HISTORY OF ECONOMIC THOUGHT
LECTURE 4
John Stuart Mill—The Economist and Social Reformer
1. The Last of the Classical Political Economists
John Stuart Mill is considered the last of the so-called classical “political” economists. The economists that
followed Mill belong to the neoclassical school of economics. Note that with the neoclassical school, the term
“political” is no longer present in the description of this school of thought. There is a good reason for this.
Even though at the core of classical school was the analysis of the market system, the main emphasis was on
the production side and the role of the agents of production in this sphere. The agents of production were not
simply the impersonal, physical entities called land, labor and capital. Rather, they were landlords, workers,
and capitalists. Thus, the market system was analyzed within context of the interaction, or conflict, between
the working class, capitalist and landowner classes. Main economic concepts such as theory of value, rent,
profit, stationary state, economic glut, etc., were all based on the role of the three main classes, and the
inevitable conflict among them, in the production and distribution of commodities.
Thus, the terms
“political” and “economy” were always used in tandem.
With the neoclassical economics, on the other hand, the attention was turned towards the theory of the firm
and behavior of the utility maximizing consumer . Factors of production became the impersonal entities
devoid of any class content. The role of the firm (the term “capitalist” is no longer in the vocabulary) was how
to combine these factors to maximize profit, and for consumer how to maximize utility subject to the budget
constraint. The class and political content of the capitalist/market economy was completely discarded in and
replaced with efficiency in resource allocation.
2. Mill and Labor Theory of Value
Perhaps the most important issue that distinguishes the classical school of economic thought from the “neoclassical” school is the issue of the factor or factors that determine the market value of goods. For Smith and
Ricardo, and also for Mill, the emphasis is on the cost of production, which is essentially the labor theory of
value. Even though the classical economists do not ignore the impact of the demand on price, they argue that
changes in demand causes a temporary deviation from the natural price. Prices always settle at the natural
level once the change in demand runs its course. This way, demand determines the quantity rather than the
price of a commodity.
In order for demand determine solely the quantity, the classical assumption is that the supply is infinitely
elastic, that is, the supply curve is horizontal, as shown in the following diagram. The cost of production at
any given period is determined by technology (division of labor or organization of production) and the
subsistence wage. This cost dictates the natural price of a commodity. An increase in demand from 𝐷0 to 𝐷1
may result in a temporary shortage and cause the price of the product to rise, but the increased production by
existing producers and, lured by higher profits, by new producers will bring the price back down to the
natural level 𝑃0 .
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S
P₁
P₀
D₀
Q₀
D₁
Q₁
There were, however, some unanswered theoretical questions relating to labor theory of value that arose
from Ricardo’s rent theory, and his comparative advantage theory of international trade.
2.1. Diminishing Returns and Cost of Production
Ricardo’s theory of rent provided that rent to landowner rises because of the rise in cost of production in the
marginal, lower quality land. Equal dosage of capital and labor applied to a lower quality marginal land yields
smaller output than that applied to higher quality land, resulting in a higher cost of each additional unit of
corn produced. We know the cost of additional unit as marginal cost. Since price of corn is determined by the
cost of production in the marginal land, then price must rise with marginal cost. Thus, the supply of corn
cannot be infinitely elastic or horizontal; the supply curve must slope upward.
Ricardo applied the theory of rent to the production of corn, where he assumed land as a fixed input. This
theory can be extended to include any input or factor of production, other than land, that is of fixed quantity.
Ricardo must have assumed that production capacity outside agriculture can increase indefinitely, unaffected
by diminishing returns.
The following set of diagrams show what happens to supply (marginal cost curve in panel C) if there is
diminishing returns in production. Panel (A) shows that as successively equal dose of variable inputs is
applied to a fixed input, output (total product) rises at a decreasing rate at each successive stage. First dose
of the variable inputs, 𝑂𝐿1 produces the output 𝑂𝑄1 . The second, equal dose of the variable inputs 𝐿1 𝐿2
produces the additional, but smaller, output 𝑄1 𝑄2 . And, the third dose, 𝐿2 𝐿3 produces even smaller additional
output 𝑄2 𝑄3 . The diminishing return pattern is presented more vividly in Panel (B) as the downward sloping
marginal product curve.
