Handbook of Public Sector Economics potx

PUBLIC ADMINISTRATION AND PUBLIC POLICYA Comprehensive Publication Program Executive Editor JACK RABIN Professor of Public Administration and Public Policy School of Public Affairs The C

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PUBLIC ADMINISTRATION AND PUBLIC POLICY

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Handbook of public sector economics / Donijo Robbins [editor].

To my parents Don and Marijo

Preface

The Handbook of Public Sector Economics is first and foremost atextbook for graduate students in public administration and publicpolicy Although most handbooks are used as reference texts, thisparticular handbook was proposed and written as a textbook to beused as the primary book in a graduate public economics course or

an important secondary or supplementary book in a public finance

or public policy course in a program where a course in public nomics is not offered The primary goal of this book is to contribute

eco-to the use and understanding of public economics and its role inpublic administration, public policy, and decision making The bookexposes students of public policy and administration to a wide array

of current issues surrounding the public provision and production

of goods and services

Three major reasons, I believe, explain the usefulness of such atext First, the book documents the history of economics and fiscaldoctrine and their place in public policy and administration Second,

it provides a comprehensive exploration of the theory of public goodsand the structures from which resources are collected and expended.Finally, it explores the emerging and heavily-debated issues ofeconomics that are important to students, faculty, and practitioners;

vi Robbins

for example, the effects of fiscal policies on saving and investment,consumer behavior, labor supply, wealth, property, and trade Theseimportant reasons guided the development and organization of thistext

Unlike textbooks, this handbook has no pictures, unless a supplyand demand figure is considered a picture Another constraint isthat not all issues of public economics are included; for example,specialization and the different market systems are not discussed

My rationale for leaving out such topics, albeit important, rests on

a belief that most graduate students in public administration andpublic policy have been exposed to these subjects in an undergrad-uate economics course If not, consulting an undergraduate intro-ductory text should clear up questions that this book does notaddress

Each chapter was written specifically for this book and in amanner that is simple and straightforward; as such the text is easy

to follow and understand Although each chapter could stand alone,the flow of the book was put together in such a way that the firsttwo parts establish the foundation of public economics In addition,each part substantiates the aforementioned reasons for this book.Part I introduces public economics, fiscal doctrine, and the role

of democracy and bureaucracy within the economic framework.Lynn C Burbridge begins, in Chapter 1, with the history of econom-ics and its doctrines from the Classical economists to the Marxists.Fiscal systems and functions are presented by William Voorhees inChapter 2 Together, the first two chapters summarize the theoryand practice of fiscal doctrine In Chapter 3, Jane Beckett-Camarataaddresses market efficiency and failure within the realm of demo-cratic decision-making Chapter 4 concludes Part I with PatriciaMoore outlining the role of bureaucracy and bureaucrats

Part II focuses on the theory of public goods Paul C Trogendefines public goods and Robert J Eger III provides a detailedanalysis of the provision and production of public goods in Chapters

5 and 6, respectively

Part III addresses the collection and distribution of governmentresources In Chapter 7, Carol Ebdon explains revenue sources, theequity and efficiency of collecting revenues, and current trends andimplications Building on fiscal federalism, Suzanne Leland pre-sents the fiscal characteristics of public expenditures in Chapter 8.Chapter 9, written by Shama Gamkhar, defines and analyzes inter-governmental grants The collection and distribution of resourcesare not always in balance Gary R Rassel discusses, in Chapter 10,

Preface vii

this imbalance by outlining its history and analyzes the impact ofpublic debt in the United States The section concludes with appli-cations of economic theory John R Bartle examines transportationinfrastructure and Donijo Robbins and Gerald J Miller evaluate e-government technology expenditures in Chapters 11 and 12, respec-tively

Part IV concludes the textbook and is composed of five chaptersfocusing on market reactions to fiscal policies In Chapter 13, Gerald

