Tag: Alfred Marshall

Alfred Marshall on the facts speaking for themselves

Alfred Marshall on state owned enterprises

The marvel of the market: the remarkable foresight of young adults in choosing what to study

Known but yet to be exploited opportunities for profit do not last long in competitive markets, including hitherto unnoticed opportunities for the greater utilisation and development of skills and experience (Hakes and Sauer 2006, 2007; Ryoo and Rosen 2004; and Kirzner 1992). Moneyball is the classic example of entrepreneurial alertness to hitherto unexploited job skills which were quickly adopted by competing firms (Hakes and Sauer 2006, 2007).

There is considerable evidence that the demand and supply of human capital responds to wage changes. For example, over- or under-supplied human capital moves either in or out in response to changes in wages until the returns from education and training even out with time (Ryoo and Rosen 2004; Arcidiacono, Hotz and Kang 2012; Ehrenberg 2004).

As evidence of this equalisation of returns on human capital investments across labour markets, the returns to post-school investments in human capital are similar – 9 to 10 percent – across alternative occupations, and in occupations requiring low and high levels of training, low and high aptitude and for workers with more and less education (Freeman and Hirsch 2001, 2008). There is evidence that workers with similar skills in similarly attractive jobs, occupation and locations earn similar pay (Hirsch 2008; Vermeulen and Ommeren 2009; Rupert and Wasmer 2012; Roback 1982, 1988).

Ryoo and Rosen (2004) found that the labour supply and university enrolment decisions of engineers is “remarkably sensitive” to career earnings prospects. Graduates are the main source of new engineers. Engineers who moved out into other occupations such as management did not often moved back to work again as professional engineers. Ryoo and Rosen (2004) observed when summarising their work that:

 Both the wage elasticity of demand for engineers and the elasticity of supply of engineering students to economic prospects are large. The concordance of entry into engineering schools with relative lifetime earnings in the profession is astonishing.

Ryoo and Rosen (2004) found several periods of surplus in the market for engineers. These periods of shortage or surplus corresponded to unexpected demand shocks in the market for engineers such as the end of the Cold War.

Figure 1: New entry flow of engineers: a, actual vs. imputed from changes in stock of engineers; b, time-varying coefficients.

Source: Ryoo and Rosen (2004)

Ryoo and Rosen (2004) noted that importance of permanent versus transitory changes in earnings. Transitory rises and falls in earnings prospects have much less influence on occupational choices and the educational investments of students.

In light of these findings that the supply of engineers rapidly adapted to changing market conditions, Ryoo and Rosen (2004) questioned whether public policy makers have better information on future labour market conditions than labour market participants do. When politicians get worked up about skill shortages, the markets for scientists and engineers often where they make extravagant claims about the ability of the market to adapt to changing conditions because of the long training pipeline involved in university study, including at the graduate level.

There can be unexpected shifts in the supply or demand for particular skills, training or qualifications. These imbalances even themselves out once people have time to learn, update their expectations and adapt to the new market conditions (Rosen 1992; Ryoo and Rosen 2004; Bettinger 2010; Zafar 2011; Arcidiacono, Hotz and Kang 2012; Webbink and Hartog 2004).

For example, Arcidiacono, Hotz and Kang (2012) found that both expected earnings and students’ abilities in the different majors are important determinants of student’s choice of a college major, and 7.5% of students would switch majors if they made no forecast errors.

The wage premium for a tertiary degree was low and stable in New Zealand in the 1990s (Hylsop and Maré 2009) and 2000s (OECD 2013). This stability in the returns to education suggests that supply has tended to kept up with the demand for skills at least over the longer term at the national level. There were no spikes and crafts that would be the evidence of a lack of foresight among teenagers in choosing what to study.

All in all, the remarkable sensitivity of engineers to a career earnings prospects, the frequent changes of college majors by university students in response to changing economic opportunities, and the stability of the returns on human capital over time suggest that the market for human capital is well functioning.

The argument that the market was not working well was assumed rather than proven. Likewise, the case for additional subsidies for science, technology, engineering and mathematics because of perceived skill shortages has not been made out. There is a large literature showing that the market for professional education works well.

