The Cambridge Capital Controversy, Essay Example

In history, economics has had numerous controversies based on the theories that are formulated by economist in a bid to understand and predict certain economic principles and facets of the economy. Some of these controversies include; the elasticity of substitution unity (investment function controversy), Keynesian monetarist dispute, liquidity preference loanable funds dispute. The Cambridge –Cambridge controversy is probably one of the most discussed controversies of the late 20^th century. The dispute is between Cambridge, Massachusetts and Cambridge, England, as pertains to the capital theory. Many economists at the time weighed in on their concerns on how capital was treated within their distinctly held perceptions of capital. This paper will focus on three major issues that are engrained within the controversy, and in doing so, seek to identify the areas where some of the arguments went wrong.

Determination of the Interest Rate and Savings

It is widely accepted that an individual’s saving is generally influenced by different factors, such as their age, income, job type and group among others. The Neoclassical economists focus on the demographic feature and characteristics, and they alternatively accept the assumption that savings in a constant portion of income when a simplified description is required for students. The economists from Cambridge also focused on the importance of other institutions, such as corporations in the determination of class behaviour and savings (here the individual is either a pure capitalist or a worker). Bothe these hypothesis cannot be simply verified. A good example is how statistics on a company’s savings may provide an unreliable and unfounded picture. This is because one can safely presume that individual savings can be substituted by corporate savings and that individuals have the ability to partially or completely see through the corporate veil. It is important to note that there has been recent evidence supporting this view. This is because, the current tax structure employed within the United States and many developing economies show that investment is indeed determined by the level and the amount of retained earnings.

The query arises in the specification of the savings behaviour of individuals and corporate entities. I believe that the solution lies in how Cambridge (U.K.) have defined the role that savings behaviour plays in determining interest rate in long-run equilibrium.

Here all the income is consumed and the interest rate is equal to the growth rate of  divided by savings. In long-run equilibrium, competitive profit-maximizing competitive firms have their rate of return on every capital good equal to the rate of interest given all relative prices are held constant. In other words, it is the marginal productivity of every commodity or good sold in terms of itself.

The atypical theory of causation is the root of the controversy in this case. The economists at Cambridge (U.K.) claim that the rate of growth and  determine the rate of profit, and as such, it determines the marginal productivity of goods. This view is founded on the fact that without knowledge of the factor supplies or the production function, one can solve for  in equation (I). Then having solved for  one can solve for the capital goods-labour ratios and marginal productivity of every good. This view faces three objections.

First, there is the lack of distinction between causation in the formal examination of the structure of a set of equilibrium circumstances causation in the temporal sense. Causation has economic significance only in the temporal sense because there is a given vector of labour and capital goods at any given time. These endowments define the rate of interest and the marginal productivity of the different capital goods within the conventionally used extremely simplified models. Putting the savings behaviour into consideration, this defines the change in capital goods stocks; the economy will converge to the point where the interest rate is equivalent to the growth rate divided by the marginal propensity to save; however, the capital goods-labour ratio define the rates of return on the different capital good at any given point in time.

Second, general models have simultaneity in the determination of the interest variables under both short-run and long-run equilibrium.

Third, the approach employed by Cambridge (U.K.) cannot be used to determine the relative factor prices in the case where there are numerous factors. A good example is when labour is not homogeneous, one can determine the relative prices of the different kinds of labourers using a given theory. The theory of marginal productivity explains all the relative prices at the same time; the Cambridge theory fails to consider this despite the fact that the prices for the different levels and types of labour are determined, the average wage has to fulfil the equation provided by Cambridge.

Reswitching of Techniques

In balanced growth, one can compare economies, where one set of techniques will employ low and high rates of interest while other techniques employ an intervening interest rate. This is called “reswitching”, and it is the extension of multiple rates of return to a whole economy. This implies that there is no strong implication for comparison of economies in steady state using the weak qualitative assumptions that are conventionally made in economics. For example, the implications of diminishing return as a result of the convexity of technology. This means that reswitching determines that stronger assumption are required in deriving simple comparative dynamics propositions. These assumptions have to be stronger than those employed in the derivation of qualitative properties in economies with initially given endowments and in the existence of competitive equilibrium. Reswitching potentially plays a role similar to that of capital theory. However, there are two areas of doubt and concern.

First, there is limited interest in steady states. The best-run economies do not consider steady rates in their economic analyses. These economies employ different consumption paths that start at the present prevailing conditions. When conventional assumptions are employed, one cannot make qualitative statements about these consumption paths. Furthermore, all kinds of paradoxes can be easily developed by employing a steady-state analysis. A good example is the opening of free trade may potentially lower steady-rate consumption. A competitive equilibrium cannot sustain all of the viable steady states found within a life-cycle model; this is the one maximize utility at steady states.

