocratic state functioning on behalf of a capitalist class, or through the exercise of market power permitted by limited competition in goods markets.
But Marx thought we would study a far more challenging question: how could the domination of labour by capital happen in an exclusive, perfectly competitive, economy governed by a liberal state? His answer was predicated on what seems a strikingly modern principal-agent representation of the employer-employee relationship, due to a conflict of interest over the quantity of labour effort performed that may be resolved within an enforceable contract.
Marx stressed that the employer purchases the worker’s time on the labour market, not the worker’s work. The employee’s way to obtain effort to the production process isn’t secured by contract but was rather an “extraction” that “only by misuse could . have already been called any sort of exchange at all” (Marx 1939).
To stress the distinctive facet of the labour market, Marx (1867) remarked that:
“[T]he rise in . wages may . be unaccompanied by any change in the cost of labour [meaning effort], or could even be along with a fall in the latter.”
The important consequence for the worker, “be his payment high or low,” was “domination and exploitation” and “a kind of despotism more hateful because of its meanness” (ibid).
The final part of Marx’s explanation of domination in a liberal capitalist economy was the procedure of accumulation and technical change that supports a permanent “reserve army" (ibid) of the unemployed, and which gives the foundation of the employer’s labour discipline strategy. The private ownership of the method of production conveys the proper to exclude others from usage of the firm’s assets, and then the owners of firms have a robust threat to induce workers to provide the effort that cannot be secured by contract: work hard, or join the "reserve army".
The politics of production
Marx didn’t explain why the labour contract was incomplete. He assumed this is an uncontroversial empirical observation and used it as the starting place for his economic theory. In this, he resembles Charles Darwin who advanced a robust theory of natural selection lacking any knowledge of the mechanism where it occurred. Genetic inheritance would later be explained by Gregor Mendel.
Just as Mendel underpinned Darwin, a far more complete knowledge of the incomplete labour contract developed in the twentieth century, but didn’t overturn Marx’s conclusions. Like Marx, Ronald Coase (1937) stressed the central role of authority in the firm’s contractual relations:
“[N]ote the type of the contract into which one factor enters that’s employed within a company . [T]he factor . for several remuneration agrees to obey the directions of the entrepreneur.”
Indeed, Coase defined the firm by its political structure:
“If a workman moves from department Y to department X, he will not go due to a change in prices but because he’s ordered to take action . the distinguishing mark of the firm may be the suppression of the purchase price mechanism.” (ibid)
Herbert Simon provided the first Coasean style of the firm (Simon 1951). He represented the employment contract as an exchange where the employees transfer control rights over their work tasks to the employer, in substitution for a wage. Simon stressed the benefit to the employer of the arrangement, because there is unavoidable uncertainty about the tasks that might be required during the period of the contract. Therefore there is a higher cost of agreeing to a complete contractual specification of the actions to be performed. Simon didn’t understand that he was modelling the incomplete contract for labour that was the fulcrum of Marx’s economic theory.
Coase or Simon didn’t directly explain why control rights confer power. As an empirical matter, the firm is apparently a political institution in the sense that some members of the firm routinely give commands with the expectation that they can be obeyed, while some are constrained to check out these commands. If we say that the manager gets the to decide what the worker can do, this implies only that the manager gets the legitimate authority, not the energy to secure compliance. Considering that, in a liberal society, the manager is fixed in the kinds of punishment which can be inflicted, and considering that the employee is absolve to leave, this is a puzzle that orders are usually obeyed.
Noticing this, Armen Alchian and Harold Demsetz challenged the Coasean proven fact that the firm is a mini “command economy”, suggesting that the employment contract is no different in this respect from other contracts:
“The firm . does not have any power of fiat, no authority, no disciplinary action any different at all degree from ordinary market contracting between any two different people . Wherein then may be the relationship between a grocer and his employee not the same as that between a grocer and his customer?” (Alchian and Demsetz 1972)
Oliver Hart (1989) responded:
‘[T]he reason an employee may very well be more attentive to what his employer wants when compared to a grocer is that the employer . can deprive the employee of the assets he works together with and hire another employee to utilize these assets, as the customer can only just deprive the grocer of his customer and so long as the client is small, it really is presumably not very problematic for the grocer to find another customer."