J Miller provides an overview of the size, scope, and role of government

in the market system, its policies, and their impact on saving, ment, and productivity Helisse Schayowitz, in Chapter 14, introducesthe household decision-making process and discusses consumer reac-tion to taxation John D Wong, in Chapter 15, offers a detailed over-view and analysis of the income, corporate, and social security taxes

invest-on the supply of labor In Chapter 16, Renée Irvin defines wealth andexamines the policies affecting wealth accumulation Chapter 17 con-cludes Part IV and the text with Rafael Reuveny presenting the scopeand the gains from international trade, as well as the impact of freetrade, restrictions, and international politics

Finally, many labored to complete this project I thank the tributors for their efforts and patience, Jack Rabin for his encourage-ment and support of the initial proposal, the production staff atMarcel Dekker, and my graduate assistant, Genevieve Verhoeven, forher help with this project We welcome comments and feedback toimprove future editions of this text

con-Donijo Robbins

Grand Rapids, Michigan

Contributors

John R Bartle is a professor in the School of Public Administration

at the University of Nebraska at Omaha He teaches and doesresearch in the areas of public finance policy and management,public budgeting, applied economics, and transportation He hasbeen published in a number of journals including Public Budgeting

& Finance, State and Local Government Review, and Journal of Public Administration Research and Theory, and he is the editor of the book

Evolving Theories of Public Budgeting (2001) His doctorate is fromthe School of Public Policy and Management at The Ohio StateUniversity

Jane Beckett-Camarata is an assistant professor of political ence at Kent State University She teaches in the doctoral program

sci-in public policy and the master’s program sci-in public admsci-inistration.Beckett-Camarata earned her Ph.D in public policy and adminis-tration from Virginia Commonwealth University in 1998 Herresearch interests include tax policy, comparative budgeting and taxsystems, economic development financing, and intergovernmentalfiscal relations Beckett-Camarata’s most recent article examinesthe effect of taxation as an incentive in revitalizing urban local

x Robbins

economic development in Elizabeth, New Jersey She has writtenabout financial emergencies and financial condition analysis and isextending that research into the relationship between revenue fore-casting accuracy and financial emergencies She has published arti-cles in Journal of Public Finance and Management, Journal of Public Budgeting, Accounting & Financial Management, Municipal Finance Journal, and Journal of Business Research She is a mem-ber of the Executive Council of the American Society for PublicAdministration (ASPA) and is an active member of Association ofBudgeting and Financial Management (ABFM) and other profes-sional organizations

Lynn Burbridge has a Ph.D in economics from Stanford sity She has worked at the Urban Institute and the Center forResearch on Women at Wellesley College She has also taught atWellesley College and Rutgers University, Newark Campus Herwork has focused on a number of public policy issues, the role ofthe nonprofit sector in the U.S economy, and the history of thought

Univer-in economics

Carol Ebdon is an associate professor in the School of PublicAdministration at the University of Nebraska at Omaha Shereceived a Ph.D in public administration from the University atAlbany, State University of New York Her primary research andteaching interests are in the areas of public budgeting and finance.Recent research includes work in local government revenue diver-sification, capital management, and citizen participation in the bud-get process

Robert J Eger III is an assistant professor of public tion and urban studies in the Andrew Young School of Policy Studies

administra-at Georgia Stadministra-ate University His pursuit of the development andapplication of budgeting, finance, economic, and accounting principles

to public entities has rewarded him with opportunities to work with

an assortment of state, local, and single-purpose government nizations Eger’s recent work has focused on price indexing for statecontracts in the volatile petroleum industry He has an extensivemanagement background in both the public and private sectors

orga-Shama Gamkhar is an Associate Professor at the Lyndon B.Johnson School of Public Affairs, University of Texas, Austin, TX.She teaches courses on public finance, financial management and

Contributors xi

environmental economic policy Her research interests include fiscalfederalism, intergovernmental grants, public school finance, andenvironmental policy She received a Ph.D in economics from theUniversity of Maryland at College Park She is the author of Federal Intergovernmental Grants and the States: Managing Devolution

published by Edward Elgar in its series Studies in Fiscal Federalismand State and Local Finance Her research papers have been pub-lished in the National Tax Journal, Public Finance Review, Public Budgeting and Finance, Journal of Health Politics, Policy and Law

and National Tax Association Papers and Proceedings Currently,she serves on a committee for the study of the long-term viability

of the fuel tax for transportation finance conducted by the portation Research Board of the National Academies

