Notes from General Theory - Chapter 3

The Principle of Effective Demand:
In a given state of technique, resources and costs, employment of labor by an entrepreneur involves two kind of expense:
a) Factor cost: Amount paid out to the factors of production, ex other entrepreneurs.
b) User cost: Amount paid out to other entrepreneurs for what he has to purchase from them + the depreciation of capital equipment in excess of normal wear and tear if the equipment were left idle.

• Income or Profit = Value of output - factor cost - user cost. Factor cost is regarded as income by the factors of production.
• So total income generated by employment given by entrepreneur = profit + factor cost (but what about amount paid to other entrepreneurs, who have made profits and in turn generated employment?) 
• Entrepreneurs try to fix employment at a level which will maximize their profits.
• Let Z be the aggregate supply price of output from employing N men, i.e. Z = s(N). This is the Aggregate Supply Function. Let D be the proceeds which entrepreneurs expect to receive from the employment of N men, i.e. D = f(N). This is the Aggregate Demand Function. (Is there any difference between the two functions?)
• Volume of employment is given by the point of intersection between the aggregate demand function and the aggregate supply function, for it is at this point that the entrepreneurs expectation of profit is maximized. This point of intersection - the point D - is called the Effective demand. (But aren't both the curves upward sloping? Demand goes up when employment is higher, so does supply). 
• The classical theory assumes that the two functions s(N) and f(N) superimpose each other, so that whatever the value of employment N may be, the proceeds D are equal to Z. Implying that effective demand, instead of having a unique equilibrium value is an infinite range of values all admissible, and the amount of employment if indeterminate except in so far that the marginal disutility of labor sets an upper limit. (So is what Keynes saying that these two curves are not parallel, which is what Classical theory has always implicitly assumed. And it is easy to fall into this trap because both the curves are upward sloping.)
• If this were true, employment will expand up to the point at which supply of output as a whole ceases to be elastic. This is same as full employment. Thus Say's law, that aggregate demand price of output is equal to its supply price for all volumes of output, is equivalent to the proposal that there is no obstacle to full employment.

II: Brief Summary of Theory of Employment:

• When employment increases, real income increases. Consumption goes up, but lesser than income. So employers will make a loss if the whole of increased employment was for satisfying the demand for immediate consumption. So, to justify and amount of employment, there must be an amount of current investment sufficient to absorb the excess of total output over consumption. So, given the community's propensity of consume, the equilibrium level of employment will depend on amount of current investment. The amount of current investment will depend on the inducement to invest, which is a function of marginal efficiency of capital and interest rates.
• Given the propensity to consume and rate of new investment, there will be only one level of employment consistent with equilibrium, otherwise there will be inequality between the aggregate supply price of output and its demand price. The level of employment cannot be greater than full employment. But it is not necessary that it is always equal to full employment.

Notes from General Theory - Chapter 1 and 2

There is nothing in Chapter 1.

Chapter 2: Classical theory depends on three crucial assumptions:

a) Real wage is equal to the marginal disutility of existing employment,
b) There is no such thing as involuntary unemployment in the strict sense
c) Supply creates its own demand in that aggregate demand price is equal to aggregate supply price for all levels of output and employment.

Classical theory of employment depends on two fundamental postulates:
a) Wage is equal to the marginal product of labor, i.e. wage of an employed person is equal to the value which would be lost if employment were to be reduced by one unit. This gives us the demand schedule for employment.

b) The utility of wage when a given volume of labor is employed is equal to the marginal disutility of that volume of employment, i.e real wage of an employed person is that which is just sufficient to induce the volume of labor actually employed to be forthcoming. Disutility covers every reason why men would withhold their labor rather than accept a wage. This gives us the supply schedule for employment.

Equilibrium happens where the utility of the marginal product balances the disutility of the marginal employment.


There can be only two forms of unemployment in the classical theory:
a) Frictional unemployment: due to various factors like time lags between job findings etc
b) Voluntary unemployment: refusal of work due to legislation or social practices.

Keynes postulated there can be a third form of unemployment, viz involuntary unemployment.

So, there can be only four means of increasing employment, which Professor Pigou described in his Theory of Unemployment:
a) Decreasing frictional unemployment, through improvement in organization or foresight.
b) Decrease in marginal disutility of labor
c) Increase in marginal physical productivity of labor in the wage-goods industries
d) An increase in the prices of non-wage goods compared with the prices of wage goods, associated with a shift in the expenditure of non-wage earners from wage-goods to non-wage goods. Didn't get this.