Second, there are few commodities that have an upward sloping demand curve, as such the paradox that is proposed by Giffen is irrelevant for most commodities but relevant and applicable to such upward-sloping demand curves. Giffen’s paradox has some empirical evidence that generate interest in it. There hasn’t been such empirical evidence of interest in reswitching. This is predominantly due to the fact there are weak conditions under which the paradox can be ruled out. A good example is the fact that reswitiching cannot take place if through an increase in labour, the input of another factor can be reduced or increased while other factors are held at constant within only one industry in the whole economy. In order for reswitching to occur, there have to be considerable changes in the price of different capital goods accompanied with the lack of substitutability in all industries within the economy. This is because the change in relative price of different capital gods leads to different processes having different levels of capital intensity at different rates of interest.

Part of the reason why this concept is generally disputed is the fact that there is need for a distinction between microeconomic and macroeconomic models in a dynamic analysis. Even though these two kinds of models should be related to some extent, one class of questions cannot be answers using both kind of models. General equilibrium analysis requires that fairly weak restrictions are imposed on every individual’s preferences. Precise quantitative and qualitative answers are required in macroeconomics which requires that one makes stronger assumptions.

Aggregate Capital

Aggregate capital is arguably the biggest point of dispute and controversy in the theory employed by Cambridge (U.K.) economists. These economists employed an aggregate capital stock in their economic analysis. In neoclassical distribution, there is no use of aggregates, and only convexity of technology is needed in making qualitative statements as those made above. One encounters numerous difficulty in making a comparative dynamic statements on the aggregate value of consumption, interest rates and capital stock under long-run equilibrium. For instance, the rate of interest may not be equal to the changes in the consumption for every unit of change in capital stock value; this is because of the changes in capital goods’ relative price. The fundamental qualitative properties of economies that are not inn a steady state cannot depend on the ability to form aggregates and analyses that employ steady states may be misleading and having little to no economic significance. When observed practically, aggregates are the values that economists deal with despite the fact that the individual units within these aggregates all have different and possibly distinct properties. There are very restrictive conditions within which aggregated values and concepts can be used as homogeneous factors of production. There are certain situations when aggregated values introduce errors within the analysis which can render the analysis irrelevant.

Reasons for Controversy

1. The Cambridge (U.K.) economists hold that the choice to follow the alternative approaches to capital theory is an ideological issue. This means that the approach used by the Cambridge (U.K.) fails to seek empirical validity of the concepts entrenched within their ideological approach. The economic analysis cannot be distinctly separated from ideology. This makes the approach lack objectivity and is subject to an individual’s interpretation relative to their generally accepted ideologies on different economic aspects. Ideology arguably has a far less important role when it comes to economic analysis. Economic analysis is supposed to be objective devoid of any ideological influences that are not founded on empirical evidence.
2. The Cambridge (U.K.) approach has received no empirical research and evidence to verify the underlying hypotheses at all levels. The economic data that is currently available within the hypotheses in the approach is not sufficient to validate the approach. As such, the economists should have provided alternative approaches that would have provided a much clearer representation of the tests that ought to be performed. Most of the Cambridge (U.K.) hypotheses such as the alternative savings hypotheses are not testable.
3. The role of economic theory has been fundamentally misunderstood by the Cambridge (U.K.) economists as depicted in the approach they used. All classes of economic problems cannot be analysed and understood by one model. Each problem is embodied and analysed with its own model according to the different variables associated with the problem in question. For example, long-term movements certain macroeconomic variables cannot be explained using an aggressive growth model. This is because each variable is distinctively unique from the other, though they may be related in one way or another. Each economic variable moves according to movements of other economic factors embodied with a given economic model. A model that fails to consider all the relevant variables fails to achieve an objective and factual analysis.
4. Individuals are prone to dislike concepts and ideologies that they do not comprehend. The treatise on capital theory by the Cambridge (U.K.) economist fails to put into consideration different consumption models that already exist on the subject. Interest rates are largely perceived to be intertemporal prices by the neoclassical economist. The capital theoretic models and static models all depict similarity in the relationship between marginal products and price (interest rates). Most economists would readily adopt the competitive profit-maximizing model in describing and understanding the economy’s behaviour in the long-run than in the short-run. This is because in the long-run, competition is much higher with firms that maximize profits performing better in this kind of model as opposed to the short-run model. The marginal-productivity theory therefore appears to be more reliable as opposed to using aggregation of capital, savings behaviour and double switching.

The distinct difference between the intertemporal model and the static model employed by the Cambridge (U.K.) economists. There is an absence of the futures markets within the static model which fails to meet the criteria of an analysis of expectation formation in dynamic economies. Even though they have pointed out the role that stochastic disturbances and expectations play in analysis, the role of expectation formation within their proposed model has been concealed by concentrating on an obsolete steady-state analysis.

In conclusion, the Cambridge (U.K.) economists have failed to discredit the marginal-productivity interpretation of interest rates, and in the process, they have fused capital theory with their own ideological interests. By virtue of mixing ideology with economic analysis, they create manage to create a model that is not only unreliable, but also inaccurate in its analysis. By introducing the static approach, as embodied in the concept of aggregate capital, they fail to fully understand and analyse a dynamic economy, one that most nations in the 21^st century possess as there are certain situations when aggregated values introduce errors within the analysis which can render the analysis irrelevant. The role of economic theory has been fundamentally misunderstood by the Cambridge (U.K.) economists as depicted in the approach they used