Trans-Renée A Irvin is an economist specializing in research on wealthand nonprofit enterprise Irvin joined the University of Oregon fac-ulty in Fall 2001, where she serves as assistant professor of plan-ning, public policy and management, as well as director of theGraduate Certificate in Not-for-Profit Management Her currentresearch includes regional wealth distribution and philanthropiccapacity mapping, the role of private philanthropy in regional gov-ernment finance, and economic modeling of community foundationformation and growth

Suzanne Leland is currently an assistant professor in the PoliticalScience Department at the University of North Carolina, Charlotte.She teaches in the areas of administrative behavior, urban politics,and state and local politics In addition she teaches intergovernmen-tal relations and public administration theory in the Master’s ofPublic Administration program Leland received her Ph.D in polit-ical science from the University of Kansas in August 1999

Helisse Levine-Schayowitz is presently a Ph.D candidate in theGraduate Department of Public Administration at Rutgers Univer-sity, Campus at Newark She has taught for the Department ofEconomics at Rutgers University, Campus at Newark for severalyears as a part-time lecturer and for the Department of Economicsand Finance at Fairleigh Dickinson University, College at Florham

In addition, she has taken every opportunity to teach while pursuingher degree and has most recently taught for the Masters of PublicAdministration at Rutgers University, Campus at Newark whilecompleting her dissertation Her teaching experience includes sta-

xii Robbins

tistics, research methods, principles of economics, political economyand public administration, and capital budgeting Levine-Schayowitzreceived her undergraduate degree in economics and a master’sdegree in financial economics Her thesis work is in the area ofpublic management and finance, with emphasis on statewide debtmanagement policy and the municipal securities market

Gerald J Miller is professor of public administration at Rutgers,the State University of New Jersey in Newark There he teachesgovernment and nonprofit financial management Miller has pub-lished 70 research articles, chapters, and monographs; they haveappeared in the Arbitration Journal (now Dispute Resolution Jour- nal of the American Arbitration Association), International Journal

of Public Administration, Journal of Public Budgeting, Accounting and Financial Management, Policy Studies Journal, Public Admin- istration Quarterly, Public Administration Review, Public Budgeting and Finance, Public Performance and Management Review, Public Personnel Management, and Review of Public Personnel Adminis- tration He has published 19 books He authored Government Finan- cial Management Theory and edited the Handbook of Debt Manage- ment His coauthored and co-edited books include Performance- Based Budgeting, Public Budgeting Laboratory (through two and

an upcoming third edition), Budgeting, Handbook of Public istration (through two and an upcoming third edition), and Hand- book of Strategic Management (now in a second edition) He is alsowriting a research methods text (with Dr Donijo Robbins) and hasco-edited a research methods handbook (with Dr Marcia Whicker)

Admin-He earned his Ph.D in political science from the University ofGeorgia He received a B.S in economics from Auburn Universityand an M.P.A degree from Auburn University (Montgomery)

Patricia Moore is assistant professor of public administration atKean University in Union, New Jersey She has a Ph.D from Rut-gers University, specializing in public budgeting and financial man-agement Her research interests are budget and organization theory.Moore has published articles on the following topics: governmentreorganization, budget allocation formula, and resource allocation

in school districts She has 11 years of diversified administrativeand technical experience working with school districts, municipali-ties, counties, and private nonprofit organizations in New Jersey.She is a member of the American Society for Public Administrationand is active in civic and political affairs Dr Moore is a member of

Research Methods for Public Administrators Rassel has M.A.degrees from the University of South Dakota and Michigan StateUniversity His Ph.D degree is from Michigan State University.

Rafael Reuveny is associate professor of political economy in theschool of public and environmental affairs at Indiana University,Bloomington His research focuses on causes and effects of economicglobalization, causes and effects of political conflict, and sustainabledevelopment His recent book, entitled Growth, Trade and Systemic Leadership, coauthored with William R Thompson, waspublished in 2004 by Michigan University Press His papersappeared or are forthcoming in various academic journals, including

International Studies Quarterly, Journal of Politics, Review of national Political Economy, Journal of Peace Research, Journal of Conflict Resolution, Policy Studies Journal, Policy Sciences, Ecolog- ical Economics, International Organization, Review of International Economics, and American Journal of Political Science.