Why does unemployment exist? Classical theory argues that full employment could always be reached by making real wages sufficiently low. Keynes disputes that, for two reasons.

a)  Labor focuses on money wages, not real wages. If inflation were to increase prices, that is equivalent to a reduction in real wages. But labor does not strike because of this, unless the inflation is gargantuan. So supply of labor is not a function only of real wages, which is what classical theory assumes.

b) Look around during Depression years in 1932. Can it really be argued that unemployment exists because labor is unwilling to work at a low wage?  


Also, classical theory assumes that a fall in money wages is accompanies by a fall in real wages. In a short period of time, that is not true. A fall in money wages might very well be accompanies by a rise in real wages, and vice versa. One can argue that nominal wages will fall only during a pronounced deflation, during which real wages might actually rise. And conversely, nominal wages track inflation with a lag, so real wages might actually fall during a boom.


Classical theory assumes that there is a collective bargaining that labor does to bring its real wages in line with the marginal disutility of employment. Keynes argues that something like this doesn't exist at all. Employment and real wages are determined in ways other than the demand-supply curve of labor.  


The struggle on nominal wages primarily affects the distribution of aggregate real wage between different labor groups, and not its average amount per unit of employment, which depends on different set of forces. The effect of combination on the part of a group of workers is to protect their real relative wage. The general level of real wages depends on other forces of the economic system. Didn't get this.


Involuntary employment: Men are involuntary unemployed if in the event of a small rise in the price of wage-goods relative to the money wage, both the aggregate supply of labor willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of employment. i.e. if marginal profitability were to increase and entrepreneurs were to hire labor, there is labor available. 


So the second postulate - that real wage is equal to marginal disutility of employment - corresponds to absence of involuntary unemployment.  Classical theory is the theory of distribution under conditions of full employment.

Axiom of parallels: Demand price of output as a whole is equal to its supply price. Didn't get this. 

Notes from General Theory: Preface

I am attempting to read Keynes signature book - General Theory of Employment, Interest and Money - for the first time. It is a very complicated book, so I am planning to take lots of notes.

My biggest challenge while learning Economics has been a lack of understanding of the chronological order in when different theories emerged. Economics textbooks present theories in a logically cohesive way, rather than in a chronological order. So, I have only a vague understanding of what the prevailing theory of the day was in the 1930's, when Keynes wrote his book. Several elements of the "Classical theory" as we now understand were certainly developed after the 1950's. So what exactly was it that Keynes disproved?

The book is so complicated that I can make notes starting right from Preface. There are actually four prefaces - one each for the British, German, Japanese and French reader.

• "Classical theory": I guess Keynes himself labelled the pre-Keynesian theory as Classical theory.
• "A monetary economy is essentially one in which changing views about the future are capable of influencing the quantity of employment and not merely its direction." I guess classical economics did not include the influence of expectations. Which leads to the question - Does neo-classical synthesis postulate that people are rational in their expectations, hence future expectations are already built into today's prices, so lets get back to classical economics? Will explore this later.
• Alfred Marshall wrote a book "Principle of Economics" in 1890. It was probably the equivalent of Samuelson's Economics today - the standard text book of economics. Why does wikipedia say he is one of the founders of neoclassical economics. I thought it came after Keynes.
• "The Manchester School and Marxism both derive ultimately from Ricardo." Didn't get this.
• "While Germany has had its school of economists, they are content with historical and empirical analysis, so there isn't any predominant theoretical framework of economics in Germany."
• "This book traces its descent from Malthus rather than Ricardo." Didn't get this.
• "Savings = Investment is a controversial statement. What is true at individual level is not true at the system level, and vice versa."
• "Many economists believe that the rate of interest is determined by the point of intersection of the supply curve of savings and demand curve of investment. But if aggregate S = I, then this explanation collapses. Interest rate preserves equilibrium between demand and supply of money, not capital goods."
• Montesquieu was the French equivalent of Adam Smith.
• "Economics everywhere has been dominated by the doctrines of J.B. Say. His basic fallacy was the assumption that demand is created by supply. Saw implicitly assumed that the economic system was always operating up to its full capacity, so that a new activity was always in substitution for, and never in addition to, some other activity."
• "This book breaks away from the doctrines of JB Say in the theory of production, and returns to the doctrines of Montesquieu in the theory of interest."