The onus is on those who advocate intervention to come up with hard evidence, rather than innate pessimism about markets that are poorly understood because of a lack of attempts to understand it. Studies dating back to the 1950s by George Stigler and by Armen Alchian found that the market for scientists and engineers works well and the evidence of shortages were more presumed than real.

Second law of supply and demand alert: There is no such thing as a skills shortage – updated

Could you define both a severe skills shortage and a skills shortage?

  • How do these concepts differ from concepts such as rising demand, rapidly rising demand, and reduced and sharply reduced supply?
  • Are the phrases severe skills shortage and a skills shortage more precise than the phrases rising demand, rapidly rising demand, and reduced and sharply reduced supply?
  • Are the phrases severe skill shortage and a skill shortage more informative than referring to the short and long run elasticity of demand and supply as summed up in the second laws of demand and supply?
  • Why are rising demand, rapidly rising demand, and reduced and sharply reduced supply considered to be social problems. What causes rising demand, rapidly rising demand, and reduced and sharply reduced supply?
  • For whom are rising demand, rapidly rising demand, and reduced and sharply reduced supply considered to be problems? Employers? Employees? Others?
  • Should governments intervene to stop employers from competing to set wages to reflect increases in the marginal revenue product of labour?
  • Is not the purpose of short and long-term upward changes in relative prices or wages to induce people to buy less of a now scarcer resource and search for substitutes and additional sources of supply, and for new suppliers to enter the market in response to the higher prices or wages?

As a starter, I thought I would update Alchian and Arrow’s timeless 1958 analysis for the Rand Corporation of the purported shortage of engineers and scientists at the height of the missile gap in the cold war.

Alchian and Arrow tested the robustness of claims of a labour market shortage of scientists and engineers by investigating the sudden appearance of a servant shortage during World War II.

I will update this idea of a servant shortage to a purported shortage of nannies, as shown in figure 1 below which sets out the initial equilibrium and then an increase in demand.

Figure 1: the demand and supply for nannies by the old rich and power couples


In the diagram above, the initial equilibrium has the old rich hiring Q1 nannies at a wage W1 with demand curve D1, and the supply curve for nannies.

  1. Power couples then enter the nannies market pushing total demand out to D2 with wages increasing to W2 and quantity supplied increasing a little to Q2;
  2. The old rich can now afforded to buy only Qs in nannies and power couples hire (Q2 – Qs) in nannies.

By construction, the quantity of nannies supplied increases slightly in the short-run, with a large increase in wages for nannies! (Q2 – Q1) new nannies enter the market, lured in by the higher wages.

The old rich now face a shortage of nannies equal to the quantity (Q1 – Qs). These nannies having switched to work for power couples on much better pay. (In the case of the original analysis Alchian and Arrow analysis, they switched into defence work or backfilled jobs of those that moved into defence work).

As with the wartime servant shortage, the old rich are unwilling to admit they are no longer able to keep themselves in the style they were accustomed too because the demand for domestic labour has increased.

Better to blame their loss of social status on a skills shortage in a poorly functioning market rather than accept the rise of middle class power couples outbidding them in the hire of domestic help. As Alchian and Arrow (1958, pp. 39-40) explain:

… Many people who formerly consumed some of the commodity or service in question and now find the price so high that they no longer want as much (or any) would describe the situation is one of “shortage”.

Actually, this is merely one way of saying that they can’t get the given commodity at its old price.

We can think of many examples of this use of the word “shortage”. For example, the “servant shortage” during World War II was a case in point.

Those with whom the increase in household servants wages were more than they could afford to pay, apparently found it more convenient to describe their change in circumstances as a result of a “shortage” than to admit baldly that they couldn’t afford to keep the servants…

It seems reasonable to explain a good deal of the current complaint about a shortage of scientists and engineers is a variant of the “servant shortage” phenomena.

Employers who find themselves losing engineers to other firms and at the same time find it uneconomic to try and keep these employees by offering them substantial salary increases may see the situation as a “shortage” rather than recognise that other firms can put these skills to more valuable uses…

While we lack specific evidence, we have the impression that the firms who have complained most consistently about “shortage” have been those whose demand has not increased or at least not increased as rapidly as that of other firms in their industry.