Inter-Donijo Robbins is associate professor for the School of Public andNonprofit Administration at Grand Valley State University in GrandRapids, Michigan, where she teaches graduate and undergraduatecourses in public budgeting, financial management, and researchmethods Robbins received a B.S degree (1994) in economics andpolitical science from Central Michigan University and a M.A degree(1995) in economics and a Ph.D degree (1998) in public administra-tion from Rutgers, The State University of New Jersey in Newark

Paul C Trogen is assistant professor of public finance at EastTennessee State University in Johnson City, Tennessee His teachinginterests include public finance, budgeting, public organizations, andeconomics He enjoys researching determinants of economic devel-opment, interactions between public policies and markets, economic

xiv Robbins

reforms, and public budgeting He has published articles in Journal

of Financial and Economic Practice (JFEP), International Journal

of Economic Development (IJED), Journal of Public Budgeting, Accounting, and Financial Management (JPBAFM), and Southeast- ern Political Review (SPR) He has also written chapters in the

Handbook of Comparative and Development Administration (2nd tion) and the Handbook of Bureaucracy, both published by MarcelDekker Trogen has a Ph.D in public administration from FloridaState University (1995), with a concentration in public financialmanagement

edi-William Voorhees is an assistant professor of public finance in theSchool of Public Affairs at Arizona State University His researchand publications have investigated topics such as revenue forecast-ing, governmental accounting, and tax-exempt bonds Voorhees is amember of the Governmental Accounting Standards Advisory Coun-cil and is on the Executive Board of the Association of Budgetingand Financial Management Prior to his teaching career, Dr.Voorhees was employed for over 20 years in the health care financialmanagement systems industry He holds a Ph.D from the School ofPublic and Environmental Affairs, Indiana University at Blooming-ton, and an M.P.A degree from the Andrew Young School of PolicyStudies at Georgia State University in Atlanta

John D Wong is associate professor in the Hugo Wall School ofUrban and Public Affairs at Wichita State University (WSU) Hereceived his Bachelor of Business Administration and Master of Arts

in Economics degrees from WSU, a Juris Doctorate from WashburnUniversity, and a Doctor of Philosophy degree from NortheasternUniversity In 1995, Wong served the Kansas Governor’s Tax EquityTask Force as a consultant on the distributional impact of tax reformand the effect of taxation on economic development He is presentlythe principal author of the annual Governor’s Economic and Demo-graphic Report, senior consulting economist for the official KansasConsensus Revenue Estimating Group, a consulting economist forthe Kansas Department of Revenue, and a consulting economist forthe Kansas Department of Human Resources He has also previ-ously served as a consultant for several cities and counties Wongcoauthored State and Local Government Capital Improvement Plan-ning and Budgeting and Public/Private Partnerships and has writ-ten extensively on public finance and policy issues including severalarticles on revenue forecasting, taxation, electric utility deregula-

Contributors xv

tion, and health care finance, as well as contributions to the book on Taxation and the State and Local Government Debt Issu-ance and Management Service Wong’s primary teachingresponsibility is in the areas of public finance and public policy, and

Hand-he has taught graduate level courses in public sector economics,public finance, local government finance, state and local financialsystems, urban and regional economic development, policy analysisand program evaluation, and public works He has also taughtseveral classes in the areas of criminal justice and law and geron-tology and has made numerous professional development and train-ing presentations on fiscal management issues to finance officersand other state and local government officials Wong is also licensed

to practice law in Kansas state and federal courts as well as theU.S Supreme Court

Table of Contents

PART I Introduction to Public Economics

and Fiscal Doctrine

1 The Evolution of Economics: The Search for a Theory

xviii Robbins

PART II Theory of Public Goods

Paul C Trogen

6 Provision and Production of Public Goods 209

Robert J Eger III

PART III Collection, Allocation, and Distribution

Donijo Robbins and Gerald J Miller

PART IV Market Reactions Collection, Allocation,

and Distribution

Gerald J Miller

Table of Contents xix

Helisse Levine-Schayowitz

15 Federal Taxes and Decision Making: Individual Income,

Corporate Income, and Social Security Taxes 561

Part I

Introduction to Public

Economics and Fiscal Doctrine

of known facts.

