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Economics and physical reality

Thermodynamics and Economics
Dietmar Lindenberger    (Institute of Energy Economics, University of Cologne, Germany)
Reiner  Kümmel   (Institute of Theoretical Physics, University of  Würrzburg,  Germany)

Since Georgescu-Roegen´s statement on entropy, there has grown a vast literature on the implications of the laws of thermodynamics for economics. Most of this literature is related to the environmental consequences of the 2nd law, i.e. that any economic activity unavoidably causes pollution1. This important insight could, at least to some extent, be integrated into (environmental) economic theory. Other implications of thermodynamics will probably be more difficult to be incorporated into the prevailing neoclassical framework, if this is possible at all. An example is the notion of irreversibility, which implies at least some sort of non-equilibrium. A corresponding micro-economic modelling approach was proposed recently in this journal [1]. Another example is discussed in the following. We address the issue of appropriately including  the indispensable production factor energy into macro-economic theories of production and growth, and try to draw some conclusions.

In conventional neoclassical theory the production factor energy is either neglected altogether, which is inconsistent with thermodynamics, or attributed only marginal importance. The argument is that energy's share in total factor cost is small compared to the cost shares of labor and capital. However, the recessions after the oil price crises in 1973/74 and 1979/81 have posed the question how a production factor of monetarily minor importance can have such grave economic consequences.

The conventional view of the low economic importance of energy dates back to the first stages in the development of neoclassical economic theory. Initially, the focus was not so much on the generation of wealth, but on its distribution and the efficiency of markets. Consequently, the early thinkers in economics started with a model of pure exchange of goods, without considering their production. With a set of assumptions on rational consumer behavior it was shown that through the exchange of goods in markets an equilibrium results in which all consumers maximize their utility in the sense that it is not possible to improve the situation of a single consumer without worsening the situation of at least one other consumer (Pareto optimum). This benefit of (perfect) markets is generally considered as the foundation of free-market economics. It shows why markets, where "greedy" individuals meet, work at all. But later, when the model was extended to include production, the problem of the physical generation of wealth was coupled inseparably to the problem of the distribution of wealth, as a consequence of the model structure: Since the neoclassical equilibrium is characterized by a (profit-maximizing) optimum in the interior -and not on the boundary- of the region in factor space accessible to the production system according to its state of technology, factor productivities had to equal factor prices. In the resulting production model the weights with which the production factors contribute to the physical generation of wealth, i.e. the elasticities of production, have to equal the factor cost shares. These cost shares, in the industrialized countries, are typically 0.7 (labor), 0.25 (capital) and 0.05 (energy).

Consequently, according to the neoclassical model, the elasticities of production of the factors, which -roughly speaking- measure the percentage of output growth if a factor input increases by one percent, would have to have these values: labor 0.7, capital 0.25, and energy 0.05. With these input weights a decrease of energy utilisation of up to 7%, as observed during the first oil crisis between 1973 and 1975, could explain a decrease of value added of only 0.05(7% = 0.35%. The actually observed decreases of economic output,
however, were roughly ten times larger.

Furthermore, a substantial part of observed long-term economic growth cannot be explained by the growth of the factor inputs, if these are weighted by their cost shares. Large residuals remain. In most cases the residuals play a more important role than the explanatory factors, which, according to Gahlen, makes the neoclassical theory of production tautological [2]. Solow, after noting " is true that the notion of time-shifts in the [production] function is a confession of ignorance rather than a claim of knowledge'' [3], comments: "This ... has led to a criticism of the neoclassical model: it is a theory of growth that leaves the main factor in economic growth unexplained'' [4].

As it has been shown recently, the residuals of neoclassical growth theory can mostly be removed by taking into account the production factor energy appropriately [5-11]. It turns out that the crucial point is to drop the neoclassical equilibrium assumption, and to determine the elasticities of production of the factors by purely technological and empirical considerations instead. Thereby, the previously unexplained technological progress reveals its two principal elements: The first one is the activation of the increasingly automated capital stock by energy; and, of course, the people who handle capital have to be qualified appropriately. The second one consists of improvements of organizational and energetic efficiencies of the capital stock. The short-term impact of the first element is much bigger than that of the second element, but the reverse may be true for the long-term impact, if efficiency improvements fundamentally change the course of economic evolution [11]. The efficiency improvements are identified by shifts of the corresponding technology parameters in the production functions, whereas energy's high productive power in increasingly automated production processes is revealed by its high elasticity of production: Energy's elasticity, in industrial sectors of the economy, is typically of the order 0.5, i.e. as large as those of capital and labor together. In service sectors it still exceeds energy's low cost share significantly [7]. Both in industrial and service sectors, labor's elasticity is far below its cost share. Only in the case of capital, do elasticities of production and cost shares turn out to be roughly in equilibrium, as neoclassical theory presupposes.2