And that's it.

Fed should destroy 2mn homes

If Fed were to buy 2 mn. homes in US at $200K apiece, and destroy them, it will cost $400bn. After that, housing inventory is gone. Housing starts will rise from current 300K odd level to 600K level, and housing growth (to which a lot of things get ultimately linked) will lead to rebound in economy. It will increase employment without a doubt, as construction generates employment.

This is much better than the cost of any other alternative that is being proposed. Print money and we don't know whether it leads to inflation over time. Increase fiscal deficit and we don't know what taxes are over long-term. In this solution, US government will take a one-time hit of $400bn. Because economy will start growing robustly again, that should be more than offset by the reduction in fiscal deficit and anxiety.

Facebook vs Google

We are probably at one of the tipping points in the evolution of the Internet. That tipping point is Facebook. And the question is - as more people spend more time on Facebook, and the number of clicks on Facebook surpasses Google, is it possible that Facebook itself replaces Google? Particularly as traffic moves from desktop to mobile, where the first thing consumers use is Facebook and not Google.

It is certainly possible. And over the next 2 years, Facebook might start eroding Google's search business. But, the first thing that Facebook will hit is display, not search. It is probably already happening - Yahoo is barely growing its ad revs. Maybe, it is time to short some of the traditional display focussed ad biz on the Internet. Yahoo is so cheap that there is no point shorting it.

SuperMedia and DEX One

Directories just keep coming back to market after a trip to bankruptcy court. We have DEXO (former RH Donnelley) and SuperMedia (former Idearc) back in the market - still levered up 3x-4x Net Debt/EBITDA. These stocks will most likely still go to 0, but there might be some nasty bounces along the way. I hope they come out with a decent qtr, where ad rev decline is 12% instead of 15%.

Google Verizon Proposal

Google and Verizon announced a joint policy proposal today. While it is quite interesting in its entirety, what caught my eye was the word legal - "First, both companies have long been proponents of the FCC’s current wireline broadband openness principles, which ensure that consumers have access to all legal content on the Internet, and can use what applications, services, and devices they choose."

So Google is agreeing with Verizon that it can block bittorrent bits? That's very strange coming from Google.

Getting wages indexed to a labour index

There are several amazing things about the great recession:

a) Margins remained strong throughout, and will now go through previous cycle peak. Companies have squeezed labour costs hard.

b) Commodity prices have zoomed right back, even in commodities like oil which have near-term oversupply dynamics.

Traders in commodity pits have turned out to be the saviours of commodity exporting nations. Had it not been for their speculation, it is entirely possible that commodity prices would have been lower, and commodity consumers benefited at the expense of commodity producers. In case of commodities like oil, one can argue that traders are looking through near-term supply-demand imbalance and looking 3 years out.

What I have been wondering is - suppose labor costs were similarly linked to some wage index on the exchanges. Wouldn't the wage costs also have jumped - which is the right thing to have happened if corporate profits are booming? Now there will be political issues with such a construct. In a downturn, wage costs might also fall below what is considered acceptable. But maybe, leftists should just think about this idea.

Sugar stocks get pounded

Stocks like Shree Renuka and Dhampur have been absolutely crushed. Next time to buy these stocks will be 2014. It is pretty amazing - to say the least.

Emerson Radio

This one is interesting. MSN announced a special dividend of $1.10 on March 2. That day, stock was at $2.27. Today, it is at $4.64. I saw the announcement two days after it was announced. The stock was at $3.47, and I debated whether I should purchase it. Too bad I didn't do something on impulse.

Company is some sort of distributor of electronics, and it seems they make money. 2009 was a pretty good year for them for some reason.

The blog is back

After a brief hibernation.

I calculated my carbon footprint here. The results are quite shocking. The key reason is the number of flights I take. I guess it is absolutely necessary that Boeing and Airbus come out with their new planes. Another technology that will help is video conferencing (Cisco and Polycom). This is something which is quite here and now. Maybe Cisco should encourage regulators to put a carbon tax on long-distance flights. Cisco might also benefit from attempts to make utility grids more smarter. Can Cisco become the new climate evangelist?

Can GM seeds reduce carbon emissions? Due to higher productivity of these seeds, one can argue that total farmland area can reduce and still lead to higher food grain production. Farming is one of the biggest carbon emitters. It will also probably use lesser water, fertilizers, pesticides etc. Monsanto might also become a climate evangelist. That will be really interesting.