The Economist as Savior, p 119.

4 Burbridge

1.1 INTRODUCTION

The above story about John Maynard Keynes’ encounter withMax Planck has been told so often one wonders whether it isapocryphal Keynes’ biographer, however, confirms that Keynesdid in fact tell this story in his obituary of another greateconomist, his mentor, Alfred Marshall It is interesting tobegin with this tale because many economists have, in fact,tried to steer economics to emulate the natural sciences, par-ticularly physics Planck’s statement, while a compliment inemphasizing the difficulties in analyzing and understandingthe complexities of economic systems, would be discouragingfor those who have sought throughout the history of the field

to give it the same precision as is found in physics (Mirowski,1989) The subtitle of this chapter, “The Search for a Theory

of Value,” underlines the efforts spent by economists to finduniversal laws underlying the working of the economy thatwould have the same power as a theory of gravity or thesecond law of thermodynamics, or the conservation principle,ideas that have been important in the history of physics.The search for a theory of value, therefore, becomes auseful organizing tool to discuss the evolution of economics(see Figure 1.1) While not all economists spend as much timethinking about whether economics has a good theory of value,some of the important turning points in the history of thefield have centered on finding or improving on one And somefeel that the field is ultimately about value (e.g., Schumpeter,1966; Stigler, 1965): what people value, the valuation process,impediments to the valuation process, and what value actu-ally means It is a concern that begins with the earliest phi-losophers to discover the intrinsic source of value, over andabove the price something may fetch in the marketplace, butreceived its first truly thorough treatment with the classicaleconomists, starting in the eighteenth century

Before beginning, an apology is in order, however Thischapter is a layperson’s guide to the history of thought Adetailed critique of various doctrines is beyond the scope ofthis already long piece The focus is on the evolution of eco-nomic thought and critical turning points in the history of

Popper Ancient Philosophers

6 Burbridge

that thought Much is left out For a detailed critique, thereader is referred to Schumpeter (1966), with 1100 pages ofanalysis, and Blaug (2002), with 700 pages

1.2 THE CLASSICAL ECONOMISTS

Before getting to the eighteenth century, many historians ofeconomic thought begin with the earliest discussions of eco-nomics, usually going back to the fourth century B.C to thetime of Aristotle One should note, however, that Huag-Chang(1974) traces economic thought even further back to the writ-ings of Confucius in the sixth century B.C in China, and Sen(2002) notes an Indian philosopher, Kautilya, who was pri-marily responsible for writing Arthasastra, a book devoted toeconomics and politics, around the same time that Aristotlewas speculating about economic topics interspersed with hiswritings on politics and ethic So the current discussionfocuses on the Western tradition in economic thought as ithas evolved over time; which, after all, is the tradition thatinfluenced the classical scholars of the eighteenth century.The word economics comes from the Greek word, oikono- mia, which was a discipline that focused on estate manage-ment and public administration (Lowry, 1979) And generallywhen Aristotle (384–322 B.C.) used this term, he was referring

to household management.* Nevertheless, he discussed anumber of topics relevant to current economic thought (Spie-gel, 1991) He was the first to discuss the difference betweenvalue in use and value in exchange, which has been an impor-tant consideration in the development of theories of value inmodern economics He was one of the first to give a defense

of private property, using an argument familiar to many omists, that private property provides an incentive for owners

econ-* It is important to remember that in ancient Greece most people lived on self-sufficient farms A separate economic sphere was unheard of for most people So since most economic decisions involved household management, this was not a trivial topic.