Panels (C) and (D) describe the cost side of the story. Panel (C) shows that each additional equal bundle of
output is produced at a higher cost (in terms of embodied variable inputs) than the previous bundle. Here,
cost of producing the first bundle, 𝑂𝑄1 , is 𝑂𝐶1 . The cost of the second bundle 𝑄1 𝑄2 is 𝐶2 𝐶3 , and the cost of the
third bundle 𝑄2 𝑄3 is 𝐶2 𝐶3 , where 𝐶2 𝐶3 > 𝐶1 𝐶2 > 𝑂𝐶1 . Panel (D) shows, in modern economic theory, the
familiar supply curve, which coincides with the rising marginal cost.
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(A)
(B)
)
Q₃
Q₂
)
Total
Product
MP₁
Q₁
MP₂
Marginal
Product
MP₃
O
L₁
L₂
O
L₃
L₁
(C)
L₂
L₃
(D)
Total
Cost
C₃
MC₃
Marginal
Cost
MC₂
C₂
MC₁
C₁
O
Q₁
Q₂
O
Q₃
Q₁
Q₂
Q₃
Now if we include the downward-sloping demand curve in Panel (D) we get the familiar supply/demand
diagram in economics textbooks today. Thus, demand and supply (cost of production) together determine
both quantity and price.
S
P₁
P₀
D₁
D₀
Q₀
Q₁
2.2. Relative Cost/Price in International Trade
Ricardo’s comparative advantage theory was based on the differences in relative costs of producing
Wine/Cloth in England and Portugal, each depending on the amount of labor (man-hour) required to produce
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the goods in question. If both countries realize their comparative advantage and engage in trade, the
international price ratio of Wine/Cloth will differ from the intra-national cost ratio that prevailed before
trade. Then embodied labor no longer can account for the relative price at which the two goods are traded
across the border.
Although Mill did not address the role of demand in determining the price within the context of diminishing
returns discussed in the previous section, he did address the issue of relative prices in international trade.
This is where he applied the supply/demand framework to explain price formation in international trade.
The produce of a country exchanges for the produce of other countries, at such values are
required in order that the whole of her exports may exactly pay for the whole of her imports.
This law of International Values is but an extension of the more general law of Value, which
we called the Equation of Supply and Demand...the value of a commodity always so adjusts
itself as to bring the demand to the exact level of the supply. But all trade, either between
nations or individuals, is an interchange of commodities, in which the things that they
respectively have to sell, constitute also their means of purchase: the supply brought by the
one constitutes his demand for what is brought by the other.
Mill did not use the supply and demand diagram or use the terms equilibrium price and equilibrium quantity,
but his words match exactly the interaction between supply and demand shown in the previous diagram.
3. Productive versus Unproductive Labor
Mill discusses at length an interesting issue which has important ramifications for modern U. S. economy, and
that is his distinction between productive and unproductive labor. The issue was first brought up by Adam
Smith. Mill defines productive labor as the effort that produces concrete objects that add to material wealth of
the nation, particularly capital stock. Unproductive labor does not produce concrete objects. Therefore, it
does not add to material wealth. The larger the proportion of labor force which is engaged in productive
labor, the higher the rate of capital accumulation and economic growth.
Sandmo argues that, “The distinction between the two types of labor has long since been discarded in
economics.” I don’t agree with this assessment. Mill’s definition of unproductive labor applies closely to most
jobs today in the so-called service sector of the economy: sales clerks, janitors, fork-lift operators and other
warehousing-related jobs, fast-food workers, gambling institutions and other low-level entertainment jobs,
and similar occupations, all low-paying jobs that have replaced the high-paying jobs in production facilities,
those that have been transferred off-shore. The distinction between productive and unproductive service
jobs in modern economy becomes important when we take into account the “value-added” aspect of
productive labor. Service jobs involve little or no value-added.
4. Wages Fund
In classical economic thought wages fund referred to the amount that capitalist employers allocated as
prepayments to workers at the beginning of the production process. Therefore, wages fund required that
capitalists build up a special capital, called circulating capital, to make these advance payments. The size of
the wages fund is fixed, dictated to the economy by the existing technology and, therefore, cannot be changed
by workers demand for higher wages. Thus, the wage rate at any given period is determined as the ratio of
circulating capital over population, or the size of labor force.
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Mills initially subscribed to this view, but rejected it later, citing the influence the trade union movement on
wages. This altered view went along with Mill’s distinction between the laws of production versus the laws of
distribution. (This is issue is discussed further below.)