Why are people priced out of any market? Given a fixed income and the many other alternative uses of their incomes, any rise in price makes buying the old quantity no longer the best bargain.

Who will admit that they can no longer keep themselves in the style they were accustomed to when they complain of market failure, skill shortages and lack of government investment in skill formation.

Alfred Marshall’s comparative statics of price adjustment

The analysis of the time path of price adjustment for any commodity was developed by Alfred Marshall in 1890. He was concerned that time was an important factor in how the markets adjusted to demand and supply changes:

… markets vary with regard to the period of time which is allowed to the forces of demand and supply to bring themselves into equilibrium with one another, as well as with regard to the area over which they extend. And this element of Time requires more careful attention just now than does that of Space.

For the nature of the equilibrium itself, and that of the causes by which it is determined, depend on the length of the period over which the market is taken to extend.

We shall find that if the period is short, the supply is limited to the stores which happen to be at hand: if the period is longer, the supply will be influenced, more or less, by the cost of producing the commodity in question; and if the period is very long, this cost will in its turn be influenced, more or less, by the cost of producing the labour and the material things required for producing the commodity.

Marshall divided the price adjustment process into the market period, the short run, and the long run.

In the market period, production is fixed; and all factors of production are fixed in supply during this time period. The burden of price adjustment is on the demand side.

As the supply is fixed in the market period, it is shown as a vertical line SMP. It is also called as inelastic supply curve. When demand increases from DD to D1 D1, price increases from P to P1. Similarly, a fall in demand from DD to D2 D2 pull the price down from P to P2.

In the short run, supply to be partially adaptable, in the sense that increased production can occur but capital equipment and certain other overhead items are held constant.

SSP is elastic implying that supply can be increased by changing a variable input. Note that the corresponding increase in price from P to P1 for a given increase in demand from D to D1 is less than in the market period. It is because the increase in demand is partially met by the increase in supply from q to q1.

The short run is the conceptual time period in which at least one factor of production is fixed in amount and others are variable in amount. In the short run, a profit-maximising firm will:

  • increase production if marginal cost is less than marginal revenue;
  • decrease production if marginal cost is greater than marginal revenue;
  • continue producing if average variable cost is less than price per unit, even if average total cost is greater than price;
  • Shut-down if average variable cost is greater than price at each level of output.

In the long run, supply is fully flexible – there are no fixed factors of production. The Marshallian long-run allows for optimal capital stock adjustment.

The long period supply curve SLP is more elastic and flatter than that of the SSP. This implies the greater extent of flexibility of the firms to change the supply.

The price increases from P to P2 in response to an increase in demand from D to D1 and it is less than that of the market period (P1) and short period (P2). It is because the increase in demand is fully met by the required increase in supply. Hence, supply plays a significant role in determining the lower equilibrium price in the long run.

The market is cleared in the long run within a framework in which supply can be considered to be fully adaptable because all factors have adjusted to the new situation. Alfred Marshall explains:

In long periods on the other hand all investments of capital and effort in providing the material plant and the organization of a business, and in acquiring trade knowledge and specialized ability, have time to be adjusted to the incomes which are expected to be earned by them: and the estimates of those incomes therefore directly govern supply, and are the true long-period normal supply price of the commodities produced.

In addition, in the market period, the short run, and the long run, foresight is not perfect, information is not free, and the cost of adjusting something is not independent of the speed in which you wish to do so.

The 2nd laws of supply and of demand

Another way to discuss how time interacts with responsiveness of supply and demand are the second laws of supply and demand.

The Second Law of Supply states that supply is more responsive to price in the long run. The Second Law of Supply relates to how flexible producers are in terms of how much of a good they produce.

Supply is more elastic in the long run because given more time, producers can more easily adapt to the change in the price.

Within shorter periods of time, producers cannot as easily change the amount of a good they produce (since changes in production often require adjustments within factories, with workers etc.)

The Second Law of Demand states that demand is more responsive to price in the long run than in the short run. Initially, when the price of a good increases or decreases, consumption does not change drastically. However, when consumers are given more time to react to the change in price, consumption can either increase or decrease more dramatically. Demand is not only determined by price but also factors such as: income, tastes, and the price of related goods.

