Sunday, July 29, 2007

Influence Of Tastes On Prices

1.0 Introduction

This post illustrates why the non-substitution theorem includes an assumption of no joint production. I have previously gone a little into the the theory of joint production in an analysis of depreciation. I have also previously illustrated the non-substitution theorem with an example in which the theorem's assumptions are met (part 1, part 2, Kurz and Salvadori on the theorem).

2.0 The Technology

Consider three islands, Alpha, Beta, and Gamma. A competitive capitalist economy exists on each island. These islands are identical in some respects and differ in others. The point is to understand how differences in tastes can be related to other differences, particularly in prices.

All three islands have the same Constant Returns to Scale technology available. They also exhibit the same rate of profits, and have fully adapted production to their conditions. The technology consists of processes to produce rye and wheat, where workers use inputs of rye and wheat to produce rye and wheat available at the end of the time period associated with each process. This time is a year. That is, each production process requires a year to complete. Each process fully uses up their inputs in producing their outputs.

The processes here exhibit joint production. A process is an example of joint production when its output consists of more than one good. The production of wool and mutton is a well-known example. With joint production, there is room in the economy for processes producing the same set of outputs in different proportions, as in this example. Table 1 shows processes, some subset of which are chosen by the firms at the ruling prices in this example. I think a better example might fully specify a larger technology from which to chose processes.
Table 1: The Technique of Production
Inputs Hired
At Start
Of Year
Labor1 Person-Year1 Person-Year
Rye1/8 Bushel3/8 Bushel
Wheat1/16 Bushel1/16 Bushel
Outputs1 Bushel Rye
& 1/2 Bushel Wheat
1/2 Bushel Rye
& 1 Bushel Wheat
Notice that the net output of the predominately rye process, for an unit level of operation, consists of 7/8 bushel rye and 7/16 bushel wheat. The net output of the predominately wheat process consists of 1/8 bushel rye and 15/16 bushel wheat. Linear combinations, in which each process is operated at some non-negative level, can produce only some ratios of rye and wheat. Hence, these processes cannot meet all possible requirements for use, where such requirements include both consumption needs and requirements for growth. If no process exhibits joint production, any ratio of outputs can be be met by some line combination of processes. This contrast in joint production leads to requirements for use being able to influence which goods are commodities, that is, positively priced.

3.0 Quantity Flows

The employed labor force grows at a rate of 100% on each island. Each island differs, however, in the mix of outputs that they produce.

The population on Alpha wants to eat only rye. They do not and will not consume wheat. Table 2 shows the quantity flows per employed laborer on Alpha. Notice that the commodity inputs purchased at the start of the year total 1/8 bushel rye and 1/16 bushel wheat. Since the rate of growth is 100%, 1/4 bushel rye and 1/8 bushel wheat will be needed for inputs into production in the following year. This leaves 3/4 bushels rye available for consumption at the end of the year per employed worker. There is also an excess output of 3/8 bushels wheat per worker, freely disposed of each year.
Table 2: Quantity Flows On Alpha Island Per Worker
Inputs Rye Process
Labor1 Person-Year
Rye1/8 Bushels Rye
Wheat1/16 Bushels Wheat
Outputs1 Bushel Rye
& 1/2 Bushel Wheat
GROSS OUTPUTS PER WORKER: (1 Bushel Rye, 1/2 Bushel Wheat)
CAPITAL PER WORKER: (1/8 Bushel Rye, 1/16 Bushel Wheat)
A linear combination of the two processes that exactly satisfies requirements for use arising for 100% growth on the Alpha island operates the predominately wheat-producing process at a negative level. This makes no economic sense. No other possibility arises other than that shown in Table 2.

