unit2_feb2015.pdf

Funded by the Institute for New Economic Thinking with additional funding from Azim Premji University and Sciences Po

2INNOVATION AND THE TRANSITION FROM STAGNATION TO RAPID GROWTH

HOW IN THE 19TH CENTURY SOME COUNTRIES, LED BY BRITAIN, BROKE THE VICIOUS CYCLE OF ECONOMIC STAGNATION AND POPULATION GROWTH.You will learn:

What a Malthusian population trap is.

How technical progress allowed some countries to escape it.

Why the Industrial Revolution started in Britain.

How relative wages, the cost of machinery and other prices matter for economic decisions.

How innovation creates temporary rewards for the innovator that are subsequently destroyed by competition.

February 2015 beta

See www.core-econ.org for the full interactive version of The Economy by The CORE Project. Guide yourself through key concepts with clickable figures, test your understanding with multiple choice

questions, look up key terms in the glossary, read full mathematical derivations in the Leibniz supplements, watch economists explain their work in Economists in Action and much more.

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in 1845 a mysterious new disease appeared for the first time in Ireland. It caused potatoes to rot in the ground; by the time it became clear that a plant was infected, it was too late. The potato blight, as it became known, devastated Irish food supplies for the rest of the decade. Starvation spread. By the time the Irish famine had ended about a million people had died, out of an initial total of 8.5 million. This was a far worse mortality rate than any country would suffer during the second world war.

The Irish famine sparked a worldwide relief effort. Former slaves in the Caribbean, convicts in New Yorks Sing Sing prison, Bengalis both rich and poor, and Choctaw Native Americans all donated money, as did such celebrities as the Ottoman Sultan Abdulmecid and Pope Pius IX. Then as now, ordinary people felt empathy for others who were suffering, and acted accordingly. But many economists were much more hard-hearted. One of the best-known, Nassau Senior, consistently opposed British government famine relief, and was reported by a horrified Oxford University colleague as saying that he feared the famine of 1848 in Ireland would not kill more than a million people, and that would scarcely be enough to do much good.

Seniors views were morally repulsive, but did not reflect a genocidal desire to see Irish men and women die. On the contrary, they were a reasonably logical consequence of one of the most influential economic doctrines of the early 19th century, Malthusianism. This was a body of theory developed by an English clergyman, Thomas Malthus, in An Essay on the Principle of Population first published in 1798. In this unit we will look at how Malthuss theory can help us understand the long, flat section of the hockey stick graph we saw in Unit 1. That, in turn, can help us to better understand Nassau Seniors views, although it certainly does not excuse them. We will also look at how and why some parts of the world moved on to the upward sloping portion of the hockey stick at some point in the late 18th or early 19th centuryironically, at more or less the same time that Malthusian theory was formulated.

2.1 MALTHUSIAN ECONOMICS

one of the most important concepts in economic theory is the idea of diminishing returns. To understand what this means, imagine an agricultural society that produces just one good, food. Imagine that food production is very simpleit involves only farm labour, working on the land. In other words, ignore the fact that food production also requires a variety of equipment and buildings, from spades to combine harvesters, and from chicken coops to grain elevators and silos. In the language of economic theory we are going to ignore these inputs and assume that food is produced with only two factors of production: land and labour. Now think about what would happen if, for some reason, the population started to increase

UNIT 2 | INNOVATION AND THE TRANSITION FROM STAGNATION TO RAPID GROWTH 3

(we will see why this might happen later). As it does so, the land under cultivation expands as well. It seems reasonable to assume that the best land was cultivated first. Over time, therefore, as population expands, the farmer will be forced to cultivate less fertile and less productive land. This means the additional workers will be less productive, and produce less additional food over time. Eventually, all the available land in the country will be cultivated. As the population continues to expand, what happens then? The amount of available land for each worker will start to decline. Once again, it seems reasonable to assume that, as we add successive workers to the fixed land area, the total output will increase; but the extra output obtained by each successive worker declines. So the average output per worker falls.

To summarise, as we add extra workers to the fixed land area in the country concerned, the extra food produced by each additional worker declines over time. Economists call this the law of diminishing returns. Diminishing returns implies that as population increases, farmers incomes on average will fall. This makes sense: a greater population means that worse land is being cultivated, or that more workers are having to be squeezed into a fixed amount of land; and this implies that living standards decline.

Is it sensible to assume that production is characterised by diminishing returns? After all, the real world is much more complicated than the simple thought experiment outlined above. Nevertheless, there is evidence for diminishing returns in the historical record, if we know when and where to look. A famous example is the Black Death of the 14th century which we discussed in the previous unit: between a quarter and a third of Europes population died between 1348 and 1351, and the plague reoccurred frequently in the succeeding centuries. If diminishing returns predict that a rising population should lead to falling living standards, then it should also be true that a falling population increases living standards.

As we saw in Unit 1, this is exactly what happened: the real wages of English building workers started to rise at the time of the Black Death, and had doubled by the middle of the 15th century. Real wages also rose sharply in other countries for which we have real wage evidence, such as Spain, Italy, Egypt, the Balkans and Constantinople (present-day Istanbul). In Italy, an irate Florentine complained in 1363 that wage costs were much higher than they used to be, and commented that ordinary people now wanted the dearest and most delicate foodswhile children and common women clad themselves in all the fair and costly garments of the illustrious [people] who had died.


DISCUSS 1: DEFINING ECONOMIC PROGRESS

Why do you think our Florentine observer in 1363 was irritated about the fact that real wages had increased? Compare the use of the growth of real wages and of GDP per capita as measures of economic progress; what arguments can you propose in favour of each, and what are the drawbacks of each measure? The philosopher John Rawls would have proposed a third: the living standard of the least well off segment of the population. What are the advantages and disadvantages of this measure?

Try out your arguments on others. Do you agree or not? If you disagree, are there any facts that could resolve your disagreement, and what are they? If there are not, why do you disagree?

On their own, diminishing returns do not explain the long, flat portion of the hockey stick. All the concept says is that living standards depend on the level of population. It doesnt say anything about why, over long periods, living standards and population didnt change much. The other main element of Malthusian theory is Malthuss explanation for what determined the change in a countrys population. Some years before Malthus developed his theories, an Irish economist, Richard Cantillon, had stated that Men multiply like mice in a barn if they have unlimited means of subsistence. Malthusian theory essentially regarded people as being not that different from other animals. This may be one reason why Malthuss essay was an important influence on Charles Darwin (1809-1882), who pioneered the study of biological evolution.