In the market period, any adjustment must be made through changes in price. This means that there could be initially a large price increase.

In the short run, there are some capability for more supply to come forward. This additional supply will temper the initial large price increase.

In the long run, producers are fully able to adapt their circumstances to the changing market conditions and higher prices. This will reduce prices as compared to the initial price spike when market conditions first changed.

In the long run, new firms can enter the industry and old firms can exit as required by the price change and their entrepreneurial expectations of the future of the industry.

Search and matching in a decentralised labour market

To cover off the bases, the simultaneous existence of vacancies and unemployed in a labour market is no evidence of either of surplus or shortage. It takes time for workers to locate vacancies and assess their competing job options. It takes time for employers to locate suitable workers to fill vacancies.

The simultaneous existence of vacancies and unemployed is the result of, as mentioned earlier, imperfect foresight, the fact that information is not free, nor freely available, and the costs of doing anything is not independent of the speed in which you wish to act. Searching for suitable vacancies, or suitable employees, is costly, and neither jobseeker nor employer knows whether any match will work out.

The one-price (one-wage) market that clears instantly will occur only where the cost of information about the prices (wages) offered by buyers and sellers is zero. As George Stigler observed in the opening paragraph of his famous 1961 paper The Economics of Information:

One should hardly have to tell academicians that information is a valuable resource: knowledge is power. And yet it occupies a slum dwelling in the town of economics.

Mostly it is ignored: the best technology is assumed to be known, the relationship of commodities to consumer preferences is a datum.

And one of the information producing industries, advertising, is treated with a hostility that economists normally reserve for tariffs or monopolists.

Job search cost are of two types: direct costs of gathering information about competing opportunities and the opportunity cost of being unemployed or staying in your current job at your current pay.

  • The benefit from job search is the expected gain in earnings that will result from waiting for a better wage offer.
  • The rational job searcher searches for better offers until the marginal benefit and cost of additional search are equal.
  • A significant cost of continued job search is the earnings foregone by not taking the previous best opportunity.

Unemployment can be a cost-effective method of searching for better employment opportunities and higher wage offers as David Andolfatto observed:

One frequently reads that “unemployment represents wasted resources.”

But if job search is an information-gathering activity, designed to locate a high quality job match, in what sense does such an activity necessarily constitute wasted resources? (Does the existence of single people in the marriage market also represent wasted resources?)

If the unemployment rate were to suddenly plummet because a large number of workers aborted their job search activity–accepting crappy jobs, or exiting the labour force–is this a reason to celebrate?

The behavioural responses of employers and workers to change are so pronounced because the cost of acquiring new information is profound (Alchian 1969). Many such costs impede wages from instantly fluctuating to rebalance labour supply with demand. Hicks (1932) explained this uncertainty and state of flux as follows:

For although the industry as a whole is stationary, some firms in it will be closing down or contracting their sphere of operations, others will be arising or expanding to take their place.

Some firms then will be dismissing, others taking on, labour; and when they are not situated close together, so that knowledge of opportunities is imperfect, and transference is attended by all the difficulties of finding housing accommodation, and the uprooting and transplanting of social ties, it is not surprising that an interval of time elapses between dismissal and re-engagement, during which the workman is unemployed.

A job seeker does not initially know the location of suitable vacancies, the wages for various skills, differences in job security and other factors. Job seekers must search for this information, keep this knowledge current and forecast whether better vacancies may open soon. Employers must search to learn the location, availability and asking wages of applicants. There is a tendency for unpredicted wage changes to induce costly additional job search. Long-term contracts arise to share risks and curb opportunism over sunken investments in relationship-specific human and organisation capital. These factors all lead to queues, unemployment, spare capacity, layoffs, shortages, inventories and non-price rationing in conjunction with wage stability (Alchian 1969; Alchian and Allen 1967, 1973; Klein 1984; Hashimoto and Yu 1980; Hall and Lazear 1979).

