Cambridge capital controversies (1930S- )

Cambridge capital controversies refer to the debate between British and American economists concerning the neoclassical approach to economics. They were based at Cambridge University (England) and the Massachusetts Institute of Technology (Cambridge, USA), respectively.

The Modern School, particularly influenced by Alfred Marshall (1842-1924) and headed by the English economists Arthur Cecil Pigou (1877-1959) and John Maynard Keynes (1882-1946), refuted the microeconomic ideas of neo-classical economics; especially as seen in the work of the Americans Paul Samuelson (1915- ) and Robert Solow (1924- ).

Emphasizing the macroeconomic approach, the English denied (among other things) the existence of a functional relationship between the rate of profit and the capital intensity of an economy, and demonstrated the possibility of capital re-switching. (That is, if it is possible when the rate of return falls for firms to switch to more capital intensive methods of production (thus increasing the rate of investment), it is also possible that under certain circumstances the rate of return will reach such a level that firm switch from more to less capial intensive methods of production.)

The Modern School also questioned the existence of an aggregate production function and the determination of savings and interest levels.

In classical, orthodox economic theory, economic growth is assumed to be exogenously given: Growth is dependent on exogenous variables, such as population growth, technological improvement, and growth in natural resources. Classical theory claims that an increase in either of the factors of production, i.e. labor or capital, while holding the other constant and assuming no technological change, will increase output but at a diminishing rate that will eventually approach zero.

The so-called natural rate of economic growth is defined as the sum of the growth of the labor force and the growth of labor productivity. The concept of the natural rate of growth first appeared in Roy Harrod’s 1939 article where it is defined as the “maximum rate of growth allowed by the increase of population, accumulation of capital, technological improvement and the work/ leisure preference schedule, supposing that there is always full employment in some sense.” If the actual economic growth-rate falls below the natural rate, then the unemployment rate will rise; if it rises above it, the unemployment rate will fall. Consequently, the natural rate of growth must be the rate of growth that keeps the rate of unemployment constant.

If the natural rate of growth is not exogenously given, but is endogenous to demand, or to the actual rate of growth, this has two implications. At the theoretical level, there are implications for the efficiency and speed of the adjustment process between the warranted and the natural rates of growth in Harrod’s growth model. Also, there are implications for the way the growth process should be viewed, and for understanding why growth rates differ between countries: whether growth is viewed as supply determined; or whether growth is viewed as demand determined; or determined by constraints on demand before supply constraints begin to operate.

Harrod produced a mathematical model of growth whereby the natural rate of growth fulfills two important functions. First, it sets the ceiling to the divergence between the actual growth rate and warranted growth rate and turns cyclical growth into slumps. Consequently, it is important for generating cyclical behavior in trade-cycle models that rely on first-order difference equations. Second, it ostensibly provides the maximum attainable long-run rate of growth. The natural rate is treated as strictly exogenous; it is shaped by the growth of the labor force and the growth of labor productivity, without recognition nor assumption that both might be endogenous to demand.[note 5] Additionally, there was no fiscal or other economic mechanism in the theory that could bring the warranted rate of growth in line with the natural rate of growth, i.e. for society to achieve full or fuller utilization of its resources.

Central issue
The question of whether the natural growth rate is exogenous, or endogenous to demand (and whether it is input growth that causes output growth, or vice versa), lies at the heart of the debate between neoclassical economists and Keynesian/post-Keynesian economists. The latter group argues that growth is primarily demand-driven because growth in the labor force as well as in labor productivity both respond to the pressure of demand, both domestic and foreign. Their view does not mean, post-Keynesians state, that demand growth determines supply growth without limit; rather, they claim that there is not one, single, full-employment growth path, and that, in many countries, demand constraints (related to excessive inflation and balance of payments difficulties) tend to arise long before supply constraints are ever reached.

The Harrod–Domar model
Further information: Harrod–Domar model
Roy Harrod, in his seminal paper, developed a model, subsequently refined by Russian-born Evsey Domar, that aims to explain an economy’s growth rate in terms of the level of saving and of the productivity of capital. Despite its progenitors ostensibly Keynesian viewpoint, the Harrod–Domar model was actually the precursor to the exogenous growth model.

According to the Harrod–Domar model there are three kinds of growth: the rate of warranted growth; the rate of actual growth; and the natural rate of growth. Warranted growth-rate is the rate of growth at which the economy does not expand indefinitely or go into recession. Actual growth is the real rate-increase in a country’s yearly GDP. Natural rate of growth is the rate at which the growth an economy requires that full employment is maintained. For example, If the labor force grows at 3 percent per year, with everything else being equal, then to maintain full employment, the economy’s annual growth rate must be 3 percent.

