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Where do profits come from?

Lending Memo/Flickr

Readers of Paul Krugman's blog may have noticed on April 24th a post given the obscure title "On Gattopardo Economics" and discussing the issue of whether or not "labor and capital are paid their marginal product." On May 1, he referred to "a fairly desperate attempt to claim that the Great Recession and its aftermath somehow prove that Joan Robinson and Nicholas Kaldor were right in the Cambridge controversies of the 1960s."

The significance of this is likely to pass the casual reader by. But what Krugman is alluding to here is one of the most explosive issues inside the world of politically engaged left-of-center economists. It goes back to a dispute between mainstream liberal economists based in Cambridge, MA and the nascent school of "post-Keynesian" economists based in Cambridge, England. And it has to do with where profits come from.

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The simple view

To see the mainstream view, think about a place like Siem Reap in Cambodia near Angkor Wat and other famous temples. It starts out that labor is plentiful in Cambodia — lots of peasant farmers — but there are very few nice hotels for western tourists to stay in. Because labor is plentiful but hotels are scarce, adding one nice hotel will create a lot of extra economic output whereas adding additional workers will add almost no economic output. That is to say that the marginal product of a hotel is high. And in a situation where the marginal product of hotels is high, people who own hotels earn a high rate of return on their investment. As more and more hotels get built, the value of adding one more hotel falls. At the same time, more hotels mean that demand for workers is rising. The marginal product of hotel labor is on the rise, and so wages in the hotel sector will rise.

The mainstream (or "neoclassical") view of the economy simply extends this story about hotels and hotel workers across everything. When capital (hotels and factories and houses and patents and machines and everything else) have a high marginal product, then people who own capital earn a high return. When labor has a high marginal product, then wages rise and profits fall.

The big problem

Since the 1960s, a minority "heterodox" band of economists has complained that there is an enormous problem here. When considering the highly simplified model in which hotels are the only kind of capital goods and hotel stays are the only kind of output, it is simple enough to say that the quantity of capital is something like the number of hotels or the square footage of hotel space. But in a complicated modern economy where the stockof capital goods is extremely diverse, it makes no sense to talk about an "amount" of capital being employed. In practice, economists measure the capital stock by translating everything into monetary terms. All the buildings in America sum up to $X, all the patents to $Y, all the business equipment to $Z, and it all adds up to a total sum of capital.

The problem here is that the monetary value of capital goods is largely a function of how profitable it is to own them. If a city imposes a stiff new tax on hotels, it will become less profitable to own hotels in that city. Thus, the price (or value) of that city's hotels will decline. But it would be an egregious error to conflate a decline in the price of hotels with a decline in the quantity of hotels.

Heterodox economists argue that it is circular to say that the profits accruing to the owners of capital are determined by the marginal productivity of capital, and then to calculate the quantity of capital in part by asking how profitable it is to own the capital goods.

The mainstream reply

Mainstream economists went through a few iterations of attempting to refute this objection before essentially concluding that it was correct. This is, indeed, one of the reasons why people on the heterodox side often seem to be embittered. The mainstream concedes the point, but tends to deny its significance.

As libertarian economist Tyler Cowen put it in 2007, "The non-neoclassicals won virtually every point on the modeling, but it doesn't much matter when it comes to the substance." Krugman, who disagrees with Cowen about most partisan political issues, agrees on this: "nothing about marginal productivity theory depends on the exact truth of a simple aggregate production function with capital defined by a single number."

Thomas Piketty's new book Capital in the 21st Century has brought this issue to the fore by being both very pleasing to left-wing and to critics of mainstream economic thinking, and also entirely founded on the premise that adding up the market price of capital goods into an aggregate is a useful thing to do. When I asked him about it he, like Krugman and Cowen, essentially shrugged: "when I do sum all these assets and their market value, I do not mean to suggest that this is an adequate summary of everything."

To the mainstream, in other words, this is just one of many cases in economics where a stripped-down model is sometimes useful even if not literally true.

Is this right?

Almost by definition, the mainstream view among economists is that mainstream economists are right about this and it doesn't really matter. Certainly Krugman is correct that you don't need to appeal to any particularly unusual ideas to explain either the financial panic or the enduring recession.

But there are some things mainstream economics doesn't seem to explain very well.

For example, on the neoclassical theory poor countries that successfully get rich should do so by liberalizing their financial systems, running trade deficits, and importing foreign money until over time they build up enough capital for the marginal productivity of labor to increase. In practice, successful catchup stories (first in Japan, then in Singapore and Taiwan and Korea, now in China) work the other way around — countries use financial repression and run trade surpluses to develop increasingly sophisticated local businesses.