Imagine a herd of antelopes on a vast and otherwise empty plain. There are no predators to complicate their lives (or our analysis). When these antelopes are better fed, they live longer and have more offspring. When the herd is small the antelopes can eat all they want, and the herd gets larger. Eventually the herd will get so large, relative to the size of the plain, that the antelopes can no longer eat all they want. As the amount of land per animal declines, their living standards will start to fall. This reduction in living standards will continue as long as the herd continues to increase in size.

Since each animal has less food to eat, the antelopes will have fewer offspring and die younger; population growth will slow down. Eventually, living standards will fall to the point where the herd is no longer increasing in size. The antelopes have filled up the plain. At this point, each animal will be eating an amount of food that we will define as the subsistence level. When the animals living standards have been forced


down to subsistence level as a result of population growth, the herd is no longer getting bigger. If animals were eating less than the subsistence level, the herd would actually start to get smaller.

Much the same logic would apply, Malthus reasoned, if we considered a human population living in a country with a fixed supply of agricultural land, rather than antelopes on the savannah. As Malthus said, Elevated as man is above all other animals by his intellectual facilities, it is not to be supposed that the physical laws to which he is subjected should be essentially different from those which are observed to prevail in other parts of the animated nature. As long as people have unlimited subsistence they would multiply like mice in a barn; but eventually they would fill the country, and further population growth would push down real wages as a result of diminishing returns. Falling living standards would slow population growth, as death rates increased and birth rates fell; ultimately real wages would settle at subsistence level, again defined as the level at which population would neither rise nor fall.

It is worth pausing for a moment to ask what would happen if population growth did not slow down as real wages fell. With no mechanism to slow down population growth, population would continue to rise to the point where people started to starve. Malthusian economists thought that something like this had happened in Ireland, and blamed the Irish famine on overpopulation. Its ultimate cause, they believed, was the failure of the Irish peasantry to have fewer children, despite their extreme poverty. As long as Ireland remained overpopulated, famine was inevitable. The only sustainable solution as far as Malthusians were concerned was a radical decline in both the Irish population and the Irish birth rate. Nassau Senior and many of his contemporaries interpreted the famine with the economic ideas they had at their disposal. Their mistake was to allow these theories to harden their hearts towards the suffering of other people.

In the more general version of Malthusian theory, as we have seen, there is a mechanism to prevent famine: population growth will slow as real wages fall and eventually come to a halt when living standards have declined to the subsistence level. As long as this subsistence level is high enough to prevent starvation there will be no famine. That is the good news. The bad news is that, in the long run, the combination of population growth and diminishing returns will always drive the real wage down to the subsistence level. Workers will never see their living standards rise in the long run.

Malthus recognised, however, that human beings are different from animals: we are smarter. As we saw in the previous unit, one consequence of human ingenuity is technological progress, which can squeeze a lot more output from the same amount of inputsand therefore makes us better off. At any time it is possible that technological progress could raise the total amount produced per worker. If the bargaining power of workers were sufficient, as would be the case when labour was scarce, real wages would rise above subsistence. But Malthusian theory predicts that this improvement in living standards would only be temporary. Increasing real wages above the subsistence level would lead to population growth, and hence to labour


abundance rather than labour scarcity. The reduced level of output per worker, and diminished bargaining power of the poor, would eventually force real wages back down to subsistence. Even if the workers productivity were to increase, therefore, their numbers would go up, but not their wages. The writer H.G. Wells, author of War of the Worlds, wrote in 1905 that humanity spent the great gifts of science as rapidly as it got them in a mere insensate multiplication of the common life.

2.2 MODELLING MALTHUSIAN ECONOMICS

malthuss argument is summarised in Figure 1, using two diagrams.

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Figure 1. A Malthusian economy.

INTERACT

Follow figures click-by-click in the full interactive version at www.core-econ.org.


We start in the left portion of the figure at point A, which shows that the average income of people who work the land is low at a medium population level. We can see that average income would be higher at point B, where the population is smaller. Both A and B are answers to the hypothetical question: if population were the amount indicated on the horizontal axis, then what would the average income be? There are many such points, each for a different level of population. If we plot all of these points, including A and B, the resulting line gives the relationship between population and living standards. It slopes downward to the right because of diminishing returns: higher population implies a lower average income.

Malthus argued that the economy moves from a situation with high population and low living standards like A (like Ireland prior to the potato famine) and a situation like B, with a lower population and higher living standards (like Ireland prior to the famine), and also in the reverse direction.

To fully understand the Malthusian model as a movement between A and B, it is also useful to plot the relationship between average income and population growth. We do this in the right-hand part of Figure 1.

Let us assume that when the average income of people that work the land is low, living standards are at the subsistence level. Tracing this across to the population growth diagram at point A, we can see that population growth is equal to zero (that is, the population is constant). When average income rises above this level, population growth is positive, as shown by point B. If we join points A and B this shows the relationship between population growth and living standards. It slopes upward to the right because higher incomes imply more births and lower death rates. We can see that if average income should fall below the subsistence level, population growth will be negative (meaning that the population falls).

Putting together both parts, the diagram explains what we refer to as the Malthusian population trap. Population will be constant when average income is at the subsistence level, it will rise when average income is above subsistence, and it will fall when average income is below subsistence. The trap is that even if productivity increases, living standards in the long run do not.

TEST YOUR UNDERSTANDING

Test yourself using multiple choice questions in the full interactive version at www.core-econ.org.


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Figure 2. The introduction of a new technology in a Malthusian economy.

Figure 2 shows how the effects of the introduction of a new technology can be modelled in a Malthusian economy. The economy starts at point A, where there is a medium-sized population and the average income is at the subsistence level. An advance in technology (for example, better seeds) means that the average income will be higher for any level of population. This results in the entire average income line shifting outward as shown by the blue line in Figure 2. At the initial population level, average income increases and the economy moves to point B on the new average income curve. At point B, average income has risen above subsistence and therefore the population starts to grow. As population increases, the economy moves down the average income curve in the left hand panel, and the average income starts to fall again. As average income falls back toward the subsistence level, population growth slows and the economy moves back down the population growth curve in the right hand panel. The process eventually comes to a halt at a new, higher level of population. At point C, wages are once more back at their original subsistence level.


