Groucho Marxism

The most ubiquitous economic metric is Gross Domestic Product, or GDP, which is a measure of the total value of goods and services produced by a country. There are two ways of calculating GDP: the ‘income approach’ and the ‘expenditure approach’ (there is also a third way – the ‘production approach’ – but that need not concern us here). Using the income approach, nominal GDP, Y, is equal to total labour costs, L, plus total profits, H: in symbols, Y = L+H. Here, total labour costs represents the total remuneration to employees for work done, including both wages (in the usual sense of the term) and salaries. Conversely, ‘total profits’ represents any income derived otherwise, including profits (again, in the usual sense), rent, and interest. Both total labour costs and total profits are gross quantities, so include taxes.

Wages and profits are nominal values measured in terms of money; but GDP is a real value measured in terms of goods and services. Real values are converted to nominal values using a price index or price level. Denoting real net output by y and the overall price level by p we can write: py = L+H. Rearranging this formula gives an expression for the price level: p = (L/y)(1+H/L). To break this down further we need to understand where wages and profits come from. For labour costs this is easy: people earn wages by working, so total labour costs are equal to the overall level of employment – that is, the total time spent working – denoted here by u, multiplied by the price of labour – that is, the average wage – denoted here by w: L=wu.

To understand where profits come from, we need to use the so-called Kalecki profit equation, named after the Marxist economist Michał Kalecki. The Kalecki profit equation is derived using the expenditure approach to calculating GDP. Using this approach, nominal GDP equal to the total of consumption, C, investment, I, government spending, G, and net exports, N: in symbols, Y = C+I+G+N. Calculating GDP in this way gives the same result as calculating GDP using the income approach, as we did above. This is due to the circular flow of the economy: one person’s spending equals another person’s income, and vice-versa. We can therefore substitute in the equation for GDP using the income approach (see above) to give the following formula: L+H = C+I+G+N.

Moving total wages to the right-hand side yields the following expression for total profits, where, for reasons that will shortly become clear, I have split total consumption C into consumption out of wages, C_L, and consumption out of profits, C_H: H = C_L+C_H+I+G+N–L. Now, workers can use their wages for one of three things: consumption, saving, and paying taxes. It follows from this and the equation above (after doing a little bit of algebra – note that consumption from wages cancels out) that the following holds, where S_L is saving out of wages and T_L is total taxes on wages: H = C_H+I+G+N–T_L–S_L. We have just derived the Kalecki profit equation. The truth of this equation is not in question as it is based on macroeconomic accounting identities.

What is in question is the direction of causality: do profits determine the quantities on the right-hand side, or do the quantities on the right-hand side determine profits? According to Kalecki, the causality runs right-to-left: aggregate profits are always determined by the quantities on the right-hand side of the Kalecki profit equation. This seems paradoxical. If investment and consumption out of profits increase then you would think that this would cause profits to decrease, and vice-versa. However, although this is obviously true for an individual firm, it is not true for the firm sector as a whole, as the investment and consumption of one firm become the profits of another. This highlights a key difference between capitalists and workers.

Whereas workers have to earn money by selling their labour-power for a wage, capitalists as a class essentially determine their own income. As Kalecki put it: workers spend what they get, and capitalists get what they spend. In fact, the capitalist class also determines the price level indirectly through its investment and consumption decisions. Recall from above our simple expression for the price level p: p = (L/y)(1+H/L). Let us denote the time spent per unit of production – that is, the inverse of labour productivity – by v, so that: u = vy. In Marxian economics, the quantity v is referred to as the value of labour. Then, as L = wu, we have: L = vwy. Substituting this into our equation for the price level gives: p = vw(1+H/wu).

What does this mean in English?! In brief, it means the price level depends positively on total profits, the average wage, and the value of labour, and negatively on the level of employment. Again, the truth of this equation is not in doubt as it is based on macroeconomic accounting identities. At this point it is helpful to think about how firms set prices. There is a large body of evidence suggesting that firms set prices by adding a fixed percentage, known as a mark-up, on top of the cost of a unit of product. We can therefore write: p = vw(1+m), where r denotes the average mark-up for the whole economy. Equating the two expressions for the price level gives: m = H/wu. Thus, if prices are set using a mark-up over wages then the average mark-up must be equal to the ratio of total profits to total wages.

We have already seen that total profits are determined by the quantities on the right-hand side of the Kalecki profit equation. Thus, the capitalist class as a whole determines the average mark-up, and therefore the price level, through its investment and consumption decisions. So the next time prices go up, you know who to blame!