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Long Period Analysis

Long Period Analysis

ADAM SMITHS FOUNDATION

CLASSICAL ECONOMICS AND NEOCLASSICAL THEORY

BIBLIOGRAPHY

The forces that operate on economic processes are manifold and complex. In the eighteenth century philosophers of the Scottish and French Enlightenments, influenced in part by developments in the natural sciences (notably Newtonian mechanics) sought to identify the mechanisms that regulate social life. With the displacement of feudalism by a nascent market system as the dominant mode of material provisioning, an obvious question arose concerning whether the interactions of countless self-interested economic actors could generate benign social outcomes. Thomas Hobbes, in Leviathan (1651), had argued that a powerful state was necessary to contain the destructive potential of human nature. Mercantilist policies were partly grounded in the view that the market is an unreliable guarantor of the commonwealths prosperity. In The Fable of the Bees (1724) Bernard Mandeville suggested that sentiments and behaviors commonly regarded as vices envy, cupidity, gluttony, lust, prideunderpinned national economic well-being by stimulating demand for services and for the products of industry. Mandeville, who delighted in poking respectable opinion in the eye, had put his finger on a distinctive feature of capitalism: that markets to a significant degree generate order out of the self-interested behavior of atomistic agents. But he provided no scientific account of how markets coordinate the decisions of individual economic actors.

Market outcomes are not always benign. But capitalism is not chaotic. Somehow commodities get produced using sophisticated technologies that require the cooperation of many workers performing specialized tasks at different locations. The commodities are produced not in random quantities but in amounts that roughly match the demand for them. Resources get channeled from declining industries into expanding sectors. The process can be messy, and occasionally it falters. Yet the system manages to reproduce itself, to grow and to undergo structural and technological transformation. It is able to do all this without the intervention of a conscious coordinating hand.

ADAM SMITHS FOUNDATION

Adam Smith is credited with providing the first systematic account of how markets generate order. His argument owes a good deal to Richard Cantillons Essai sur la nature du commerce en général (1755) and to Anne Robert Jacques Turgots Réflexions sur la formation et la distribution des richesses (17691770). Smiths argument is set out in book 1, chap. 7 (Of the Natural and Market Price of Commodities) of the Wealth of Nations (1776). The chapter outlines a method of analysis that grounded theoretical economics until the middle of the twentieth century. That method, long period analysis, starts from the premise that in a market economy competition manifests itself as a tendency for profit rates to equalize across all lines of production. Smith drew a distinction between the natural price of a good and the market price. The natural price, which later generations of economists called the long period equilibrium price, is the price that would, if it obtained, be just sufficient to cover the commoditys cost of production, where cost is understood to include a normal rate of return for the owners of the capital invested in the enterprise. The market price of a good is the price that is actually observed. Smith argued that the natural price is a center of gravitation toward which market prices are pushed by the dominant and persistent forces operating in a market economy. Accidental and temporary circumstances may cause market prices to rise above or fall below the natural price, but they are constantly tending towards it (Smith 1776, book 1, chap. 7, p. 65).

The mechanism that pushes market prices toward their long period equilibrium levels is what coordinates the self-interested activity of the economys participants. We may reasonably suppose that the owners of capital will prefer to invest it in enterprises that earn high rates of return rather than in enterprises that earn low rates of return. That is why, from the economists point of view, a normal return on investment is an element of cost: The market prices of a good must, on average, be sufficient not only to cover labor costs, the costs of raw materials, and the cost of depreciation of physical equipment; if the price is not high enough to give the owners of capital the same rate of return they could obtain in other lines of production, the owners will eventually transfer their capital to those other sectors. As capital flows into the high return sectors, the output of those sectors increases, and as the supply of those commodities becomes more abundant, their market prices fall, lowering the rate of profit in those sectors. In the sectors that are experiencing an outflow of capital, outputs decline, causing market prices and hence rates of return to rise. The overall tendency is for rates of return to converge, provided there are no impediments to the movement of capital, and for prices to move toward their natural levels, which are consistent with equalization of profit rates. (If there are barriers to the movement of capital, such as patents or monopolistic control of particular necessary resources, the mechanism nevertheless operates, but the long period position will then be characterized by profit rate differentials.) The flow of capital in pursuit of its highest return brings the structural composition of production capacity into line with the composition of demand. It is also the principal mechanism by which economic systems absorb new technologies and adjust to major changes in the regulatory or institutional framework or in the availability of natural resources. It is what Smith meant by the invisible hand (1776, book 4, chap. 2, p. 477).