2.3 WAGES AND LAND RENTS IN A MALTHUSIAN ECONOMY

we now have a theory to explain the long, flat portion of the hockey stick. Human beings periodically invented better ways of making things, both in agriculture and in industry, and this periodically raised real wages above subsistence. But on each occasion the higher real wages led young couples to marry earlier and have more children, and it led to lower death rates. This caused population growth, which eventually forced real wages back to subsistence levels. The major long run impact of better technology in this Malthusian world was therefore more people, which might explain why China and India, with their relatively sophisticated economies, ended up with such large populations.

This is an over-simplified account of economic life before the Industrial Revolution, but there is some evidence to support it. As we saw in Unit 1, real wages were remarkably constant over the very long run before the 19th century, just as the theory predicts. The stately homes and palaces of 17th and 18th century Europe are not inconsistent with the theory, even though they suggest that living standards were rising substantially before 1800 in Europeat least for some people. As population continued to grow, the demand for food also grew, and the land on which that food was cultivated became more valuable. Crowded land is valuable land. Real wages would be flat in the long run, but the income that aristocratic landowners made from hiring others to cultivate it, or renting out their land, would rise.

In a Malthusian world, therefore, population growth should have led to the relative economic position of labour falling, and to the relative economic position of landowners rising. In other words, the division of the economic pie should have moved in favour of the aristocrats who built the stately homes, and against ordinary workers. Figure 3 shows that this increase in economic inequality is exactly what happened in England between 1500 and approximately 1850. It plots an index of the ratio of unskilled wages to the income derived from owning an acre of land, where the index is set equal to 100 in 1900. The figure does not allow us to compare workers and landlords incomes at any point in time; different landowners owned different amounts of land, so this would be an impossible calculation. Rather, it allows us to see how the relative incomes of these two groups changed over time.


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Figure 3. Ratio of unskilled wages to income from land in England, 1500-1936.

Source: ORourke, K. H., and Williamson, J. G. 2005. From Malthus to Ohlin: trade, industrialisation and distribution since 1500. Journal of Economic Growth 10, pp. 534.

DISCUSS 2: LIVING STANDARDS IN THE MALTHUSIAN WORLD

Imagine that the population growth schedule in Figure 1 shifted to the left (with fewer people being born, or more people dying, at any level of income). What would happen to long run living standards in a Malthusian world?

2.4 ESCAPING FROM MALTHUSIAN STAGNATION

the model of the economy outlined above does not offer an optimistic vision of economic progressat least as far as ordinary workers are concerned. Even if people succeeded in improving technology, in the long run workers were condemned to enjoy no more than the subsistence level of real wages. And for many centuries, real wages increased slowly, if at all.


Yet living standards did eventually increase, and they did so rapidly and permanently. This means that the Malthusian model we have presented stopped providing a reasonable description of the world. The top panel of Figure 4 is one way to see this. It shows English real wages and population levels from the 1280s to the 1860s.

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Figure 4. Escaping the Malthusian population trap: Population and real wages in England, from the 1280s to the 1860s.

Source: Clark, G. 2005. The condition of the working class in England, 12092004. Journal of Political Economy 113: 130740, pp. 1310, 1312.

The bottom panel of Figure 4 is a different way to track the movement of two variablesin this case, population and the real wageover time. It shows the same data as in the top panel. In this case, each point in the figure shows the combination of the level of the population and the level of the real wage at a given year. This figure can be matched to the model in Figures 1 and 2, in which we have the same variables on the two axes.


In the bottom panel of Figure 4 we can see that in earlier centuries there was a clear negative relationship between population and real wages: when one went up the other went down, just as simple Malthusian theory suggests.

Eventually, however, the relationship began to break down. First population started increasing without real wages falling much, if at all. Eventually the economy moved to what seems to be an entirely new regime, with both population and real wages simultaneously increasing.

The Industrial Revolution was essential to Britains escape from stagnation. What changed?

First, our simple thought experiment illustrated in Figure 2 looked at the implications of a one-off improvement in technology. This led to real wages increasing and then falling again as population started to grow. But what if technology started to improve constantly? What if it became sufficiently rapid and strong that the average income curve shifted so much that population could not entirely catch up; so real wages never had the time to fall back to their subsistence level, despite population growth? In that case, the economy might be able to take off and achieve a durable increase in living standards as long as the technical progress continued.

Britain could also import food from its land abundant colonies in the New World. As a result, population growth in Britain did not have to be accommodated by putting more farmers on a strictly limited area of land. This reduced the pressure of diminishing returns on which the Malthusian population trap is based. As you can see by looking back at Figure 3, this had implications for income inequality as well. Real wages not only increased in absolute terms from the middle of the 19th century, they increased relative to the incomes enjoyed by aristocratic landowners.

We will see in Unit 17 that this change in the relative fortunes of workers and landlords was probably partly due to the growing integration of the world economy, which allowed the demand for food in Britain to be met in part from crops grown in North America, reducing the scarcity of land in Britain.

Eventually something else also changed: as people gained higher incomes, many chose to have smaller families. This was the beginning of the demographic transition mentioned in Unit 1. If the population growth curve in Figure 1 stopped sloping upward, or even started to slope downward, then population growth and diminishing returns would not prevent sustained wage rises. The demographic transition would make the escape from the Malthusian population trap irreversible.

By the end of the 19th century, the old, Malthusian relationship between living standards and population growth was breaking down in many rich countries.


DISCUSS 3: DEMOGRAPHIC TRANSITION

Why do you think the positive relationship between living standards and population growth in Figure 1 broke down? Explain why population growth might become slower when countries become richer.

In this unit, however, we will concentrate on the earlier shift towards more rapid and continuous technological change that occurred during the Industrial Revolution.

The Industrial Revolution saw an extraordinary number of radical inventions in many different sectors; but the most important, economically speaking, were in the textiles industry, metallurgy, and energy production.

