Perhaps the greatest contribution of the exchange economy to the study of society has been the development of economic theory as a total system, part of which goes by the name of “macroeconomics.” Even price theory, which is normally considered microeconomics, has an important macroeconomic element, insofar as it deals with the impact of the complete set of relative prices and considers this price structure not as determined by individual acts of exchange or bargaining, but by a complete system of interactive decisions.
In this sense, macroeconomic theory began with Adam Smith, whose remarkable “vision” — we might almost call it that — of a “natural” or normal price structure, containing the idea of a general equilibrium of the price system, was worked out more explicitly one hundred years later by Walras. Similarly, Alfred Marshall’s theory of prices, although often expressed in microeconomic terms, is also a theory of general equilibrium of magnificent proportions.
The concept of a set of equilibrium relative prices is quite fundamental to economic theory and is a very important contribution of that science. Equilibrium may not be a single set of relative prices; in fact, it may be a set of such price sets, caused by things such as inertia, threshold effects — the door that will not open until the last pound of pressure is applied — and so on. But this does not invalidate the general principle that, if the existing set of relative prices is not within the equilibrium set, then, if the equilibrium is stable, forces will come into action to move it toward the equilibrium set.
One of the cardinal principles of economics has been that the structure of relative prices is not arbitrary. Government price controllers seem to have to relearn this fatal truth in every generation.
Of course, it is one thing to postulate an equilibrium and quite another to describe the dynamic processes that move the system toward it, if it is a stable equilibrium, or away from it, if it is unstable. The difficulty of the problem is illustrated by the fact that, in the exchange economy, two different dynamic processes have been postulated, and there has never been any truly satisfactory reconciliation between them.
Thus, in the tradition that began with Adam Smith in The Wealth of Nations and was elaborated by Alfred Marshall, the dynamics of the system work through the effects produced by a divergence between the actual market price and the normal price or, in Marshall’s terms, the supply price.
If such a divergence exists, the terms of trade are “too good” for those sectors and occupations in which the price of the product is above the normal price, or above the supply price, and “too bad” in those sectors or occupations in which the market price is below the normal or supply price.
However, those industries for which the terms of trade are “too good” will expand as resources are attracted toward them. Those for which the terms of trade are “too bad” will contract as resources leave them. This will increase production and therefore reduce prices in the former, while the reduction in production will raise prices in the latter, and the whole system will move toward equilibrium.
A different system was first formulated by Walras and later developed by John Hicks. In this model, the main dynamic engine is the difference between the quantity demanded and the quantity offered for sale.
If the price of a particular commodity is “too high,” more will be offered for sale than is demanded, surpluses will accumulate in the hands of sellers, and these surpluses will force them to reduce the price. If the price of a commodity is “too low,” more will be demanded than is offered, there will be a shortage, inventories will decline, and sellers will be able to raise their prices.
Perhaps it would not matter so much if these two processes were equivalent, but in fact it can be shown that they are not. Under certain circumstances, the equilibrium of the price system will be stable according to one dynamic process and unstable according to the other.
In the real world, both processes appear to operate, but how many movements toward equilibrium, or away from it, are the result of one process and how many are the result of the other, we do not really know.
This is a serious defect in what might be called the “classical theory of prices,” and later we will investigate whether the concepts of the grants economy can be used to make some contribution to this problem.
The other part of economic science that deals with the functioning of the system as a whole is what is more generally called “macroeconomics,” or the economic theory of national income. It originated mainly in the work of John Maynard Keynes, although importance must also be given to the work of Simon Kuznets and others, who developed national income accounting at an empirical level.
The basic concepts of national income theory are quite simple and familiar to all economists.