The Beta population eats only wheat. Table 3 shows the quantity flows on Beta. Here the same sort of calculations reveal that Beta has 3/4 bushel wheat available for consumption at the end of the year, per employed worker.
Table 3: Quantity Flows On Beta Island Per Worker
Inputs Rye ProcessWheat Process
Labor1/4 Person-Year3/4 Person-Year
Rye1/32 Bushels Rye9/32 Bushels Rye
Wheat1/64 Bushels Wheat3/64 Bushels Wheat
Outputs1/4 Bushel Rye
& 1/8 Bushel Wheat
3/8 Bushel Rye
& 3/4 Bushel Wheat
GROSS OUTPUTS PER WORKER: (5/8 Bushel Rye, 7/8 Bushel Wheat)
CAPITAL PER WORKER: (5/16 Bushel Rye, 1/16 Bushel Wheat)
Gamma's quantity flows, shown in Table 4, are one possible intermediate case. Gamma has 9/14 bushel rye and 3/7 bushel wheat available for consumption at the end of the year per employed worker.
Table 4: Quantity Flows On Gamma Island Per Worker
Inputs Rye ProcessWheat Process
Labor25/28 Person-Year3/28 Person-Year
Rye25/224 Bushels Rye9/224 Bushels Rye
Wheat25/448 Bushels Wheat3/448 Bushels Wheat
Outputs25/28 Bushel Rye
& 25/56 Bushel Wheat
3/56 Bushel Rye
& 3/28 Bushel Wheat
GROSS OUTPUTS PER WORKER: (53/56 Bushel Rye, 31/56 Bushel Wheat)
CAPITAL PER WORKER: (17/56 Bushel Rye, 1/8 Bushel Wheat)
CONSUMPTION PER WORKER: (9/14 Bushel Rye, 3/7 Bushel Wheat)

4.0 Price System

Since these economies have adapted to their requirements for use, stationary prices prevail. Assume a rate of profits of 100%, identical across all three islands. Also assume the wage is paid at the end of the year.

4.1 Prices on Alpha

Recall that there is excess production of wheat on Alpha. "If there is excess production of [wheat], [wheat] becomes a free good" (J. Von Neumann, "A Model of General Economic Equilibrium," Review of Economic Studies, 1945-1946: 1-9). Asuming the wage is paid at the end of the year, the price system given by Equation 1 will be satisfied:
where w is the wage and r is the rate of profits. I have implicitly assumed in the above equation that the price of a bushel rye is $1. The wage can be ound in terms of the rate of profits:
Since the rate of profits is 100%, the wage on Alpha is 3/4 bushel rye per person-year.

4.2 Prices on Beta and Gamma

The price system given by Equations 3 and 4 will be satisfied on Beta and Gamma:

where p is the price of a bushel wheat. The wage can be found in terms of the rate of profits:
The price of wheat, in terms of the rate of profits, is given by Equation 6:
Given a rate of profits of 100%, the wage on Beta and Gamma is 3/2 bushel rye per person-year, and the price of a bushel wheat is 2 bushels rye.

5.0 Conclusions

Under the conditions satisfied by this example, in which the economies on different islands are fully adapted to tastes, the prices shown in Table 5 prevail. Differences in tastes between Beta and Gamma are associated with unchanged prices, even in this context. Different tastes on Alpha, however, are associated with a difference in which goods have positive prices and a consequent difference in the wage.
Table 5: Summary of Prices
AlphaBeta & Gamma
Wheat (Bushel)0 Bushel Rye2 Bushel Rye
Labor (Person-Year)3/4 Bushel Rye3/2 Bushel Rye
Note that the quantity flows specified above show the wage entirely consumed and profits entirely invested.

Note that if only goods with a positive price were shown in the techniques chosen on the respective islands, the input-output matrices would be square in all cases (1x1 on Alpha and 2x2 on the other two islands). I think that this property can arise in some cases where wages are not entirely consumed and profits not entirely invested. As I understand it, however, it is a theorem that the input-output matrices are square under this golden-rule condition.

If wages were the same across all three islands, then the rate of profits would vary between Alpha, on the one hand, and Beta and Gamma, on the other. Since the rate of growth is equal to the rate of profits, the rate of growth for a fully adjusted economy would be determined endogeneously. The different choices of the workers on how to consume their wages would result in a difference in the rate of growth between Alpha and the Beta and Gamma islands.