Making textiles involves several stages of production. The raw fibre (for example wool, or raw cotton) is cleaned and prepared for spinning; the prepared fibre is then spun into yarn; the yarn is then woven into cloth; and the cloth can then be bleached or dyed. The most famous inventions involved spinning, traditionally carried out by women (known as spinsters, meaning female spinner, not older unmarried woman, as the term now means in English), and weaving, traditionally carried out by men. In 1733 John Kay invented the flying shuttle, which greatly increased productivity in weaving. This increased the demand for yarn, to the point where it became difficult for spinsters to produce sufficient quantities using the spinning wheel technology of the day. According to some, it now took five spinsters to supply the yarn needed by one weaver. Three famous inventions followed which increased productivity in spinning: James Hargreaves spinning jenny, Richard Arkwrights water frame, and Samuel Cromptons mule, which (as the hybrid animal for which it is named suggests) combined the best features of the previous two inventions. The spinning wheel had just one spindle, onto which the yarn was wound as it was spun; early spinning jennies had 12; Cromptons first mule had 48. Later inventors found ways of operating mules using animal, water or steam power. In the 1820s Richard Roberts invented the self-acting mule, which did away with the need for skilled and highly paid mule operators. By the 1890s mules had 1,320 spindles each. Eventually weaving was mechanised as well, and by the 1830s handloom weavers, who had enjoyed a golden age as a result of growing supplies of ever-cheaper yarn, were displaced by machines.

A major breakthrough in iron-making was Henry Corts development of the puddling process in 1784. This produced wrought iron, which was easily shaped and durable, far more efficiently than earlier techniques. Another key challenge was how to smelt iron ore using coal rather than charcoal (which was produced from wood). Abraham Darby solved the puzzle in 1709, smelting ore with coke (a form of purified coal), and the technique became widespread from the middle of the 18th century onwards.


Coal was also the key to the steam revolution. Thomas Newcomen developed a steam engine in 1712 to pump water from mines. James Watt began working on an improved design in 1765, and his engines were in commercial use by 1776. Steam engines were a typical invention of the period in many ways. They relied on developments in other areas, notably metallurgy: great designs would have been of no use without engineering skills and cheap supplies of the right sort of metal. They were gradually improved over a long period of time. And they were eventually used across the economy: not just in mining, but also in textiles, in other manufacturing sectors, and in the railways and steamships that drove the integration of the world economy in the 19th century. They are an example of what is termed a general purpose innovation or technology, which we will study in more detail in Unit 20.

The growing use of coal in metallurgy and energy production was crucial. Prior to the Industrial Revolution most of the energy used in the economy was ultimately produced by edible plants, which converted sunlight into food for both animals and people, or by trees whose wood could be burned or transformed into charcoal. More energy production meant less land available for food production: this was a world in which the available supply of land was a major constraint on production. This partly explains why the Malthusian model was a reasonable description of how the economy worked prior to 1800.

By switching to coal, humans were able to exploit a vast reserve of what is effectively stored sunlight. This allowed them to greatly expand production. For example, English coal production in 1800 yielded as much energy as would have been produced by burning the timber growth from 11 million acres of woodland: an enormous number, when you consider that the total English land area is just 32 million acres (13 million hectares). There is no way that the huge increase in production after 1800 could have been sustained using traditional energy sources. The cost has been that the switch to using fossil fuels has had major environmental implications, as we saw in Unit 1 and will return to in Unit 18.

2.5 EXPLAINING THE INDUSTRIAL REVOLUTION

why did these inventions, and many others, emerge when and where they did? This is one of the most famous and important questions in economic history, and historians continue to debate the issue.

As we saw in Unit 1 the Industrial Revolution did not lead to economic growth everywhere in the world. Because the Industrial Revolution originated in Britain, and spread only slowly to the rest of the world, it also implied a huge increase in income inequality between countries in the 19th and 20th centuries. One of the most famous


historians of the Industrial Revolution, David Landes, once asked Why are we so rich and they so poor? By we, he meant the rich societies of Europe and North America; by they he meant the poorer societies of Africa, Asia and Latin America. Landes suggested, a little mischievously, that there were basically two answers to this question:

One says that we are so rich and they so poor because we are so good and they so bad; that is, we are hardworking, knowledgeable, educated, well-governed, efficacious, and productive, and they are the reverse. The other says that we are so rich and they so poor because we are so bad and they so good: we are greedy, ruthless, exploitative, aggressive, while they are weak, innocent, virtuous, abused, and vulnerable.

If you think that the Industrial Revolution happened in Europe because of the Protestant Reformation, or the Renaissance, or the Scientific Revolution, or the development of superior private property rights, or favourable government policies, then you are in the first camp. If you think that it happened because of colonialism, or slavery, or the demands of constant warfare, then you are in the second.

You will notice that these are all non-economic forces that, according to some scholars, had important economic consequences. You can probably also see how the question of which of Landess two answers is right might become ideologically charged; although, as Landes points out, It is not clearthat one line of argument necessarily precludes the other. At the end of this unit there are some suggestions if you want to read more about this fascinating issue. For now, however, we will point out that the question of why the Industrial Revolution happened in Europe rather than in Asia, and in Britain rather than in France, might also have something to do with the simple economics of the relative cost of labour and other inputs and the way that this promoted technical progress (which obviously does not rule out the possibility that religion, culture, science, politics, oppression, geography, and warfare mattered as well).

One of the most important assumptions in economics is that people respond to economic incentives. Of course, in real life people are motivated by lots of factors: love, hate, sense of duty, desire for approval. But the desire for material comfort is definitely a prominent motive. When you are thinking about how people behave as workers, as the owners of firms, as shoppers, as citizens or simply as family members, it is always worth thinking about the economic incentives that we face and how they influence the choices we make.

When owners or managers of firms decide how many workers to hire, or when shoppers decide what and how much to buy, prices are going to be a crucial factor determining their decision. When deciding whether to shop in a neighbourhood convenience store, or in a discount supermarket, one obvious factor influencing your decision will be how prices compare in the two stores, as well as the costs of getting to the two stores. If prices are a lot cheaper in the discount store than in the corner shop and it is not too far away, this will be a good argument for shopping in the


former rather than the latter. Of course, not everyone will choose to do so, since there are other factors influencing where we shop: brand loyalty, convenience or snobbery, for example. But you would expect that if prices in the discount supermarket became a lot cheaper than prices in corner shops, then on average we would see buyers switch to the cheaper shops.