Neoclassical economists claimed shortcomings in the Harrod–Domar model, in particular pointing out instability in its solution,and, by the late 1950s, they started an academic dialogue that led to the development of the Solow–Swan model.

The Solow–Swan model
Further information: Solow–Swan model
The model was developed separately and independently by Robert Solow and Trevor Swan in 1956, in response to the supposedly Keynesian Harrod–Domar model. Solow and Swan proposed an economic model of long-run economic growth set within the framework of neoclassical economics. They attempt to explain long-run economic growth by looking at capital accumulation; labor growth or population growth; and increases in productivity, commonly referred to as technological progress. At its core, the model offers a neoclassical (aggregate) production function, often specified to be of Cobb–Douglas type, which enables the model “to make contact with microeconomics”.

The debate
The Harrod-Domar model’s lack of a mechanism that could bring the warranted rate of growth into line with the natural rate of growth triggered the growth debate in the mid-1950s, a debate that “engaged some of the greatest minds in the economics profession for over two decades.”[6] The neoclassical and Neo-Keynesian sides were represented by Paul Samuelson, Robert Solow, and Franco Modigliani, who taught at the MIT, in Cambridge, Massachusetts, USA, while the Keynesian and Post-Keynesian sides were represented by Nicholas Kaldor, Joan Robinson, Luigi Pasinetti, Piero Sraffa, and Richard Kahn, who mostly taught at the University of Cambridge in England. The common name of the two places gave rise to the terms “the two Cambridges debate” or “the Cambridge capital controversy.”

Both camps generally treated the natural rate of growth as given. Virtually all the focus of the debate centered on the potential mechanisms by which the warranted growth rate might be made to converge on the natural rate, giving a long-run, equilibrium growth-path. The American Cambridge side focused on adjustments to the capital/output ratio through capital-labour substitution if capital and labour were growing at different rates. The English Cambridge side concentrated on adjustments to the saving ratio through changes in the distribution of income between wages and profits, on the assumption that the propensity to save out of profits is higher than out of wages.

Ideological issues
Much of the emotion behind the debate arose because the technical criticisms of marginal productivity theory were connected to wider arguments with ideological implications. The famous neoclassical economist John Bates Clark saw the equilibrium rate of profit (which helps to determine the income of the owners of capital goods) as a market price determined by technology and the relative proportions in which the “factors of production” are used in production. Just as wages are the reward for the labor that workers do, profits are the reward for the productive contributions of capital: thus, the normal operations of the system under competitive conditions pay profits to the owners of capital. Responding to the “indictment that hangs over society” that it involves “exploiting labor,” Clark wrote:

It is the purpose of this work [his 1899 ‘Distribution of Wealth’] to show that the distribution of the income of society is controlled by a natural law, and that this law, if it worked without friction, would give to every agent of production the amount of wealth which that agent creates. However wages may be adjusted by bargains freely made between individual men [i.e., without labor unions and other “market imperfections”], the rates of pay that result from such transactions tend, it is here claimed, to equal that part of the product of industry which is traceable to the labor itself; and however interest [i.e., profit] may be adjusted by similarly free bargaining, it naturally tends to equal the fractional product that is separately traceable to capital.

These profits are in turn seen as rewards for saving, i.e., abstinence from current consumption, which leads to the creation of the capital goods. (Later, John Maynard Keynes and his school argued that saving does not automatically lead to investment in tangible capital goods.) Thus, in this view, profit income is a reward for those who value future income highly and are thus willing to sacrifice current enjoyment. Strictly speaking, however, modern neoclassical theory does not say that capital’s or labor’s income is “deserved” in some moral or normative sense.

Some members of the Marxian school argue that even if the means of production “earned” a return based on their marginal product, that does not imply that their owners (i.e., the capitalists) created the marginal product and should be rewarded. In the Sraffian view, the rate of profit is not a price, and it is not clear that it is determined in a market. In particular, it only partially reflects the scarcity of the means of production relative to their demand. While the prices of different types of means of production are prices, the rate of profit can be seen in Marxian terms, as reflecting the social and economic power that owning the means of production gives this minority to exploit the majority of workers and to receive profit. But not all followers of Sraffa interpret his theory of production and capital in this Marxian way. Nor do all Marxists embrace the Sraffian model: in fact, such authors as Michael Lebowitz and Frank Roosevelt are highly critical of Sraffian interpretations, except as a narrow technical critique of the neoclassical view. There are also Marxian economists, like Michael Albert and Robin Hahnel, who consider the Sraffian theory of prices, wages and profit to be superior to Marx’s own theory.

Also see: capital theory

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