The exercise of power
This explanation takes a demonstration that power – in a few well-defined sense – could be exercised by employers over employees in the equilibrium of a competitive economy. It really is nevertheless puzzling that power is exercised in a competitive economy, where each actor engages voluntarily in exchanges, that each is equally absolve to walk away.
The next sufficient condition for the exercise of power captures the central top features of Marx’s (1867) representation of the “despotism” of the workplace:
For B to have power over A, it sufficient that, by imposing or threatening to impose sanctions on A, B is with the capacity of affecting A’s actions with techniques that further B’s interests, while A lacks this capacity regarding B. (Bowles and Gintis 1992)
This is clarifies the difference between your employer and the grocer in Hart’s response to Alchian and Demsetz. The sanctions imposed on the employee by depriving that employee usage of the administrative centre good are severe (technically, first order), while those imposed on the grocer by the departing customer are negligible or zero (second order). The disgruntled consumer who walks out the entranceway will not impose a sanction on the grocer as the grocer (in competitive equilibrium) was maximising profits by choosing the degree of sales that equates marginal cost to the exogenously given price. A little variation in sales has only a second-order influence on profits. But this is simply not the case for the employer-employee relationship. It is because involuntary unemployment is a characteristic of the competitive equilibrium of market where labour effort isn’t covered within an enforceable contract(Bowles 1985, Gintis and Ishikawa 1987, Shapiro and Stiglitz 1985). The employer’s threat to terminate the worker’s position wouldthus impose a first-order cost on the worker. This is actually the basis of the exercise of power by employers.
The incomplete nature of the labour contract is therefore necessary to showing both why the employer’s power over the worker is vital to profit-making, and in addition how it could be sustained by equilibrium unemployment. Marx understood the first however, not the next, providing instead a dynamic (rather than entirely convincing) account of the way the reserve army will be sustained over time.
Microeconomist or precursor to modern micro?
Marx was a pioneer in the analysis of principal-agent relationships, though of course he didn’t utilize the term. Principal-agent models now form the microeconomic foundation for the analysis of relationships among classes (though economists usually do not use that term) in capitalist and other economies, including the standard treatments of the exchanges between employer and employee, or between lender and borrower. These models are crucial to current analysis of workaday economic problems like the cyclical patterns in wage-setting and productivity, and the number constraints that borrowers face in credit markets. Both these problems have substantial microeconomic importance, but are also important foundations of macroeconomics.
Marx was a visionary precursor of modern microeconomics, and modern microeconomics has repaid him the favour by clarifying the limits of a few of his most significant ideas. Included in this the labour theory of value as a representation of an over-all system of exchange (Morishima 1973, 1974), and his “theory of the tendency of the profit rate to fall” (Bowles 1981, Okishio 1961). As Michio Morishima (1974) described, Marx didn’t resolve the outstanding theoretical problems of his day, but instead anticipated issues that would later be addressed mathematically.
Modern public economics, mechanism design and public choice theory in addition has challenged the idea – common amongst many latter-day Marxists, though not originating with Marx himself – that economic governance without private property and markets is actually a viable system of economic governance.
Political and economic problems
In 1972 Abba Lerner astutely identified among the limits of the neoclassical paradigm. A contract transforms “a political problem into an economic problem. An economic transaction is a solved political problem . Economics has gained the title Queen of the Social Sciences by choosing solved political problems as its domain.” (Lerner 1972)
Whether that is an attribute or a bug depends upon your viewpoint. The Queen’s domain hasn’t seemed too cramped as the same paradigm provided grounds to believe that unsolved “political problems”, including the incomplete nature of the labour contract, or the exercise of power byemployers over workers, were illusions. Joseph Schumpeter made this aspect: "What distinguishes directing and directed labour appears initially sight to be very fundamental," he wrote. But, he argued, the truth is the difference "constitutes no essential economic distinction . the conduct of the former is at the mercy of the same rules as that of the latter . also to establish this regularity . is a simple task of economic theory." (Schumpeter 1934)
Why, one wonders, would Schumpeter think about this indicate be of such exceptional importance? The answer is that if Marx’s despotism of the workplace is real, then your liberal argument against economic democracy – there’s nothing there to democratise – is false.
Editors’ note: This column is founded on a more substantial work of the same title to be published in Japanese in a particular problem of Keizai Seminar, edited by Naoki Yoshihara.
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