Note that it is not the price level in one shop or the other that matters, but the price level in one shop compared to the other. In other words, relative prices matter for the decisions of shoppers, or consumers, as we tend to call them in economic theory. If supermarkets lowered their prices, but the corner shops then lowered their prices proportionally in response, there would be no incentive for consumers to switch away from convenience stores.

Relative prices are simply the price of one option relative to another. We often express relative price as the ratio of two prices. We will see that they matter a lot in explaining not just what consumers decide to buy, but why firms make the choices that they do. For now we are interested in the choices made by inventors at the time of the Industrial Revolution, and in the subsequent choices of firms regarding whether or not they would implement the new industrial technologies described above.

What did inventions such as the spinning jenny do? As we saw, the first spinning jennies had 12 spindles. They therefore replaced 12 spinsters, working on 12 spinning wheels, with one machine operated by just one adult. Later spinning mules had a lot more spindles; more than a thousand by the late 19th century. They therefore replaced more than a thousand spinsters each with a much bigger machine operated by a very small number of people. These machines no longer relied on human energy. Early in the Industrial Revolution, many were powered by water wheels. As time went on, more and more were powered by steam engines using coal.

In other words, the old technology used a lot of workers, each worker using only a small amount of machinery and other equipment and non-labour inputs (the spinsters spinning wheel, for example). The new technology used a lot of what we call capital goods such as spinning mules, factory buildings, and water wheels or steam engines. They used a lot of coal and not much labour.

In the language of economics, the pre-Industrial Revolution technology was labour-intensive, while the new technology was capital- and energy-intensive. Another way to make the same point is to say that the new technologies of the Industrial Revolution were labour-saving, and capital and energy-using. In other words, this was an example of biased technological change: in this case a technological change that was biased towards using more capital and less labour.

Why would someone bother to invent such a technology and why would anyone want to use it, were it invented? We can guess that the main aim was to lower the cost of production in order to make more profits. But when would switching from a labour-intensive technology to a capital and energy-intensive technology lower costs? The


answer has to do with the relative costs of labour on the one hand, and of capital and energy on the other. The incentive to switch to the new technology would be high when workers were expensive and machinery and other capital equipment, and energy, were cheap: that is, when the relative cost of labour was high. There would be much less of an incentive to switch if wages were low and capital and energy were expensive. In other words the incentive to switch to the new technology would depend, among other things, on the relative prices of labour, capital, and energy.

Why Britain was such an inventive country is a complex question. But an important part of the answer is that there were many skilled workmen, engineers and machine makers who could build the machines that inventors designed. Looking at how relative prices differed among countries can help us understand why the labour-saving, capital- and energy-using technologies of the Industrial Revolution were invented in Britain rather than elsewhere, and first adopted in Britain rather than elsewhere.

Figure 5 shows the price of labour relative to the price of energy in various cities in the early 1700s. In other words, it shows the wages of building labourers divided by the price of energy (more precisely, the price of a million British Thermal Units (BTU), a unit of energy equivalent to slightly more than 1,000 joules). What you can see is that labour was very expensive relative to the cost of energy in England and the Netherlands. It was less expensive in France (Paris and Strasbourg), and a lot less expensive in China.

Wages were high in England, relative to the cost of energy, both because English wages were higher than wages elsewhere, and because coal was cheaper in coal-rich England than in the other cities in the diagram. Factors raising English wages

included its overseas trade, which sucked workers into bustling merchant cities, and productive agriculture. Coal was especially cheap in Newcastle and other northern cities close to coalfields; which is why the price of labour, relative to the price of coal, was so much higher there than in London. Wages were more expensive in London than in Newcastle, but coal was even more expensive.

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Source: Allen, R. C. 2009. The British Industrial Revolution in Global Perspective. Cambridge: Cambridge University Press, p. 140.


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Figure 6. Wages relative to the cost of capital.

Source: Allen, R. C. 2009. The British Industrial Revolution in Global Perspective. Cambridge: Cambridge University Press, p. 138.

Figure 6 shows trends in the cost of labour, relative to the cost of capital goods, in England, France and Austria from the late 16th to the early 19th century. It shows the wages of building labourers divided by the cost of using capital goods. This cost is calculated from the prices of metal, wood and brick, and the cost of borrowing, and takes account of the rate at which the capital goods wear out, or depreciate. As you can see, workers became steadily more expensive, relative to capital goods, in England; but the price of labour divided by the price of capital remained constant, or even fell, in France and Austria during the same period. In other words the incentive to replace workers with machines was increasing in England during this time, but the same was not true in the other two countries. In both France and Austria the incentive to save labour by innovating had been stronger during the late 16th century than it was 200 years later, at the time the Industrial Revolution began to transform Britain.

2.6 INNOVATION RENTS AND THE INTRODUCTION OF NEW TECHNOLOGY

figures 5 and 6 showed that the incentive to replace labour-intensive technologies with newer technologies that saved labour (and used capital and energy more intensively) was higher in England than in other countries, and had been increasing. The argument is summarised graphically in Figures 7 to 9. Together they


show how firm owners choose between technologies that are more or less labour-intensive, based on economic incentives; in particular, the cost of labour and other inputs.

Since the graphs are two-dimensional, the figures show the owners choosing between just two inputs, which we label as labour and energy. This is a simplification, just as when we explained diminishing returns by assuming that the only inputs to farming were land and labour. In fact, as we have discussed, there were three broad categories of inputs that mattered in the textile industry: labour, energy and capital.

Firm owners and managers care about the costs of machines, as well as labour and energy. But Figures 7 to 9, which simplify the problem to being one of choosing between labour and energy, give us a good idea of the choices that these firm owners faced, because technologies that used a lot of capital goods also used a lot of energy.

Imagine therefore that textiles are produced with just two inputs, labour and energy, and that there are two ways of producing 100 metres of cloth. The first, labelled A in Figure 7, uses the old technology. The second, labelled B in Figure 7, uses the new technology. We can see that it requires four workers and two tonnes of coal to produce 100 metres of cloth using the traditional technology but only one worker and 6 tonnes of coal once the new technology is introduced. So A is labour-intensive, and B is capital-intensive.

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Figure 7. Modelling a firm producing 100 metres of cloth.

You will notice that there are two L-shaped lines plotted on Figure 7, whose right angles occur at points A and B respectively. These two lines are known as isoquants. They give combinations of worker inputs and coal inputs that produce equal amounts of output, in this case 100 metres of cloth.