Even though differences in tastes can be associated with differences in prices, it is not clear that this example illustrates a model consistent with the neoclassical (scarcity) theory of value:
" a production makes no sense to talk of 'endowments' of given physical quantities if these physical quantities, to be carried over from one period to another, are the unknowns to be determined. It makes no sense to talk of 'scarce' resources, if these resources can be produced in whatever quantities may be needed by the economic system...

When all inputs are themselves produced, a change in the composition of demand simply means that more of some inputs and less of other inputs will have to be produced, while the optimum technique remains the same. In other words, the process of adaptation to any given change in the composition of final demand is, in a production context, radically different from the one considered by traditional theory. Whereas, with given and fixed inputs (the traditional case), the only way to adapt is through a change of technique which may allow the substitution of some inputs for others, in a production context in which all inputs are themselves produced the obvious way to adapt is to produce the inputs which are needed and to cut down production of those which are no longer needed. There is no question of changing the technique. Input substitution, in a production context, has no role to play...

Another route which has been pursued to minimize the importance of the new results...consists in attributing the irrelevance of substitution to the 'very special' case of no joint production and constant coefficients [ = constant returns to scale -RLV ]. But the inconsistency of this contention is here brought into sharp relief by the very analysis of the previous pages...

As already pointed out...the joint production and nonconstant coefficients case is more complicated than, but not basically different from, the case concerning single products and constant coefficients. The complication arises from the fact that a change of the composition of demand may entail a change of the optimum technique and of the price structure. However, this does not enable us to say anything about the direction in which the input proportions will change.

...It is precisely the unambiguous direction in which relative prices and input proportions are related to each other that justifies talking of 'substitution.' But there is nothing of the sort in a production context. No general relation exists between the changes in the price structure and changes in the input proportions. More specifically, no monotonic inverse relation exists, in general, between the variation of any price, relative to another price, and the variation of the proportions among the two inputs to which these two prices refer. When this is so, to talk of 'substitution' among these inputs no longer makes any sense." -- Luigi L. Pasinetti (1977). Lectures on the Theory of Production, Columbia University Press: 186-188


YouNotSneaky! said...


So correct me if I got this wrong:

NS Thm holds, no joint production:
Prices determined by technological coefficients, quantities determined by demand. So it's the opposite of the classical dichotomy (MV=PY + QT and all that). A change in composition (or level) of demand has no effect on prices but only on the composition of output produced. Which is what makes this truly "Keynesian".

NS Thm holds, joint production:
Both prices and quantities can be affected by both demand and technological considerations but there's no monotonic relationship between'em. So if demand for some good/factor rises it may not be the case that the price (quantity too?) of that good will rise. Hence it makes no sense to talk of scarcity in the neoclassical sense.

As I understand it, however, it is a theorem that the input-output matrices are square under this golden-rule condition.

Golden-rule = wages consumed, profits invested, like in VN, right? But this paragraph is a bit confusing. Are you saying that the i/o matrices are guaranteed to be square under the GR, and only possibly square without it?

Also, I’d say that the Neoclassicals would consider the case of constant coefficients to be a special case of CRS, not equivalent to it. Of course under the assumptions of the NS Thm it might be equivalent. (Again, I’m saying this in the hope of being corrected, not as a statement of fact). (Actually maybe not – you could have just one non-productible input, labor, but have fixed costs, to be paid in terms of labor, which would generate IRS... uh, I guess that would be the non constant coefficient of 0 then something positive though)

Robert Vienneau said...

The NS Thm does not hold under the case of joint production.

The NS Thm holds if there is no joint production, CRS, and only one non-produced input (e.g., "labor"). The composition or level of consumer demand has no effect on solution to price equations. But the solution depends on distribution, as well as the technology available. (I deliberately leave out the word "change"; the points of the islands metaphor is to emphasize transition paths are not being analyzed.)

Under the case of joint production, the level and composition of consumer demand affects the steady-state prices. But, right, one does not get demand functions.

Yes, under various conditions, apparently the Input/Output matrices can be non-square if the GR does not hold.