What are the consequences of these findings? Let us frame one selected point as follows. If wealth had been distributed according to the "marginal productivity theory", labor would have received only a share of national income much smaller than the observed 70%. But apparently, in the past most of the value added by energy was attributed to labor. The underlying mechanism of distribution was that of wage-negotiations in which free labor unions, powerful during times of high employment, regularly succeeded in winning wage increases according to the growth of productivity, i.e. increased production due to increased and more efficient energy utilization. This way most of the population in the industrialized countries benefited from the wealth generated by the production factors capital, labor, and energy.

With increasing automation in production, however, human routine labor becomes more and more dispensable. A possible consequence is the increasing inequality in the distribution of income, as can be observed in the US, where, due to flexible labor markets, the hours worked per year have increased, but the problem of the "working poor" remains unsolved. Consequently, if society wishes to organize labor markets more competitively, while socially unacceptable distributional effects are to be avoided, the question arises how the institutional settings within market-economies have to be adapted to the changing technological conditions.

Certainly, increased investments in education and the design of appropriate labor market and social policies are crucial issues. Here, let us address the issue of how such policies may be financed in a sustainable way. In the past the financial burden resulting from social policies was mainly put on the production factor labor. This is one of the causes of the identified disequilibrium between the cost shares and productive powers of labor and energy, which, in turn, accelerates technical progress towards increasing automation. If this disequilibrium is sufficiently steep, the newly emerging and expanding sectors of the economy will no longer be able to compensate for the losses of jobs due to increased automation in the existing industries, thus destabilizing the system as a whole. Therefore, in view of social and fiscal stability, it might be worthwhile to consider a shift of taxes and levies in the industrial countries in such a way that the production factors labor and energy are burdened more according to their productive contributions to value added.

1.  I.e., the emission of heat and substances into the environment due to entropy production.
2.  The production systems are operating in boundary cost minima in factor space, where the boundaries, at a
given point in time, are established by the state of technology in information processing and automation and
prevent the system from sliding at once into the absolute
cost minimum of nearly vanishing labor input.

[1] Martinás, K., "Is the Utility Maximization Principle Necessary?", post-autistic economics review, issue no. 12,
March 15, 2002, article 4 and references therein,
[2] Gahlen, B., Der Informationsgehalt der neoklassischen Wachstumstheorie für die Wirtschaftspolitik, J.C.B.
Mohr, Tübingen, 1972.
[3] Solow, R. M., Investment and Technical Progress, in: Mathematical Methods in the Social Sciences,
K.J. Arrow, S. Karlin, and P. Suppes (Eds.). Stanford, 1960, p. 89-104.
[4] Solow, R.M., Perspectives on Growth Theory, Journal of Economic Perspectives 8, 1994, p. 45-54.
[5] Kümmel, R; Strassl, W.; Gossner, A.; Eichhorn, W., Technical Progress and Energy Dependent Production
Functions, Journal of Economics 45, 1985, p. 285-311.
[6] Beaudreau, B.C., Energy and organization: growth and distribution re-examined, Westwood (CT),
reenwood Press, 1998.
[7] Lindenberger, D., Wachstumsdynamik industrieller Volkswirtschaften - Energieabhängige
Produktionsfunktionen und ein faktorpreisgesteuertes Optimierungsmodell, Metropolis-Verlag, Marburg, 2000.
[8] Ayres, R.U., The minimum complexity of endogenous growth models: the role of physical resource flows,
in: Energy - The International Journal 26, 2001, p. 817-838.
[9] Ayres, R.U., Warr, B., Accounting for growth: the role of physical work, in: Reappraising Production Theory,
Workshop of the Max Planck Institute for Research into Economic Systems, Jena, 2001.
[10] Hall, C; Lindenberger, D.; Kümmel, R.; Kroeger, T; Eichhorn, W. (2001), The Need to Reintegrate the
Natural Sciences with Economics, BioScience 51 (8), 2001, 663-673.
[11] Kümmel, R.; Henn, J.; Lindenberger, D., Capital, Labor, Energy and Creativity: Modelling Innovation
Diffusion, Structural Change and Economic Dynamics, 2002 (in press),   (fields of research, Ref. 14).

Dietmar Lindenberger and Reiner Kümmel, "Thermodynamics and Economics", post-autistic economics review,
issue no. 14, June 21, 2002, article 1.

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