Since I did a post on increasing returns to devoting resources to producing rice, I think it is time to focus on the opposite. That is, it’s time to focus on resource depletion and decreasing returns.
To do this, it may be useful to introduce some concepts from ecological economics. First there is throughput. Throughput is the amount of energy and matter involved in a production process. A big argument of ecological and biophysical economics is that many of what have appeared as “productivity increases” to economists has historically actually been increasing throughput of energy. Regeneration meanwhile is the idea that when natural resources are left unused they start to regain their original characteristics. Thus the essential distinction between non-renewable and renewable resources is their rate of regeneration. Technically fossil fuels, even considering the greenhouse gas effect, do have a rate of regeneration. However since we are thinking in terms of human resource use the time scale for regeneration, and the level of resource unemployment required to get there, these resources can be called non-renewable given how extremely slow their rate of regeneration is. That last point is worth emphasizing, renewability only matters relative to human time scales. No humans and the time it will take for oil to reform in the ground is irrelevant- at least to us.
This leads us to our final concept: the maximum sustainable scale. This refers to the idea that there is a level of employing a natural resource where the rate of throughput, ie the rate at which this material or energetic natural resource is used, is equal to the rate of regeneration. In other words there is a rate of use where the stock of this natural resource remains constant. A scale of production beyond that will deplete the natural resource and, for our purposes here especially important, lead to diminishing returns over time. This can potentially end with the resource being used up all together. Thus, to simplify here we’re only going to be dealing with homogenous nature. In reality of course, there are many different material forms of nature that are important to different production processes and techniques and have different rates of regeneration.
Thus, rather than dealing with increasing returns in rice, I’m going to deal with decreasing returns in grapes. In this example “Monocropping” grapes leads to an overuse of the soil and less returns each year. At maximum production, Friday produces one less grape meal each year. The less resources devoted to producing grapes, the slower the “decreasing returns” are. For simplicity’s sake I’ve not only assumed the midpoint of the production possibility frontier is the point that maximizes utility but that it is also the spot of maximum sustainable production for Grapes. For those not up on the jargon, I’m assuming that the combination of rice and grape Robinson Crusoe or Friday would choose to produce without specialization both leads to them getting the most enjoyment but also involves producing grapes at the maximum sustainable scale. In other words they would be led by their “short run” self interest to choose to produce the level of grapes and rice that leaves their stock of natural resources constant. With all that in mind, let’s go to the data. I’m starting with the same numerical values as i used in the first post and will try to stick to those numerical values for every Crusoe post I do.
So what’s going on here? What happened is that there was a jump to the no specialization “special case”. That is, there is a point at which Crusoe’s absolute advantage is identical for both goods and thus there are no gains from trade. Because of decreasing returns in grape production, the gains from trade were eliminated by changing relative prices . This is a point that never gets discussed enough- the difference in the absolute advantage Robinson Crusoe has and thus the difference between the opportunity costs of production are changed under any situation that isn’t constant returns to scale. This is why the handwaving when discussing the situation where Crusoe’s absolute advantage of both goods in undergraduate economics classes are so misleading. Yes it is a “special case” but in a situation where some fundamental forces are driving changes in relative prices it becomes a point that all models will pass through. Thus as we’ve seen, if you assume “short run” maximization in a situation where relative prices aren’t constant (which is most situations) then eventually short run gains from trade will disappear or explode. As we’ve also seen however, in both cases “short run” optimization is inconsistent with intertemporal optimization.
The reason we get the result that output is actually lower in “equilibrium” even as the decreasing returns end is the nature of “maximum sustainable production”. The jump to no specialization led to production at the midpoint of both Crusoe’s and Friday’s production possibilities frontier. This led to no further decreases in natural resources but also not a return to the original “stock”.
What is truly galling about this result is decreasing returns to scale with regard to natural resources was an essential part of Ricardo’s rent theory. That following static comparative advantage when one good experienced diminishing returns not only eliminated gains from trade but lowers equilibrium output relative to the no specialization case makes discussions of comparative advantage infuriating to those with some knowledge of the history of economic thought and the inherent limitations of this perspective.
The point of this isn’t that professors should be using the Robinson Crusoe analogy to convince their students of protectionism and militate against specialization instead of convincing them of free trade and specialization. The point is, are you sure your students could follow either of these broadsides against the way the usual comparative advantage model is used? If not, and i suspect the answer is no, then this part of every undergraduate economics education is propaganda and not education as such. Students should be able to explain and use economic concepts and because the basic example isn’t intuitive and isn’t really connected to their lived experiences, they generally don’t. Instead they are rushed along to more baroque and mathematically complex versions of the same models that are also not very understandable. This leaves students in a mass of confusion, but they still remember the slogans long after which, to a cynical man, might appear to be the point.
The word “real” has an extremely tangled and messy history in economics. Because of economist’s penchants for price level indices and the constant division of monetary sums by price level indices, this is a common implication of the word real. However, economists ALSO love talking about the “veil of money” and looking at the “real” things that are going on. Further, economists have historically been interested in barter economies and the existence of a “neutral money” that would provide a common method of transaction (dealing with the “inconveniences of barter”) without any effects on how the economy functions. This still gets attention (as I’ve written about previously here ) in the notion of a “natural” rate of interest and is if anything having rising policy influence. Thus economists mean by real both the exchange value ie the relative prices of various forms of output that are also sometimes summed together AND the underlying use values and physical structures that underlie the economy. Thus real wages can mean a sum of money a worker receives deflated by a price level OR the basket of output a worker is paid or both at the same time. As the reader can Imagine, this causes enormous confusion (I wrote about this last year here here.
I personally think (as I’ve written before) that deflation by composite price level indices is extremely overused and that ratios of flows to stocks, flows to flows and stocks to stocks should come more in vogue. These ratios do much to contextualize nominal sums in a way that makes sense and does so without having to mess around with price levels. A nominal to nominal ratio has the same value as a real to real ratio and a nominal to real ratio is invalid. Price level indices are also used without any true grasp of what underlies them, as Morten Jervens has shown in his both hilarious, infuriating and depressing work around african national statistics and their abuse by western mainstream economists. For example asking the question of how price level movements could improve the household income to household debt ratio would lead clearly to the notion that it is not inflation that workers need but wage increases and the deflating debt sums is a fun exercise with no practical meaning. It tells you nothing about the worker’s experience. Saying the “real” value of the debt is decreasing or increasing because you’re dividing it by a price level is like saying the temperature value of the debt has risen or fallen because the temperature rose or fell.
For all these reasons I will be using the term biophysical in the places most mainstream economists (and even some heterodox economists) use the term real to refer to underlying input-output relationships, production processes, physical amounts of output etc. I’m attracted to the term biophysical because it is precise, clear and because it reminds the reader that monetary economies where production decisions are made in monetary terms have impacts on the world in which we live and on the consumption of resources, both renewable and nonrenewable. It also is aimed at reminding the reader that any argument in nominal terms which implies impacts on the biophysical world that violate the laws of thermodynamics are prima facie invalid even if the assumptions are all otherwise consistent in balance sheet terms.
I will refer to price level deflated sums as price level deflated sums as economics has not developed an adequate alternative. Alternatively direct payment in biophysical goods will be referred to as a “basket of goods”. If anyone has an alternative pithy word for price level deflated sums please let me know!