Wednesday, September 7, 2011

A little more on heterogeneous capital and labor

Last week Steve Horwitz had a whole series of posts arguing that what Austrians had to offer was a theory of capital and labor heterogeneity and that this was widely ignored otherwise.

It's an absurd claim, of course (not that capital and labor are heterogeneous - but that this fact is ignored).

One of the things that a lot of commenters on his posts seemed to get caught up on was the use of aggregates like K and L producing an aggregate Y. Aggregation somehow meant homogenization to them. It was never explained. I'm not sure why they drew that inference. But it was there.

I lectured at my first undergraduate macroeconomics review session tonight, and this issue of labor and capital heterogeneity actually came up when we were discussing an issue addressed on the second day of a freshman macro class: the production possibilities frontier (PPF). One of the things the students didn't quite get was why we assume the PPF is usually concave.

The answer, of course, is that different labor and capital is better at producing some things than others, and you can't just switch them around and expect them to perform as well. Labor and capital are heterogeneous. I didn't use the word "heterogeneous", but the point comes across very clearly when you start at one of the corner solutions and verbally walk through the concave PPF.

The goods the students settled on were beer and mountain bikes. Fair enough. Why would we expect a PPF of an economy producing beer and mountain bikes to be concave? Well we assume that there's a range of brewing productivity and mountain bike manufacturing productivity across labor and capital in the economy. Let's first imagine we're at a corner solution: all workers and all capital produce only beer. Some workers and some capital, though, are ill-suited to this work. So if we - sitting on this corner solution - decide we actually want some mountain bikes and we're willing to give up some beer to get it, we'd naturally release the labor and capital best suited to make mountain bikes and worst suited to make beer first. That would result in a relatively low sacrifice of beer (since that labor and capital wasn't producing much anyway), for a relatively high increase in mountain bikes. As we continue along the PPF it becomes harder to find people with such a specialization in mountain bike production, and to get more mountain bikes we have to use people that are pretty good at producing beer. The opportunity cost of producing mountain bikes gets higher, and the slope of the PPF gets steeper.


The point is these ideas about capital and labor heterogeneity are implicit in all of economics. You can get a concave PPF in other ways, of course, but this is the most obvious thing that people turn to. Perfectly interchangable workers and capital result in a linear PPF, and nobody thinks that's what we face. The same with specialization and trade. How do you teach specialization and trade without heterogeneous labor and capital? I just don't know.

For the life of me I have no idea why Steve, Troy Camplin, and others insist that this is such a mystery to other people. Specialization has been the core of economics since Adam Smith. I can't even conceive of how economics is done without capital and labor heterogeneity. I know at American University we teach it to freshman in the first month of class - and we're known to be a fairly left/Keynesian department.


Keynesianism is also simply inconceivable without capital heterogeneity especially. See why here.


  1. I dont think that the ideas of capital (and labor) heterogeneity are implicit in all economics. Marginal analysis completely ignores heterogeneity which is where i think the dwelling on aggregates comes from. I tend to think that you can aggregate heterogeneity but then I think you cant call the aggregate return to capital an "interest rate" and I think in a lot of ways that causes a lot of problem for the drastic simplification of interest rates in general.

    Capital heterogeneity was also a big deal from the other side of "heterodoxy" (and as far as I can tell better theorized than on the austrian side) Are you familiar with the "capital controversy"? Wikipedia has a good entry on it. Hopefully your history of econ thought prof will talk about it some.

    Again, I'm not an ardent "heterogeneity" guy but I do think that while its not wrong it misses the point to to say that heterogeneity is "implicit" in all economics becuase what you are really saying is that "ignoring heterogeneity is an implicit assumption in 'all' economics" which has, i fell, different implications about how present the issue is.

  2. Daniel,

    I'm not sure the argument in the lengthy quote from Keynes in the article you link to really depends upon the heterogeneity of capital.

    My reading is that Keynes is just saying that there is no automatic link between an act of savings and an increase in investments since the decision to invest depends upon the marginal efficiency of capital relative to the interest rate and that this may in fact decline if investors perceive the fall in current consumption (that resulted from the new savings) as likely to last into the future.

    This would be equally true (based on the logic in the quote ) even if capital were homogenous especially since the MEC would tend towards equality on all capital.

    Its the "paradox of thrift" that of course Austrians reject in any case.

  3. Rob -
    Certainly he's saying there's no link - but why? What does Keynes say investment requires that simply saving money cannot guarantee (if it guaranteed it, we would have a link)? What's missing - what is not implied by an act of saving, is the placement of a specific goods order in the future, which Keynes says is necessary because investors won't make investments unless they have specifics. Capital is not homogenous - it is heterogeneous across products and it is heterogeneous across time frames. If it were homogenous, then nothing would prevent savings from increasing investment automatically because not consuming now would imply consuming some homogenous blob at some time in the future, which would be enough to call up homogenous capital.

    But capital isn't homogenous so it can't work that way. Keynes uses the word "specific" several times in that passage and it seems to me he's using it for a reason.

  4. Based on your reading it seems that Keynes believes that if investors lack precise knowledge about future consumption spending then current economic activity may slow down as a result of increased savings. I had thought (based on the rest of the General Theory) that Keynes view might rather be that if investors think that consuming spending in the future on aggregate will be higher then that would increase current investment but perhaps I have mis-interpreted this.

    It may be useful to describe what I take to be the Austrian view of how markets solve the problem that Keynes describes.

    The new savings represent a lowering of time preference. If the saver places the money with a bank that lends them out then this will result in a lowering of the rate of interest in line with the time preference rate.

    The money will then be borrowed by an investor who will use the additional and cheaper funds to invest in the most profitable area available, which if the market is in equilibrium , will of necessity be in an area that will lengthen the structure of production.

    In other words the new savings will have a direct impact on the structure of production (ie the mix of capital goods that will need to be produced to maximize consumer utility taking time preference into account).

    This will be done purely based on capitalist evaluating market trends and prices correctly with no need to have details of "specific goods order in the future".

    So even if your interpretation is correct I still think that Austrians view of heterogeneity (which directly references the structure of productivity) and the Keynesian view (which based on your quote appear to be unrealistic specific) do seem to differ.

  5. Daniel,

    Based on your reading then Keynes is saying that unless investors have knowledge of "specific goods order(ed) in the future" then an increase in current savings may lead to a decline in both current consumption and investment spending (ie a general slowdown in economic activity). This seems to me to be taking heterogeneity too far.

    I had previously assumed that Keynes had thought that expectations by investors that future spending in aggregate would increase (ie with no precise knowledge of exactly what would be bought) would be sufficient to increase MEC and investment.

    Is that view mistaken ?


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