Sunday, February 16, 2014

Introduction to Macroeconomics: Feudalism and capitalism

Before capitalism, the dominant relation of production was the feudal system.

In a feudal system, households [shown above as circles with H] are largely self-sufficient. They grow and eat their own food, manufacture and wear their own clothing, build, maintain and occupy their own houses and barns, etc. There's some specialization — carpenters, blacksmiths, tinkers, doctors, priests, etc. — some inter-household trade, and some international trade, but by and large small groups of people, households and villages, are economically self-sufficient, and households produce surpluses of food.

Any time you have surpluses (wealth), you have mean people with weapons trying to take that surplus by force. The feudal nobility existed (or so they claimed) to protect households from bad guys who wanted to come and steal their stuff. To protect households, you need men with heavy armor and weapons, and big strong horses. Knights owned land, and collected part of the surplus — rent — to feed people who would create and maintain the armor, and feed the horses. You also need someone to coordinate all these knights and command them in battle. So you have feudal lords (barons, dukes, etc.) and all their advisors, teachers, servants, etc., all of whom need to be fed, so the feudal lords also collected part of the surplus.

The most important (from an economist's perspective) is that absent international trade, a feudal economy doesn't need money. During the feudal period, landowners who collected rent in money did poorly; those who collected rent in kind — specific amounts of grain, meat, wool, etc. — did much better. But just looking at the diagram, everything flows one way; there are no complex interactions to manage. You just send a wagon to each household, demand a load of grain and some sheep and cows, and drive the wagons to the knight's house. Easy.

Self sufficiency is nice, but it's economically limiting. We can produce more (than an agricultural economy) if people specialize. More importantly, the invention of steam engine technology in the late 18th century (James Watt invents the first practical steam engine in 1781) made specialization and mass production economically possible. By the middle of the 19th century, we had a new relation of production: market capitalism.

(The transition from feudalism to industrial capitalism takes about 200 years, with the intermediate stage of mercantilism. Sadly, I don't have the time to delve into the interesting, complicated details.)

Instead of self-sufficient households, we have specialized firms (businesses). Firms obtain land (L), labor (N), and capital (K), from households, each firm produces a specialized good or service, and all these goods and services are distributed to households.

This arrangement produces a problem: the problem of distribution. How do we know how much land, labor, and capital to distribute to each firm? How do we know how many goods and services to distribute to each household? And remember, no one is really "planning" how to change the relations of production; all of this stuff is evolving from individuals making individual decisions. What emerges from all of these individuals is the market system, which uses money to allocate land, labor, and capital to firms, and goods and services to households.

In this model, some households supply labor (N) to the market and receive money wages (\$w), other households supply capital (K), i.e. machinery, tools, buildings, etc. to the market and receive rent (\$r), and other households (not shown) supply land (L) and receive rent (\$t). Households then obtain goods and services (G&S) from the market, and pay a price (\$P) times the quantity of goods and services they obtain (Q). Firms obtain land, labor, and capital (L, N, K) from the market and pay wages and rent (\$w & r). They use those resources to create goods and services, which they supply to the market at a specific price and quantity. In this model, the real economy and the monetary economy flow in opposite directions. You have to have money, because the market is a feedback system, and a feedback system requires something that is fed back. When we add money to our earlier diagram, we get the basic circular flow diagram:

To sum up: Feudalism is a (mostly) one-way system: households grow food, eat some, and send the surplus up the hierarchy, where it is eventually eaten. Capitalism is a circulating system: land, labor, and capital circulate to firms, and goods and services circulate to households; in the opposite direction, money circulates to households in the form of wages and rent, and then circulates to firms in the form of purchases. Understanding this circular flow is the essence of macroeconomics.

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