The Evolution of Economics: The Search for a Theory of Value 7

to use their land more productively This was also an ment adopted by the Greek Stoics, a philosophical school ofthought that emerged towards the end of Aristotle’s life TheStoics made contributions to the field of logic, and theyembraced reason and the concept of natural law Stoicism wasintroduced to the Romans around 200 B.C and had a profoundinfluence on Roman jurisprudence

argu-Nevertheless, like many of that time, Aristotle wasopposed to interest, which he felt led to unnatural accumula-tion (Ekelund and Herbert, 1975) And while he felt commercewas necessary, he was suspicious of it; as the Greeks — plac-ing social cohesion above the benefits that might come fromtrade — felt that the specialization that would result couldundermine the common purpose (Polanyi, 2001; Muller, 2002).Schumpeter (1966) was dismissive of Aristotle’s contri-bution to economics, for while he condemned interest (because

of his social concerns), he never tried to analyze why peopleare willing to charge and pay for interest — the “why” questionsthat are of importance to economists Lowry (1979) disagrees,noting the G.L.S Shackle (1972) definition of economics as afield that reduces incommensurables to common terms, which

is something Aristotle did, in fact, do

Spiegel (1991) notes that the less philosophical Romanscontributed significantly less to economic thought, unless onetakes into account the importance of Roman law — especiallythat dealing with contracts and property — that served as aframework for British common law, which supported the emer-gence of capitalism Roman jurists adopted from the Stoicsthe concept of natural law — of great importance to classicalpolitical economists — which was “interpreted to embody theall-pervasive reason that governs the world and to reflect thenature of things” (Spiegel, 1991, p 36) Schumpeter (1966)also gives credit to Roman jurists in contributing to economicthought, albeit in regards to practical purposes, because theyoften did ask the right kinds of questions — the “why” questions.Schumpeter (1966) also credited many of the Scholasticsfor asking the right questions Following the fall of the RomanEmpire, discussions of economic issues fell into the hands of

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priest-scholars, who attempted to carry on the legacy of totle Saint Thomas Aquinas (1225–1274) is particularly givencredit for trying to reconcile Catholic philosophy with Aristote-lian thought He was a defender of private property, defendedthe businessman, and held profit as morally neutral Hedefined the concept of a “just price” in terms of the prevailingmarket price, and opened the door to reconsidering prohibi-tions against usury (Muller, 2002; Schumpeter, 1950; Screp-anti and Zamagni, 2001; Spiegel, 1991) Although he defendedcommerce, Aquinas expressed concerns about people makingmoney for its own sake or to improve their places in the socialorder (Muller, 2002) Aquinas and the other scholastics werealso concerned with the concept of natural law and providedsome inklings of a subjective (utility) theory of value (Schum-peter, 1966; Robbins, 1948)

Aris-With the demise of feudalism and the emergence of cantilism in the sixteenth century, one sees an explosion ofwriting on economic issues, which can be found in hundreds

mer-of pamphlets that were written and distributed, thanks toadvances in the printing press.* This was a time when thefocus was on the consolidation of the nation state; with amercantilist philosophy that advocated active governmentintervention to promote the trading dominance of the nationand the accumulation of gold and other forms of wealth inthe interest of the state Intellectuals were more willing toadvocate the pursuit of wealth for its own sake and the ideathat only through love of one’s self could one benefit others —i.e., that self-interest leads to trade that benefits all of society(Muller, 2002) Because these were radical ideas for the time,many of the pamphlets written on these topics were anony-mous (Letwin, 1964) Although most of these pamphlets werefocused on practical matters — such as the money supply andusury laws — some of the discussions opened by the mercan-tilists are with us today, especially in terms of the role andimportance of money (gold) in stimulating the economy

* Schumpeter notes that most of this writing was not in English tators from Italy, Spain, France and England contributed to this literature.

Commen-The Evolution of Economics: Commen-The Search for a Commen-Theory of Value 9

Eklund and Hebert (1975) note that the mercantilist ers were very concerned that their writings sound “scientific,”rather than merely self-serving The most successful, accord-ing to Letwin (1964), was Dudley North (1641–1691), whoproduced the first equilibrium model (although rudimentary)with respect to the money supply and was one of the first tosuggest that the interest rate is a price for the use of money,

writ-an idea later used by Keynes

By the seventeenth century, philosophers such as Voltaire(1694–1778), who came to be a wealthy man in his own right,were openly advocating the pursuit of the wealth through themarket (Muller, 2002) The early seventeenth century wasalso the time when the term political economy was used in abook title for the first time: Traité de l’économie politique by

a French manufacturer named Montchrétien While the book

is not highly regarded, it is important to note that the authorused the term political economy to distinguish it from thehousehold economics that was of concern to the ancient phi-losophers (Screpanti and Zamagni, 2001) Most importantly,the seventeenth century was a time of the emergence of ratio-nalist philosophers such as Descartes and John Locke, whowere optimistic in their belief in the power of reason Thisoptimism was enhanced by discoveries in science, particularlythose of Newton, whose work presented the possibility of aknowable universe