What does the fact that they are L-shaped imply? Take the old, labour-intensive technology at point A: four workers and two tonnes of coal produce 100 metres of cloth. The horizontal portion of the L-shaped isoquant implies that if you increase


the number of workers employed from four to five, but do not change the amount of coal that you are using, you will still produce only 100 metres of cloth. Indeed, no matter how many more workers you employ, you will still only produce 100 metres of cloth so long as you dont use more than two tonnes of coal. Indeed, no matter how many workers you employ, you will still only produce 100 metres of cloth so long as you dont use more than two tonnes of coal. Similarly, the vertical portion of the L-shaped isoquant implies that as long as you are only employing four workers, increasing the coal input from two tonnes to three or more would not have any impact on production.

In other words, the fact that this isoquant is L-shaped implies that this technology uses workers and coal in fixed proportions: four workers per two tonnes of coal. In later units we will see that not all isoquants are L-shaped, and that some technologies allow you to vary the ratio of workers to coal (or of any input to any other). For the purposes of this chapter, this is an unnecessary complication, and so we will stick with our assumption of fixed proportions.

What is the total cost of producing 100 metres of cloth? With just two inputs, the cost will equal the cost of hiring the workers, plus the cost of buying the necessary coal. Imagine that the cost of hiring a worker is 20, and that the cost of a ton of coal is 10. In other words, the price of a worker, relative to the price of a ton of coal, is (20/10) = 2. The cost of producing at point A will be 20 per worker, multiplied by four workers, plus 10 per ton of coal, multiplied by two tons of coal, or (20 x 4) + (10 x 2) = 100. Notice that if you hypothetically were to hire five workers and use no coal at all (that is to say, if you operated at point C on the graph), your cost of production would be (20 x 5) + (10 x 0) = 100, but there would be no production, because production requires coal. Notice also that if you used 10 tons of coal, and hired no workers (at point D), your total cost of production would also be 100, but also with no production, because production requires workers. More generally, the dashed line joining C and D, and going through point A, shows all the combinations of coal and workers that, if you bought them at these prices, would cost you 100. We call this dashed line an isocost curve, because costs of production are the same along it. Its slope is given by the height of point D, 10 tonnes of coal, divided by the horizontal length between the origin and point C, five workers: two tonnes of coal per workerignore the fact that the slope is negative. This is simply the price of workers expressed in tons of coal, or the relative price of workers; that is, hiring one worker is equivalent in terms of cost to using two tonnes of coal. LEIBNIZ 1 explains how you can find the slope of the isocost curve algebraically.

(If you want to get familiar with the notations used in our calculus supplements, or if you want to know why we used the name Leibniz for them, read LEIBNIZ 0.)


LEIBNIZ

For mathematical derivations of key concepts, download the Leibniz boxes from www.core-econ.org.

Now we turn to Figure 8 to show the effect on the firm of switching to the new technology. The firm starts in the same position as it did in Figure 7, producing at point A with total costs of 100. The advance in technology makes it possible to produce the same amount of cloth cheaper by switching to the new isoquant and producing at point B.

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Figure 8. The rents from switching to the new technology.

Figure 8 shows a new isocost curve EF, through point B. As you can see, this isocost curve is parallel to the first one, but closer to the origin. It has the same slope, which tells you that we assume that relative prices are the same as before, but the fact that it is drawn closer to the origin tells you that total costs along this isocost line are lower than total costs along the first isocost line. How much lower? Total costs at point E are (20 x 4) = 80; total costs at point F are (10 x 8), and of course this is also equal to 80 (because E and F lie on the same isocost line). Therefore, the total cost of producing 100 metres of cloth using the new labour-saving and coal-using technology at point B is (20 x 1) + (10 x 6) = 80: the new technology is cheaper than the old one, at these prices of labour and coal.


By reducing its costs of production from 100 to 80 per 100 metres of cloth, the first firm to introduce this new technology will see its profits increase by 20 for every 100 metres of cloth it produces. These extra profits are called economic rents, meaning a payment received above your next best alternative, which in this case means producing using the old technology. Notice that this use of economic rent is different from the everyday usage, where rent is the payment by someone else to the owner of land or a house for the use of it. We will see in later units that economic rents are important to the functioning of a capitalist economy in other areas, for example in the prices set by monopolists (Unit 7) and in the wages offered to workers (Unit 6).

The prospect of earning these rents is what motivates firm owners to introduce the new technology. The first adopter is called an entrepreneur. When we describe a person or firm as entrepreneurial, it refers to a willingness to try out new technologies and to start new businesses. The economist Joseph Schumpeter (see below) made the adoption of technical improvements by entrepreneurs a key part of his explanation for the dynamism of capitalism. Sometimes the extra profits made by innovators are termed Schumpeterian or innovation rents.

PAST ECONOMISTS

JOSEPH SCHUMPETER

Joseph Schumpeter (1883-1950) was born in Moravia, then part of the Austro-Hungarian Empire, and was educated in Vienna. After a varied career including spells as a politician and a banker he moved to the US in 1932, where he taught for many years at Harvard. He is best known for his view that capitalism involves a continual process of what he called creative destruction, with new innovations displacing older ways of doing things.

Rents will not last forever: other firms noticing the rents accruing to the first adopters will introduce the new technology; as they do so, they will also reduce their costs. As more firms introduce the new technology, the price of cloth will start to fall; costs of production are still lower, but so is the price of the firms output. The price of coal may also rise due to the increased demand from the firms now using the new energy-intensive technology. This process will continue until everyone is using the new technology, at which stage prices will have declined to the point where no one is earning innovation rents.


Is the new technology always cheaper? No. Assume that the cost of hiring a worker is 10 rather than 20, and that the cost of a tonne of coal is 20 rather than 10. In this case the relative price of workers, expressed in tonnes of coal, is 10/20 = 0.5, rather than 2, in the previous example. We show the effect this has on the firms decision to switch to the new technology in Figure 9.

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Figure 9. The decision to switch to the new technology depends on the relative prices of labour and energy.