The neoclassical school also rejected the wages fund. Replacing the explanation for the determinants of wage
rate, rather than the influence of labor unions, with the marginal productivity theory of wages: that the wage
rate, cost of hiring an additional worker, cannot exceed the value of the marginal product of that worker. For
example, if the price of good X is $2, and if hiring an additional worker adds ten units to the representative
perfectly competitive firm’s total output during a production period, then the value of marginal product of the
additional worker is $20. The wage rate must then equal to $20. If the wage rate is more than $20, the firm
will not hire the additional work, competition among workers who are seeking work will push the wage rate
down. And if the wage rate is below $20, competition among firms for workers will push wage rate up to $20.
5. Economic Crisis and Unemployment
Like the other classical economists, Mill strongly rejected the possibility of economic crises and long-term
unemployment. Any downturn in economic activity was considered a temporary phenomenon. Such
downturns can occur only due to external factors, such as wars, natural disasters or other causes that may
disrupt the normal flow of economic activity. The inner dynamics of the economy, the natural laws of the
market, quickly bring the flow of economic activity back to its normal, full employment level. The most wellknown simple expression of this perspective is “Say’s Law”, named after the French economist Jean-Baptiste
Say, a contemporary of Malthus and Ricardo. Say’s Law of markets simply states that “supply creates its own
demand”. In Say’s own words:
A product is no sooner created than it, from that instant, affords a market for other products
to the full extent of its own value.
In this view, any excess supply, overproduction (deficient demand) in one market, must be balanced by
excess demand in another market. The excess supply causes the price in that market to full, which will
eliminate overproduction. Economic resources, including labor, will move to another market where there is
excess demand, which has resulted in higher prices and profits. Thus, a general glut (using Malthus’ terms)
and unemployment is not possible. The aggregate supply must always equal the aggregate demand.
Mill was also an ardent proponent of Say’s Law. In Mill’s words,
Is it ... possible that there be a deficiency of demand for commodities, for want of the means
of payment? Those who think so cannot have considered what it is which constitutes the
means of payment for commodities. It is simply commodities. Each person’s means of
paying for the productions of other people consists of those which he himself possesses. All
sellers are inevitably ... buyers. Could we suddenly double the productive powers of the
country, we should double the supply of commodities in every market; but we should, by the
same stroke, double the purchasing power.
6. Distribution of Income—Laws of Production versus Laws of Distribution
On one issue Mill’s views differed significantly from other classical economists. This view, in fact, puts Mill in
a separate category from most other economists: Mill the philosopher/social scientist. Mill distinguished
between the laws of production and the laws of distribution. He maintained that the “laws of production”
were determined by economic relationships, dictated by immutable natural laws. However, the “laws of
distribution” need to be understood in a political and social context. They follow the laws and customs of
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society. This is one reason, as referred above, Mill rejected the wages fund theory. For he argued that the
wages of workers are not dictated by wages fund, essentially the generally accepted subsistence theory of
wages based on the Malthusian population theory. Wages can be affected by social action, such as labor union
movements, laws or customs, or even the employer’s conscience. Robert Owen being a good example of a
capitalist with conscience.
Heilbroner’s discussion of Mill puts far more emphasis on this distinction between production and
distribution laws. Referring to Mill’s opinion, Heilbroner states that, if society did not like the “natural”
results of its activities, it had only to change it. Thus, even though Mill did not dispute Ricardo’s “stationary
state” theory, he put his optimistic stamp on such a state, contending that a society that was stationary in an
economic sense, did not have to be stationary in an intellectual, social, or moral sense. For Mill, the stationary
state did not represent a dire outcome of capital accumulation. It is, rather, the first stage toward a benign
socialism. He wrote:
I cannot, therefore, regard the stationary state of capital and wealth with the unaffected
aversion so generally manifested towards it by political economists of the old school. I am
inclined to believe that it would be, on the whole, a very considerable improvement on our
present condition. I confess I am not charmed with the ideal of life held out by those who
think that the normal state of human beings is that of struggling to get on; that the trampling,
crushing, elbowing, and treading on each other’s heels, which form the existing type of social
life, are the most desirable lot of human kind, or anything but the disagreeable symptoms of
one of the phases of industrial progress.
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