Locke (1632–1704) is particularly important to the tory of economic thought He developed the idea of privateproperty as a natural right and gave a reasonable description

his-of what economists call the quantity theory his-of money, whichsuggests that large injections of money into the economy willgenerally result in higher prices rather than greater outputand wealth This was an idea that ran counter to that of manymercantilists, who often felt that the state could not accumu-late too much gold It remains one of the first modern eco-nomic arguments made about the causes of inflation andincludes a clear understanding of the velocity of money(Schumpeter, 1966) Locke also discussed the “natural” rate

of interest, thus incorporating a natural law concept into thediscussion of economics Further, his deductive method was

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adopted by the classical economists and remains a cornerstone

of modern economics (Letwin, 1964) Locke also suggested thepossibility of a labor theory of value but did not really use it.Locke was not the only philosopher to make a contribu-tion Letwin (1964) points out that most British philosopherswriting between 1660 and 1850 focused on economic issues —Locke, Berkeley, Hume, Bentham, and John Stuart Mill — anindication of the extreme importance of economic theory tothe times Some were skeptics, however One was EdmundBurke (1729–1797), who is famous for saying, in response tothe French Revolution, that the “age of chivalry is gone That

of sophisters, economists, and calculators has succeeded, andthe glory of Europe is extinguished for ever” (Muller, 2002,

p 132) Burke was concerned that rationalism was ing those social institutions that were necessary for the pres-ervation of social order, a concern that is also expressed byHegel some years later

William Petty (1623–1687) was a physician and a rary of John Locke He is often cited as the first of the classicaleconomists for two reasons Letwin (1964) described his eco-nomic treatises — Treatise on Taxes and Political Arithmetik —

contempo-as the first truly scientific works in economic theory, citingthe internal unity and economy of his analyses, the absence

of ad hoc explanations, and his use of basic data to highlighthis key points For Marx in A Contribution to the Critique of

“natural value,” recognizing labor as the key source of value,with land playing a smaller role in contributing to value Heacknowledged the importance of the division of labor (antici-pating Smith) and had at least some sense of economic surplus(Niehans, 1990; Screpanti and Zamagni, 2001) In the course

of his work, Petty derived the concept of National Income,which would become of great importance to modern macro-economics, and demonstrated an understanding of the possi-ble impact of population growth, long before Malthus He alsointroduced many terms to the lexicon of economics; for example,

The Evolution of Economics: The Search for a Theory of Value 11

as far is known, he was the first to adopt the term ceteris

sprinkled throughout economic writing up to the present(Spiegel, 1991) Use of the term suggests scientific inquiry,where one is trying to understand the impact of one variablewhile holding constant the impact of other possible variables.Richard Cantillon (1680–1734), a French businessman,

is also of interest in having a value theory based on land andlabor — but giving more weight to land than Petty — and inthe scientific nature of his conceptualizations, most impor-tantly a circular-flow model of the economy In his Essay on

emulate Petty in attaching a statistical appendix to his work,but it was lost and remains unavailable to this day Cantillon

is also known for a rudimentary theory of population thatanticipates Malthus, with a tendency of the wage to converge

to subsistence as a result of population growth (Letwin, 1964;Niehans, 1990; Screpanti and Zamagni, 2001) In his mone-tary theory, Cantillon was the first to recognize that the effect

of an injection of money into the economy depends on whoare the initial recipients of the cash injection, in what Blaug(2002) refers to as the “Cantillon effect.”