We start with the same isoquants as in Figures 7 and 8; the combinations of worker inputs and coal inputs that produce 100 metres of cloth have not changed just the relative prices of the inputs. The change in relative prices affects the isocost line; the isocost line corresponding to point A is now the dotted line joining C and D, whose slope is, as expected, 0.5. Costs at C are equal to (10 x 8) = 80. Costs at D are equal to (20 x 4) = 80. Costs at A are (10 x 4) + (20 x 2) = 80. Although we havent plotted the isocost line going through point B, you can see that B lies further away from the origin than the isocost line joining C and D, and that producing at B must therefore cost more than 80. In fact, producing at point B, at these prices, costs (10 x 1) + (20 x 6) = 130.

What have we learned? If isocost lines are steep, like CD in Figures 7 and 8, then the new technology is cheaper to use than the old one. If they are flat, like CD in Figure 9, then the old technology is cheaper. But the slope of the isocost line is simply the relative price of labour in terms of coal, or if you prefer, the wage rate divided by the price of a tonne of coal. So if wages are relatively expensive (isocost lines are steep), you will prefer the new technology. This makes sense, since the new technology uses relatively little labour and a lot more coal. If wages are relatively cheap (and coal is therefore relatively expensive; isocost lines are flat), you will prefer to stick to the old technology, which uses a lot of cheap labour and relatively little expensive coal.


As we saw in Figure 5, England was a high-wage, cheap-energy country, and so it makes sense that the energy-using, labour-saving technologies of the Industrial Revolution were first used there. But what might have been a cheaper technology in England was not necessarily a cheaper technology in China, or even France: wages were lower there and energy was more expensive. In terms of Figures 7 to 9, these other countries had flat isocost lines (look at CD in Figure 9 for an example), and this meant that the old technologies were more profitable than the new ones. It makes sense, therefore, that these new technologies were adopted first in England. This meant that, during the early years of the Industrial revolution, technology advanced more rapidly in England than on the continent of Europe, and even more rapidly than in Asia. This, in turn, led to British living standards pulling further ahead of those in the rest of the world.

What explains the eventual adoption of these new technologies in countries like France and Germany, and ultimately China and India? One answer is further technological progress, which reduces the cost of using the new technology. Technological progress would mean that it would take smaller quantities of inputs to produce 100 metres of cloth. Once the new technology had advanced far enough it would be profitable to switch to it even in a low-wage, expensive-energy economy. A second factor that promoted the diffusion of the new technologies was wage growth and falling energy costs (due for example to cheaper transportation, allowing countries to import energy cheaply from abroad). This made isocost lines steeper in poor countries. Either way, the new technologies started to spread, and the divergence in technologies and living standards was eventually replaced by convergenceat least among those countries in which the capitalist revolution had taken off.

2.7 CONCLUSION

in the pre-industrial economy the real wages of ordinary workers rose slowly, if at all. This can at least partly be explained by Malthusian economic theory: any increases in real wages above subsistence level were eventually eroded by the combination of rising population and diminishing returns. Diminishing returns were an important feature of the pre-industrial economy because land supplies were an important constraint on total production.

The new technologies of the Industrial Revolution ushered in a new era of growth. More rapid and continuous technological change allowed average living standards to rise permanently above subsistence level. Food came to occupy a smaller fraction of peoples consumption and, as a result, employment shifted away from farming into the production of clothing and other manufactures. These made much less use


of land, as opposed to capital goods and coal. This meant that land became a less important constraint on production, weakening the grip of diminishing returns on living standards. It also led to a decline in land rents relative to wages which started late in the 19th century, as we showed in Figure 3.

Britain was the first country to industrialise and escape the Malthusian population trap. There are many possible reasons for this, which you can discuss.

WHEN ECONOMISTS DISAGREE

WHAT WERE THE CAUSES OF THE INDUSTRIAL REVOLUTION?

The argument that Britain adopted labour-saving, and capital- and energy-using technologies before the rest of the world because it was a high-wage and low-energy-cost economy has been made by Robert Allen. He talks about one example in the video below, and the most accessible introduction to his work is his book Global Economic History: A Very Short Introduction.

But, like most arguments concerning the causes of the Industrial Revolution, Allens is controversial. Joel Mokyr, who has worked extensively on the history of technology, claims that the real sources of technological change are to be found in Europes scientific revolution and Enlightenment, and in the skilled artisans who made it possible to build the machines of the period. He claims that, while relative factor prices might tilt the direction of invention in one direction or another, they are more akin to a steering wheel than to the motor of technological progress.

According to a similarly controversial argument by David Landes, Europe pulled ahead of China for cultural and institutional reasons. The Chinese state was too powerful, he argued, and stifled innovation, while Chinese culture favoured stability over change.

Kenneth Pomeranz claimed that superior European growth after 1800 was more due to the abundance of coal in Britain than to any cultural or institutional differences with China. Pomeranz also claimed that access to the vast land in the British colonies in the New World allowed Britain to escape the constraints imposed by diminishing returns to land.


Is the debate resolved? Scholars will probably never completely agree about what caused the Industrial Revolution, and the great divergence between Europe and the rest of the world that it gave rise to. One problem is that this change happened only once, and it is more difficult for social scientists to explain one-offs. Another problem is that, as most scholars agree, the European take-off was probably the result of a combination of factors: scientific, demographic, political, geographic, military, and so on. Several argue that it was partly due to interactions between Europe and the rest of the world too, not just to changes within Europe.

Historians tend to focus on peculiarities of time and place. They are more likely to conclude that the Industrial Revolution happened because of a unique combination of favourable circumstances (they may disagree about which ones). Economists are more likely to look for general mechanisms that can explain success or failure across both time and space. Economists have much to learn from historians, but they often find their arguments are not precise enough to be testable hypotheses. Some historians may regard the economists explanations as simplistic and insufficiently informed by historical facts. This creative tension is what makes economic history so fascinating.

While there will always be these debates, economic historians have made progress in recent years in quantifying economic growth over the very long run. By making it clearer what happened, their work makes it easier for us to think about why it happened. Some of the work involves comparing real wages in countries over the long run. This has involved collecting both wages and the prices of goods that workers consumed. An even more ambitious series of projects has calculated GDP per capita back to the middle ages.

Several scholars have written reviews of each others books, which are easily accessible on the internet. For example, search for Gregory Clark review Joel Mokyr or Robert Allen review Gregory Clark to see how one researcher reviews the work of another.

