Keynes, The General Theory: Chapter 3

John Maynard Keynes,The General Theory (BN Publishing, 2008), pp. 23–34.

I.

This chapter contains Keynes’ “general theory” in a nutshell.  All the concepts mentioned in this chapter will be brought up and explained in the subsequent chapters.

A few definitions, which we will return to throughout the book,

  • Factor Costs: The money amount paid out by the entrepreneur (for Keynes, the entrepreneur is one who commands the factors of production) to purchase the factors of production.  This does not include money paid out to other entrepreneurs for complimentary capital goods (so, we are talking about only the original factors of production);
  • User Cost:  This is an intertemporal opportunity cost.  It is equal to the money paid out to other entrepreneurs and the sacrifice incurred by using these capital goods, rather than keeping them idle;
  • Income:  This is profit, or the (monetary) “value” of the resulting output minus the factor cost and user cost ([price][output] – [factor cost + user cost]).
  • Total Income (Proceeds): Similar to the concept of “aggregate surplus,” or income plus factor cost (since the factor cost is income for owners of these factors).
  • Aggregate Supply Price:  The expectations of minimum total income sufficient to justify the employment of one’s resources.

Thus, given technique, available resources, and factor cost the entrepreneur will employ a number of resources decided by the aggregate supply price.  In other words, the entrepreneur will look to maximize proceeds minus factor costs.

Z = aggregate supply price of output from employing N men, or Z = φ(N) — this is the aggregate supply function.

D = proceeds expected from employing N men, such that D = f(N) — this is the aggregate demand function.

If D>Z, entrepreneurs will increase employment (N will be a greater figure) until D = Z.  Employment is decided where D and Z intersect.  This Keynes calls “effective demand,” or the equilibrium employment of resources that can be expected under certain conditions.

Finally, Keynes goes into another criticism of classical theory (or Say’s Law), where “[s]upply creates its own [d]emand.” Keynes interprets this to mean that φ(N) and f(N) must be equal at all levels of N, and when Z increases so does D by an equal amount.  Instead of having a single possible equilibrium, this relationship suggests an infinite number of possible equilibrium values, where the volume of employment is determined only by the upper limit of the marginal disutility of labor.  Keynes’ main argument against Say’s Law is that aggregate demand is not always equal to aggregate supply (I imagine we can interpret this as the existence of a “general glut”).

II.

Given a technique, resources, and costs, income depends on N (level of employment).  Society will consume a certain part of this income (D1) based in its propensity to consume.  Thus D1 is based on aggregate (total) in come.  In turn, N will depend on D1 and D2, where the latter refers to expenditure on “new investment.”  D1 + D2 = D = φ(N); D1 is a function of N and we will call this relationship χ(N).  Thus φ(N) – χ(N) = D2.  The “essence” of the general theory of employment is that N depends on φ (aggregate supply function), χ (propensity to consume), and D2 (new investment).

For each and every level of N there is “a corresponding marginal productivity of labor in the wage-goods industries,” which determines the real wage.  N cannot exceed the “value which reduces the real wage to equality with the marginal disutility of labor.”

Keynes established that χ < φ, so the gap has to be filled by D2.  If D2 < φ – χ we find ourselves at an underemployment equilibrium.  N is determined, again, by χ and D2, but N also depends on the level of real wages; it is not N which determines real wages (as postulated by the Classical economists — see my notes for chapter two).  Thus, at underemployment equilibriums we find ourselves in a situation where real wages are greater than the marginal disutility of labor.

This is where Keynes sees a major problem with advanced, growing, capitalist economies.  He suggests that these economies suffer from insufficient effective demand even before full employment is achieved, even though real wages are higher than the marginal distutility of labor.  The wealthier the community, or the greater φ is, the greater will be the gap between φ and χ.  According to Keynes, this is because the savings of the wealthy outstrip the consumption of the poor, and the gap can only be fulfilled by a growing D2.  The problem here, writes Keynes, is that as more capital is accumulated the rate of interest will have to fall in order to induce more investment — Keynes postulates that this will not occur (to a sufficient degree).  We are introduced to concepts that Keynes will explore in greater detail later: the marginal efficiency of capital, the liquidity preference theory of interest, the propensity to consume, and his theory of prices.

III.

This section is a brief interpretation of why Ricardian economics won over other doctrines.  Keynes notes that Malthus attempted to grapple with the idea of effective demand, but ultimately was not persuasive enough to make his ideas academically popular.  Therefore, effective demand goes unmentioned in the work of Marshall, Edgeworth, and Pigou.

Keynes makes some wild claims, including that the counter-intuitive nature of Ricardian economics made it prestigious, and that its consistent and logical “superstructure” made it beautiful.  Finally, it justified the actions of the wealthy, who were the dominant social authority of the time.  Despite the unquestioning attitudes of the profession towards Ricardian economics, the latter has not done well in its predictive powers.  At least, Ricardian theory has oftentimes been unable to fit the facts.  As such, economics lost the prestige offered to other, more accurate sciences.  Ricardian economics, concludes Keynes, might be how we would like our world to be, but it is not the world we live in.

One thought on “Keynes, The General Theory: Chapter 3

  1. Blue Aurora

    Out of curiosity Jonathan, did you see the footnote in Chapter 3 which refers to Chapter 20: “The Employment Function”? It’s in Book V where you can find the equations that give the multiple equilibria model.

    Reply

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