By acquiring more information, a job seeker learns more about their options and can improve their prospects of finding better-paid job matches. Job seekers and employers invest time and resources to find one another, size each other up and form a job match or try their luck elsewhere. A job match is a pairing of a worker with a particular employer.

Job seekers will apply for a portfolio of job vacancies that reflect their asking wage and their known alternatives. An asking wage is the minimum that a job seeker is willing to accept given their options.

  • The extent of job search depends on the costs of job-information production and acquisition, the income available to job seekers while searching, the frequency and the magnitude of shifts in the relative demand between different sectors, the costs of relocation and retraining, and the extent and frequency of declines in aggregate demand (Alchian and Allen 1967).
  • The more varied will be the potential job opportunities and the greater will be the gains to job seekers from continued job search, the greater are the rate of change in tastes and demand, the greater are the differences in the skills of job seekers and the requirements of job vacancies, and the greater are the costs of moving (Alchian and Allen 1967).

Employers face an information dilemma as well. If they wait a bit longer, hold a job vacancy open, a better job applicant may come a long and a more profitable and longer lasting job match may result.

Of course, the employer is taking a chance here on the job applicant pool improving with time. There are elements of luck involved for both employers and job seekers when filling vacancies and finding jobs.

The employer must balance the costs of holding the vacancy open with his estimation of the value and probability of a better applicant applying at a later date if he searches further the prospective recruits. But reducing your ignorance has costs as Stigler (1961) explained:

Ignorance is like sub-zero weather: by a significant expenditure its effects upon people can be kept within tolerable or even comfortable bounds, but it would be wholly uneconomical entirely to eliminate all its effects.

The rate at which job vacancies are filled and the rate at which people leave unemployment and change jobs is determined by the job search decisions of job seekers and the recruitment decisions of employers. The way in which the process works is well explained by Andolfatto’s analogy to the marriage market:

In many ways, the labour market resembles a matching market for couples.

That is, one is generally aware that the opposite side of the market consists of better and worse matches (we seldom take the view that there are no potential matches).

The exact location of the better matches is unknown, but may be discovered with some effort.

In the meantime, it may make sense to refrain from matching with ‘substandard’ opportunities that are currently available.

But since search is costly, it will generally not be optimal to wait for ones “soul mate” to come along. Furthermore, since relationships are not perfectly durable, there is no reason to expect the stock of singles to converge to zero over time

As in the labour market, there are marriages and divorces and young people come of age and look for the first time; people also link up for short-term relationships; and some relationships do better than others.

To say there is involuntary unemployment is to say there is also involuntarily unmarried people. But we can always marry the first person we meet in the street, if they’ll have us. Search and matching is a two sided affair. I doubt that our first encounter in the street would accept this offer of marriage from a stranger. I doubt that anyone would want to marry a stranger who would so willingly marry a stranger. I think both sides suspect that such a random pairing would not last long because the pairing occurred after so little mutual scrutiny and measured assessment of alternatives, current and prospective. The same principles apply to search and matching in the labour market.

Why are superstars paid so much more than in the past?

We all want the best. The best surgeon, the best TV shows, our favourite sports team, and the best lawyer. We will pay top dollar to get these stars.

In the last few decades, the top performers in many fields have earned extraordinarily large increases in wages, royalties and other forms of income. The top dogs in every field are paid many times more than the top dogs were paid a couple of decades ago.

Sport is an obvious example where cricketers in the early 1970s were paid $200 a test, with six tests per season, but are now paid $1 million a year.

In the past, a successful athlete might hope for an upper middle-class income and some savings for their retirement, which may come early due to injury.

Now, the top athletes in the sports that get on television are seriously rich and are among the richest in the world – athletes and celebrities are genuine members of the top 1%.

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This wage effect is called the superstar effect and is a major driver of income inequality in our time. Superstar wages and income arise in markets that have two characteristics:

1. Every customer wants to enjoy the good supplied by the best producer; and

2. The good or service is produced with a technology that makes it possible for the best producer to supply additional customer at a low cost.

If it becomes much easier for the best of the best in a field to supply their services to a much larger market, these superstars will be paid a lot more than before.