Other countries in northwest Europe, such as Belgium and Germany, soon followed. From Figure 1 in Unit 1 we can see that Japan and Italy took off about a century after Britain, with China and India following about 100 years afterwards, each taking a slightly different escape route. The national trajectories of the early followers were influenced in part by the dominant role that Britain had come to play in the world economy. Germany, for example, could not compete with Britain in textiles; but the government and large banks played a major role in building steel and other heavy industries.


DISCUSS 4: WHY DID THE INDUSTRIAL REVOLUTION NOT HAPPEN IN ASIA?

Use the readings at the end of the unit to discuss why the Industrial Revolution happened in Europe rather than in Asia, and in Britain rather than in Continental Europe. Which arguments do you find most persuasive, which arguments do you find least persuasive, and why?

For the early followers, and for many who caught up later, the escape from Malthusian stagnation was possible because of an economic systemcapitalismthat granted substantial rents to those who first adopted new technologies. There was also a backlog of innovation, first from Britain and later from the first followers, who had become leaders in different industries. Remember also that in Unit 1 we discussed how, in the Soviet Union, an economic system with very different institutions achieved industrialisation using central planning, and why it was later abandoned. In Unit 17 we will also explore the role played by international tradeglobalisationin the adoption of new technologies and the growth of living standards.


UNIT 2 KEY POINTS

1. Malthusian economics uses the principle of diminishing returns to predict that, as the population in a fixed area of land increases, the output obtained by each successive worker will decline. The average output per worker will fall, and living standards will decline as a result.

2. In the long run, in a Malthusian economy the response of population to changes in living standards drives them down to a subsistence level, at which they remain constant.

3. The Malthusian trap: a new technology increases income by raising the output per worker. Increasing real wages above the subsistence level leads to population growth and labour abundance. The reduced level of output per worker and diminished bargaining power of the poor drives real wages back down to subsistence levels.

4. By the end of the 19th century rich countries escaped from the trap. Continuous technological progress had created a durable increase in living standards. Eventually, as people gained higher incomes, many chose to have smaller families too resulting in the demographic transition.

5. In Britain the escape was made possible by labour saving innovations such as the spinning jenny and the steam engine, which were continuously and rapidly improved.

6. The entrepreneurs who first introduced these innovations received innovation rents which eventually were competed away as the innovations were also adopted by competitors, raising the labour productivity in the entire economy and leading to a wider sharing of the benefits of technical progress.

7. There are many explanations for why the Industrial Revolution happened in Britain and Europe first, but economic incentives played a part: in Britain, labour was comparatively expensive compared to energy. As a result there was an incentive for British capitalists to capture innovation rents by adopting labour-saving technology to lower the cost of production.


UNIT 2: READ MORE

2.1 MALTHUSIAN ECONOMICS

The Black Death and the transformation of the westDavid Herlihy argues that the Black Death transformed Europe.Herlihy, D. 1997. The Black Death and the Transformation of the West, Cambridge, MA: Harvard University Press.

2.3 WAGES AND LAND RENTS IN A MALTHUSIAN ECONOMY

Malthusian models and Chinese realitiesJames Lee and Wang Feng discuss ways in which Chinas demographic system differed from Europes, and question the Malthusian hypothesis that Chinese poverty was due to population growth.Lee, J. and Feng, W. 1999. Malthusian models and Chinese realities: the Chinese demographic system 1700-2000, Population and Development Review 25(1), pp. 33-65.

Gifts of MarsNico Voigtlnder and Joachim Voth use this logic to argue that the gradual rise in European living standards between 1500 and 1800 was due to the widespread war of the period: LINK.Voigtlnder, N. and Voth, H. 2013. Gifts of Mars: Warfare and Europes Early Rise to Riches. Journal of Economic Perspectives 27(4), pp. 165-186.

2.5 EXPLAINING THE INDUSTRIAL REVOLUTION

Why are we so rich and they so poor?The full text of David Landess lecture: LINK.Landes, D. 1990. Why are we so rich and they so poor?, American Economic Review 80(2), pp. 113.

2.7 CONCLUSION

Global economic historyA short and accessible introduction to the topic of why some nations are rich, and others poor.Allen, R. 2011. Global Economic History: A Very Short Introduction, Oxford: Oxford University Press.


Understanding growth in EuropeThis chapter provides an excellent introduction to the disagreements:Mokyr, J. and Voth, H. 2010. Understanding growth in Europe, 17001870: theory and evidence. The Cambridge Economic History of Modern Europe, Vol. 1: 1700-1870 (Eds, Stephen Broadberry. and Kevin ORourke). Cambridge: Cambridge University Press, pp. 7-42.

Why Europe and the West? Why not China?David Landes argues that economies in Europe and the West initially grew much more quickly than in China for cultural reasons: LINK.Landes, D. 2006. Why Europe and the West? Why not China?, Journal of Economic Perspectives 20(2), pp. 322.

The great divergenceKenneth Pomeranz argues that Europe benefitted from coal and colonisation.Pomeranz, K. 2000. The Great Divergence: China, Europe, and the Making of the Modern World Economy. Princeton: Princeton University Press.A short article by Stephen Broadberry on reconstructing historical population and GDP data to measure the great divergence: LINK.Broadberry, S. 2013. Accounting for the great divergence. Voxeu.org, 16 November 2013.RE

Technological change and industrial development in Europe Landes, D. 1969. The Unbound Prometheus: Technological Change and Industrial Development in Europe from 1750 to the Present, Cambridge: Cambridge University Press.

Energy and the English industrial revolutionWrigley, E. 2010. Energy and the English Industrial Revolution. Cambridge University Press, Cambridge, UK.

The intellectual origins of modern economic growth: LINKMokyr, J. 2005. The intellectual origins of modern economic growth. The Journal of Economic History, 65(02), pp. 285-351.

The institutional origins of the industrial revolution: LINKMokyr, J. 2008. The institutional origins of the industrial revolution. Institutions and economic performance, pp. 64-119.

The spinning jenny in Britain, France, and India: LINKAllen, R. 2009. The industrial revolution in miniature: The spinning jenny in Britain, France, and India. The Journal of Economic History, 69(04), pp. 901-927.

This work is licensed under the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International License. To view a copy of this license, visit http://creativecommons.org/licenses/by-nc-nd/4.0/ or send a letter to Creative Commons, 444 Castro Street, Suite 900, Mountain View, California, 94041, USA.

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