Cantillon had a big influence on the Physiocrats, whichSpiegel (1991) describes as the first school of economics with

a recognized leader, Francois Quesnay (1694–1774) — a courtphysician to Louis XV — and a dedicated group of well-con-nected followers From Cantillon, Quesnay inherited the cir-cular flow model, which he used to produce his Tableau

going through different sectors of the economy, showing theinterdependence between various productive processes.According to Niehans (1990), the Tableau is a precursor ofmacroeconomic and general equilibrium models that were to

be developed 200 years later, but it was not well appreciated

in its time

The Physiocrats also inherited from Cantillon a bias infavor of the landowning class They completely rejected a labortheory of value for a theory that makes land the source of all

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value Their point of view reflected an antipathy to tilism, an antipathy that was shared by most classical econo-mists, but they failed to see the great potential of industryand the ability of labor to be productive both on land and withmachines (Heilbroner, 1999; Canterbery, 1976) They saw landand rural life as superior to industry and wanted to reformthe French economy and promote large-scale farming (Spiegel,1991) This focus ultimately diminished their historical impor-tance, but they did make important contributions to politicaleconomy

mercan-First, their Tableau and their theorizing suggested aneconomy that can reproduce itself “naturally.” They are theinventors of the term “laissez-faire,” leave it alone, let theeconomy operate by its own laws, with a minimum of govern-ment interference According to Screpanti and Zamagni(2001), the Physiocrats studied the economy as if it were anatural organism; the influence of science, Quesnay’s medicaltraining, and natural law philosophy is quite apparent Sec-ond, they introduced concepts that would flow through theclassical literature, such as laissez-faire, the designation ofproductive and unproductive labor, and the concept of dimin-ishing returns The latter is attributed to another Physiocrat,Anne Robert Jacques Turgot (1727–1781), who is the onlyother Physiocrat who is remembered in our time

In spite of Adam Smith’s disagreements with this ophy, Quesnay — whom he met on a visit to France — was

philos-an importphilos-ant influence The other key influence was Smith’sgood friend David Hume Hume (1711–1776) was a politicalphilosopher who wrote on a number of topics, including eco-nomics Like Locke he criticized mercantilist arguments, butHume attacked their preference for large trade surpluses, asthey would — he argued — lead to increased prices, a loss ofcompetitiveness, and flows of cheaper imports that would justrebalance the trade accounts — a very modern macroeconomicargument, demonstrating a tendency to equilibrium Humealso made a very modern argument extending the quantitytheory of money: while an influx of gold will increase prices

in the long run, an increase in the money supply can have animpact on output in the short run (Niehans, 1990) Hume

The Evolution of Economics: The Search for a Theory of Value 13

offered a commitment to natural law, which translated intoarguments suggesting a system that moves to equilibriumwhen unimpeded, in combination with acute observations onhow the money supply may affect output

Adam Smith (1723–1790) was the first of the classical omists to be a professor He was a professor not of economics,however, but of moral philosophy

econ-Schumpeter (1966) pointed out, however, that moral losophy was a precursor to the social sciences It was thebranch of philosophy that dealt with the science of the mindand society, as distinguished from natural philosophy, whichgave birth to the physical sciences and mathematics Smith’searly work focused on moral and ethical issues, and he took

phi-up the subject of political economy relatively late in his career.That he did so should come as no surprise; as noted earlier,economic theory was an important issue for British philoso-phers of that time (Smith was Scottish.) Smith was also afriend of Hume, Quesnay, and Voltaire, all of whom wereengaged with the topic.*

Many people view Adam Smith as an apologist for talism, but most economic historians view him as a truescholar concerned about analyzing the prospects for the newlyemerging system He did not believe in accumulation for thesake of accumulation, but as a benefit to society as a whole;

capi-as a moral philosopher he wcapi-as not a crude advocate for interest, although his work has been used by others for thispurpose (Heilbroner, 1999; Niehans, 1990) Blaug (2002) notes

self-* Classical political economy involved a relatively small group of scholars who knew each other well In addition to these relationships of Smith’s, John Malthus, James Mill, and David Ricardo, whom we shall discuss shortly, were good friends Hume and Rousseau were friends of Thomas Malthus’ father Ricardo gave John Stuart Mill (James Mill’s son) his first lessons in political economy while he was still a teenager In later periods, other economists would have economist fathers, including two responsible for important and pathbreaking work in the field: Léon Walras and John Maynard Keynes