CLASSICAL ECONOMICS AND NEOCLASSICAL THEORY

The adjustments just described take place over long stretches of time, as capital goods wear out and are replaced by new and usually different ones; hence the label long period method. This method proved immensely useful for analyzing the determination of relative prices and the closely connected question of what determines the distribution of income among social classes. But the method makes no presumption about how the variables of the economy are determined. Historically two broad approaches to the explanation of prices and distribution may be identifiedthe surplus approach of Karl Marx and the classical political economists, in particular Smith and David Ricardo, and neoclassical supply and demand theory. The theories differ with respect to the data they treat as parametric in explaining prices. The classical economists and Marx took the social product, the real wage, and the technology of production as givens in their attempts to explain relative prices and the rate of profit. Perhaps the feature that distinguishes the approach most starkly from modern economics is its conception of the real wage as a socially and institutionally conditioned variable. (A later variation of the theory, associated with Piero Sraffa, treats the profit rate as the parametric distribution variable.) The marginalist or neoclassical theory that emerged in the last decades of the nineteenth century explains prices and incomes in terms of the interaction of price-elastic demand and supply functions derived from a somewhat different set of data: the preferences of economic agents, the economys endowment of productive resources and the distribution of that endowment among the members of society, and the technology of production. The two frameworks arrive at different explanations of prices and distribution, but until the middle of the twentieth century they utilized the same long period method, in which market forces are understood to move the economy toward a fully adjusted position characterized by a uniform rate or profit across sectors.

In the twentieth century, however, mainstream neoclassical economics underwent a shift in method, in which long period analysis gradually gave way to models of temporary or intertemporal general equilibrium. These models drop the requirement that equilibrium be characterized by a uniform profit rate and instead define equilibrium entirely in terms of market clearingthe absence of excess demand. (Intertemporal equilibrium models assume the existence of complete futures marketsmarkets existing in the present, which reflect agents beliefs about the probability distributions of all future contingent states of nature; in temporary equilibrium models, equilibrium occurs when agents short-term expectations about prices and quantities are fulfilled.) The emergence and then ascendance of these approaches appear to be related to two considerations. First, they may reflect an attempt to avoid capital theoretic problems that are evident in long period versions of the neoclassical theory (the same problems may well be present in intertemporal and temporary equilibrium models, but in such models they are less transparent). Second, these models were in part motivated by a desire to move beyond the static analysis of the long period approach and to depict the patterns of change that every actual economy undergoes over time. But the models are themselves limited in their ability to depict actual economic processes: Complete futures markets do not exist, and short-period equilibria can explain the temporal sequence of prices and outputs only if the equilibria are actually established by market forces. A distinct advantage of the long period method is that the equilibrium values established by the theory need not be achieved in reality: The explanatory value of long period models lies in the supposition that the equilibrium positions established by such models are centers of gravitation for the actually observed values of the variable, which may deviate from the values predicted by the theory for any number of accidental or random causes.

The long period method has been the target of criticism as well. Among institutionalist economists there is a long tradition of skepticism toward equilibrium analysis. More troublesome perhaps is the fact that the stability of long period positions is notoriously difficult to establish in both the surplus approach and neoclassical applications of the method. The stability of an equilibrium position refers to the positions status as a center of gravitation: Under what is it reasonable to suppose that an accidental disturbance of the system will set in motion a set of adjustments that move the economy back to toward the long period position? If the conditions necessary to ensure a return to the equilibrium are excessively strict, we cannot take it for granted that the long period position is a center of gravitation, and in that case the methods claims to capture real-world processes are weakened.

SEE ALSO Cantillon, Richard; Capitalism; Economics, Classical; Economics, Neo-Ricardian; Economics, Post Keynesian; Equilibrium in Economics; Keynes, John Maynard; Long Run; Markets; Marx, Karl; Prices; Ricardo, David; Smith, Adam; Surplus; Turgot, Jacques

BIBLIOGRAPHY

Eatwell, John. 1982. Competition. In Classical and Marxian Political Economy, ed. Ian Bradley and Michael Howard. London: Macmillan.

Garegnani, Pierangelo. 1976. On a Change in the Notion of Equilibrium in Recent Work on Value and Distribution. In Keynes Economics and the Theory of Value and Distribution, ed. John Eatwell and Murray Milgate. London: Duckworth, 1983.

Milgate, Murray. 1979. On the Origin of the Notion of Intertemporal Equilibrium. Economica 46: 110.

Smith, Adam. 1776. An Inquiry into the Nature and Causes of the Wealth of Nations, ed. E. Cannan. Chicago: University of Chicago Press, 1976.

Gary Mongiovi

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