Two economists pioneered the analysis of the superstar wages. The first was Alfred Marshall in 1890; the second was Sherwin Rosen in 1981. Marshall used verbal reasoning; Rosen use sophisticated mathematics.

Marshall’s explanation is easier to understand. Rosen’s mathematics allowed him to be credited for discovering and making sure that the phenomena of superstar wages stayed discovered by economists.

Marshall, by the way, was a critic of mathematics. In 1906, he wrote about his skepticism regarding the use of mathematics in economics:

[I had] a growing feeling in the later years of my work at the subject that a good mathematical theorem dealing with economic hypotheses was very unlikely to be good economics: and I went more and more on the rules –

(1) Use mathematics as a shorthand language, rather than an engine of inquiry.

(2) Keep to them till you have done.

(3) Translate into English.

(4) Then illustrate by examples that are important in real life.

(5) Burn the mathematics.

(6) If you can’t succeed in (4), burn (3). This last I did often.”

Rosen was one of the greatest labour economists of this century. He examined the economics of superstars to determine why

"relatively small numbers of people earn enormous amounts of money and seem to dominate the fields in which they engage.

Rosen argued that in superstar markets:

small differences in talent at the top of the distribution will translate into large differences in revenue… sellers of higher talent charge only slightly higher prices than those of lower talent, but sell much larger quantities; their greater earnings come overwhelmingly from selling larger quantities than from charging higher prices

Those who have above-average talent should earn more because consumers prefer to do more business with them. Consumer preferences dictate that small differences in talent become magnified in large earnings differences. For example, if a surgeon were 10 percent more successful in saving lives, most would be willing to pay more than a 10 percent premium for his services.

Preferences for the best are incapable of explaining the other aspect of the superstar phenomenon: the marked concentration of output (and rewards) on those few sellers who have the most talent.

This something else is technology rather than by tastes. The key is in many instances, one consumer’s consumption of the service does not reduce its availability to other consumers.

A performer or an author must put out more or less the same effort whether 10 or 1,000 or 1 million people show up in the (TV) audience or buy their book. This scale economy allows a few sellers to service the entire market – and the fewer that are needed to serve it, the more they can earn.

This scale economy is limited without the technology to mass duplicate their performance. Films, radio, television, records and CDs and other changes in technology have increased the scope of each performer’s audience. The top performers can reach much larger markets at little additional cost in the digital age.

Marshall had a very simple explanation for the superstar effect on wages, which had already emerged in the 19th century. Marshall explained that technology has greatly extended the power and reach of the most gifted performers.

Marshall referred to the British opera singer Elizabeth Billington. She had a strong voice that did not have access to a microphone or amplifier in 1798, let alone to CDs and the Internet. Elizabeth Billington could only reach a small audience. This limited her ability to dominate the market in the way artists do today.

The microphone was the first manifestation of the superstar effect in the entertainment industry. The architecture of theatres throughout the ages has spent an immense amount of time working out ways to amplify the voices of performers so more people could watch at little extra cost.

Throughout the Industrial Revolution, technological changes would allow the best performers in a given field to serve bigger markets and reap a greater share of its revenue.

A range of technological developments has largely favoured the very top performers in recent years.

Each communications and information technology breakthrough allowed the very top entertainment acts to reach a larger fan base and a bigger share of concert revenue. The second-best are paid not much at all because everyone preferred to buy the best and can do so at a very low cost. The best of the best are, in consequence, handsomely rewarded.

Alfred Marshall as a pioneer of human capital theory

Marshall viewed education as an instrument capable of lifting up the poor and relocating them into the middle class. The direct benefits come from eliminating much of

that wasteful negligence which allows genius that happens to be born of lowly parentage to expend itself in lowly work

The indirect benefits of education came from character formation:

[Education] confers great indirect benefits even on the ordinary workman. It stimulates his mental activity, it fosters in him a habit of wise inquisitiveness: it makes him more intelligent, more ready, more trustworthy in his ordinary work; it raises the tone of his life in working hours and out of working hours; it is thus an important means toward the production of material wealth; at the same time that, regarded as an end in itself, it is inferior to none of those which the production of material wealth can be made to subserve.

Marshall’s primary solution to the problem of poverty is education, but he also exhorts individuals to behave responsibly, with thrift and self control.

Coase, Boulding and Marshall on mathematical economics

Can anyone think of a mathematical economics proposition that was accepted that was not consistent with what Kenneth Boulding called the literary vagueness of classical economics and economic sociology:

Conventions of generality and mathematical elegance may be just as much barriers to the attainment and diffusion of knowledge as may contentment with particularity and literary vagueness…

It may well be that the slovenly and literary borderland between economics and sociology will be the most fruitful building ground during the years to come and that mathematical economics will remain too flawless in its perfection to be very fruitful.

If mathematical economics came up with a result that was not reproducible through economic intuition, did the result become popular or were they ignored? Until this barrier is passed, mathematics will be a shorthand language rather than an engine of enquiry, as Alfred Marshall argued long ago:

[I had] a growing feeling in the later years of my work at the subject that a good mathematical theorem dealing with economic hypotheses was very unlikely to be good economics: and I went more and more on the rules –

(1) Use mathematics as a shorthand language, rather than an engine of inquiry.

(2) Keep to them till you have done.

(3) Translate into English.

(4) Then illustrate by examples that are important in real life.

(5) Burn the mathematics.

(6) If you can’t succeed in (4), burn (3). This last I did often.

Marshall also

saw that excessive reliance on this instrument [mathematics] might lead us astray in pursuit of intellectual toys, imaginary problems not conforming to the conditions of real life.

Adam Smith as a pioneering labour economist

Adam Smith anticipated much of labour economics by basing it on his principle that individuals invest resources to earn the highest possible return. All uses of a resource must yield an equal rate of return adjusted for relative riskiness for otherwise reallocation would result.

The whole of the advantages and disadvantages of the different employments of labour and stock must, in the same neighbourhood, be either perfectly equal or continually tending to equality.

If in the same neighbourhood, there was any employment evidently either more or less advantageous than the rest, so many people would crowd into it in the one case, and so many would desert it in the other, that its advantages would soon return to the level of other employments.

Smith used this insight on  be equality of returns to explain why wage rates differed. Workers care about the whole aspects of the job, not only the cash wage payment: it is the “whole advantages and disadvantages” of the job that is equated across jobs in a competitive market, not wage alone. Smith set out criteria that determined how wages compensated or were discounted for the different characteristics of specific jobs:

  1. the agreeableness or disagreeableness of the employments themselves: better for more enjoyable working conditions will lead an individual to accept lower wages for their labour. Likewise, unpleasant work will have a higher wage. Wages vary with the ease or hardship, the cleanliness or dirtiness, the honourableness or dishonourableness of a job.
  2. The easiness and cheapness, or the difficulty and expense of learning them: jobs that are difficult or time-intensive to learn will pay more. Those who invest the time are being compensated for their additional effort with higher wages. The opportunity cost of forgoing the time-spent in training will be compensated for through higher wages. The difference between the wages of skilled labour and common labour is founded upon this principle.
  3. The constancy or inconstancy of employment: workers who face only partial or inconsistent employment throughout the course of the year, such as seasonal workers of agriculture, must be paid more for their labour. Their wages carry them not only during times of employment, but also during times of unemployment.
  4. The small or great trust which must be reposed in those who exercise them: individuals who have high levels of responsibility  in their jobs will be compensated with higher wages.
  5. The probability or improbability of success: this is an entrepreneurial element in wages. Employment where the chance of success is high will be paid lower than those who take more risks. If individuals were not compensated for risk, there would lack an incentive to seek employment that may not be successful.

The supply and demand for labour in different industries  determines relative wages and the relative numbers of employees in different occupations. Individuals are willing to make a trade-off between less desirable occupations and increased income. Smith spoke of how these five circumstances  listed above  lead to considerable inequalities in the wages and profits.

George Stigler thought that the second greatest triumph of Adam Smith in his Wealth of Nations was his famous list of cost factors that generate apparent but not real differences in rates of wages and profits because of training, hardships, unemployment, risk and trust. This list was quoted almost verbatim by his successors  down to this day and is the direct ancestor of both Alfred Marshall’s famous chapters on wages and of the modern theory of human capital.